By Ramsey Su
Housing is a very important component of any economy, and often an indicator of the well-being of a society. In the US, housing has been deteriorating since the sub-prime crisis. The changes are not only cyclical, but structural. Past experiences need to yield to an objective analysis of where we are heading. Here is the way I see it.
Ten years ago, mortgage financing was a free-for-all. Nonexistent underwriting guidelines with over 100% LTV, limitless debt-to-income ratios, no verification, no documentation, no qualification and no income resulted in a manufactured peak for real estate prices. Home sales and construction were at historical highs, with total disregard for underlying demand. Is this the desired housing market? Should a return to that era be considered a recovery? Of course not, and yet, that is exactly what the market and policymakers are striving for.
S&P/Case-Shiller Home Price Indexes
Defining a Healthy Real Estate Market
Real estate is basically shelter, a utility. Once upon a time, in most parts of the world, the rich and powerful lived in castles, palaces and mansions, while the peasants had a simple roof over their heads. In the modern world, shelter has become a form of entitlement, and per the United Nations, a human right. Right of ownership, at least in principle, is guaranteed by respective governments and was not granted by monarchs or rulers of the day. Under these circumstances, how do you measure the health of a real estate market?
For a capitalistic free market society where the right of enjoyment is protected, here is the way that I would define healthy market conditions:
Every household should be able to afford a minimal standard for shelter, a roof under which there are the basic utilities such as running water, sewer, electricity, high speed internet connection, etc. Affordability is best measured by housing costs as a percentage of household income, at the entry level.
There is little need to look beyond the entry level, because a healthy market at the bottom level would provide support for trade-up levels. The health of housing should be measured at this entry level, and not by the price of million-dollar penthouses in Manhattan.
Using this definition, housing in the US is decaying, and not in a recovery. Prices should be coming down instead of going up. Housing expense for the entry level, as a percentage of household income, has been going up. Hence the question - should we strive for more sales, more new construction, higher prices, or should we seek a healthy market where housing costs do not consume a disproportional share of household income?
Price increases without corresponding income increases aren't a positive sign. The same is true for rentals. Income inequality is manifesting itself in housing. If compounded by other forms of inequality, the consequences may not be something we are prepared for.
There are three major forces that hinder recovery:
1. Beating a Dead Horse - the Fed
Every time I look at housing, the Federal Reserve jumps out as the great destroyer. Here is a simple example. Say, we have a housing market where the median price of a starter home is 3X that of the annual income of a starter household. Now, the Fed decides to manipulate interest rates, resulting in a higher price of 5X annual income, but because of the lower rates, debt service payments remain the same.
The Fed may call this a recovery, but these households are paying a higher price for the same house, taking on a much higher debt amount, but are tricked into believing things are similar to before, because their monthly payments are identical. Is this a good thing? Why would any policymaker want to inflate an asset by manipulating rates so borrowers have to take on higher amounts of debt just to buy the same unit of enjoyment?
Mortgage-backed securities held by the Federal Reserve System - the Fed's interventionist policies have led to economy-wide price distortions, but the real estate market has been affected more than many other sectors.
2. Secondary Market For Mortgages - the Agencies
Equally guilty as the Fed are the agencies Freddie and Fannie, now in their 7th year under conservatorship of the Treasury. These once quasi-private organizations are now a permanent arm of the government. They pretend to do good, but in reality, these agencies are promoting home ownership at unaffordable levels of debt.
95% financing at an over-50% debt-to-income ratio is a trap. Fortunately, the masses are not as stupid as the policymakers had hoped for. Still smarting from the sub-prime spanking a decade ago, consumers are not in a hurry to jump back into the fire, in spite of unprecedented QE by the Fed and overly accommodating lending practices by the agencies. See the latest survey from Fannie Mae: Americans' Outlook on the Home Selling Market Cools amid Economic and Financial Concerns.
Policymakers have swung from no regulation to over-regulation, starting with the Consumer Finance Protection Bureau. The industry fears "TBD regulation" the most. TBD describes regulation "to be determined" in the future, if the real estate market repeats another down cycle.
This fear is preventing the industry from innovating and creating new products to meet changing needs. Regulations also extend to all areas of housing, from tenant/landlord laws, to permits, to property taxes, fees, etc. Yes, many of these are necessary, but the inefficient administration of each of these bureaucratic obstacles adds to the cost of housing, directly and indirectly.
The somewhat ominous-looking CFPB logo
Real estate is a long-term hold, either as a home or as an investment. The lack of a solid foundation is worrisome. In closing, I would like to offer a few articles of interest below, pertaining to debt and the housing market. Have fun reading them.
The first one is from Black Knight, previously known as LPS. The rise in non-mortgage-related debt is alarming.
The second on is from PEW charitable trusts. It offers some interesting data on debt. The Complex Story of American Debt.
Finally, from Fannie Mae, this is a real hype piece with very shaky data: Invisible Equity: Do Homeowners See How Much Home Equity They Are Sitting On?
(Charts by: Standard & Poor's, St. Louis Federal Reserve Research)