Over the past year U.S. mortgage rates have risen from sub-3% to over 7%. Unsurprisingly the nation’s real estate market is swooning; home sales are plummeting, inventories of new homes for sale are rising sharply and we are already starting to see signs that home prices are falling. Little doubt that most people over the age of 30 are suffering from some level of PTSD, remembering the economic carnage that came after the last collapse of the real estate market in 2007-08.
This real estate cycle and the last have similar roots — they were both created by bad policy on the part of the Federal government. The one bit of good news is that the underlying malfeasance in each cycle was completely different. Last time government policymakers did far too little, while this time it is fair to say they have done vastly too much. Ultimately, this means that this real estate cycle will have a much smaller negative impact on homeowners and thus the broader economy than the last one did.
The real estate cycle that generated the ‘Great Recession’ started with one of the greatest snake oil inventions ever dreamed up by Wall Street: the subprime mortgage-backed security. Regulators, believing in the economic myths of efficient markets and rational investors, sat idly by as trillions of dollars flowed into the housing market without any basic underwriting standards. The U.S. economy was overheated by the flood of bad debt and asset prices rose to unsustainably high levels driving both excessive consumer spending and housing investment. As with all pyramid schemes, this one eventually collapsed in on itself leading to a massive financial market mess, collapsed household net worth, and a recession that took over 8 years to fully recover from.
This time around the issue with regulators is not a lack of action, but rather too much. The Covid pandemic was a tragic human event but was never the existential economic crisis it was made out to be by too many economists and pundits. The result was one of the most preposterous overuses of stimulus ever experienced — in two short years the nation saw an enormous increase in Federal outlays funded by $6.5 trillion in fiscal borrowing. This was, in turn, funded by $5 trillion in new money delivered by the Fed in the form of quantitative easing despite the fact that the pandemic did not create any major financial problems. As a result, all this stimulus went straight into the money supply, and M2 ended up increasing by 50% in two years, faster than we’ve ever seen before.
When the money supply is expanded so dramatically and so quickly there is little mystery as to what happens — economists have studied such episodes since the very beginning of the social science’s existence two centuries ago. At first, because of money illusion, the excess liquidity creates a surge in economic activity—interest rates fall, asset prices rise, and consumer and business spending expand as a result. But inevitably this excess demand turns into inflation, which in turn causes interest rates to rise even as asset prices and spending fall.
And this is exactly what happened to the U.S. economy and why real estate markets find themselves where they are today. The excessive stimulus that began over two years ago caused mortgage rates to fall and household savings rates to increase. These two factors unleashed a massive amount of pent-up demand for homes into the market. Sales took off, tight inventories translated demand into bidding wars, and home prices leapt by over 40% in two years. None of this was sustainable because it was driven by excess money. Now inflation has kicked in, rates are rising, and the housing market is sagging.
But consider the differences between this cycle and the last one. The last cycle was driven by many years of excessive private borrowing, and the use of public stimulus occurred only after everything started to fall apart. This time the public stimulus was ultimately the driver of the housing bubble. It wasn’t private debt, but excessive public borrowing. Thus, the housing market that started to collapse in 2007 was marred by a very high debt-to-equity ratio, high household debt burdens, and an excess supply of housing. Today’s falling market has one of the lowest debt-to-equity ratios ever seen, low overall household debt burdens, and a very tight supply of housing following a decade of slow housing supply prior to the pandemic. Consider that at the start of 2007 U.S. households had $10 trillion in mortgage debt and $14 trillion in housing equity. Today the figures are $12 trillion in debt and $29 trillion in equity. In 2008, the U.S. housing vacancy rate was 2.8%, while in 2021 it was 0.9%.
Perhaps more importantly the last housing collapse occurred along with a collapse in overall consumer demand. They were highly linked during the Great Recession because it was the ease of obtaining mortgage debt that allowed consumers to overspend. This time around consumer demand is not being supported by debt accumulation but by the trillions of dollars in residual cash left over from the stimulus (household cash balances today are $4.6 trillion, compared to $1 trillion in 2018) combined with rapidly rising wages driven by a tight labor market. Hence, the drop in the housing market this time is occurring without a pullback in consumer spending and without the subsequent loss of jobs and income that hurts housing demand even more.
And this brings us back to the Federal Reserve and the current policies being pursued. Oddly, the Fed is acting as if inflation is hurting consumers, when in fact consumer spending is driving inflation. They are trying to stem inflation by jacking up interest rates, which will do little to cool base consumer demand (driven mainly by cash and earnings), and little to hurt homeowners who mostly have long-term fixed rate mortgages.
It is, however, hurting asset markets more than would be the case had the Fed just let inflation burn out on its own. And this is causing even more pain for housing assets. Still, this will not turn into a complete economic rout because the consumer is largely immune to the Fed’s efforts outside of falling asset prices. Yet again the Fed is pursuing the wrong policy and ultimately will do more harm than good.
But this harm is not as bad as the harm that was caused by looking the other way at Wall Street’s transgressions in the last cycle. Home prices may fall over the next year or two, but rental prices for housing will almost assuredly continue to increase at the same time given strong consumer demand. If we had to sum it up, the housing market of 2009 had too few buyers. The housing market of 2023 will be marked by too few sellers. The net result will be almost no foreclosures, limited price declines, and little in the way of household financial problems created the last time around. But it will be a very cold market for a while… at least until we get used to higher interest rates and begin to realize that not every negative shock is an existential crisis.
As my parents used to tell me in my teenage periods of angst: We are in danger of imminent survival.
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