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The Housing Bubble’s Back – Why It’s NOT Different This Time

My many years of working in the mortgage business, especially during the lead up to the last housing bust, have given me a special interest in the current housing market. From where I sit, the housing bubble’s back. Don’t get me wrong, I’m glad to see that property values have come back, and bailed out a lot of homeowners who were underwater. But the current trend may be exceeding that objective, and setting up the next bust.

Please be very cautious about buying a house in this market. This is particularly true in the hot markets that have seen the biggest increases in property values in the past few years. The most basic rule in investing is to buy low and sell high. So be warned – if you’re going to buy in this market, you will be buying high – which is the exact opposite of what you should be doing. The current boom could be setting up the next round of underwater mortgages. Buying now could lock you in as a future victim.

Here are some of the recent developments that you need to be aware of.

The Down Payment Requirement has Been Done Away With – Again

The Housing Bubble’s Back – Why It’s NOT Different This Time
The Housing Bubble’s Back – Why It’s NOT Different This Time
As a veteran of many years in the mortgage business myself, one of the bedrock doctrines of the industry for decades was the own funds requirement. This rule held that a person applying for a mortgage had to have some of their own money in the transaction. This was usually a minimum of 5% of the purchase price.

Even if the buyer was going to use a gift for the down payment, he still had to satisfy the own funds requirement. For example, if the buyer was borrowing a mortgage equal to 90% of the purchase price, and using a gift for the down payment, at least 5% of the purchase price still had to come from the borrower. The remaining 5% could be a gift.

The lone exception to the own funds rule was if the gift was equal to 20% or more of the purchase price. In that case, with the mortgage representing only 80% of the purchase price, it was considered to be a lower risk loan. For that reason, and only for that reason, the own funds rule would be waived.

More recently, the own funds guideline has been relaxed. The new gift guidelines no longer enforce the own funds rule as long as the property being purchased will be used as a primary residence and is a one unit dwelling. That means that you can buy a property, take a 95% mortgage, and make the 5% down payment entirely as a gift from a third-party.

We don’t need 100% loans, like we had in the years leading up to the last housing bust. But you can still buy a house with no money down – at least no money of your own. It’s the zero down mortgage packaged in less obvious way.

Setting the Stage for Another Round of Strategic Defaults

How is effectively removing the down payment requirement a problem?

  • No “skin in the game”. Lenders long ago recognized that unless the buyer has an actual investment in the purchase of the property, there is a much greater likelihood that they’ll walk away from the property, rather than trying to defend their investment. After all, if no own funds are required to buy the house, then there’s no investment to defend.
  • A lack of demonstrated financial discipline. Owning a home is more expensive than renting, if only because an owner is responsible for major repairs and maintenance. If a buyer can’t save money before buying a home, it’s unlikely that they’ll do so later. That creates a wave of financially impaired households.
  • If you can’t come up with any down payment at all do you really deserve to own a house? This is reminiscent of those blaring car sales ads that scream your job is your credit. Just show up and buy the house, no money required? Should buying something as large as a house really be that easy?

All three of these issues are contributing to a second housing bubble. But the last point is probably the most important. If no sacrifice is required to buy a house, then how much effort will be expended in order to keep it?

That’s more than a rhetorical question. The last housing bubble was characterized by strategic default. People were walking away from their houses simply because it no longer made financial sense to keep them. Aren’t we just feeding that dragon once again by enabling people to buy property with zero down?

The Real Reason for Relaxing Mortgage Regulations

Let’s get one thing straight right up front…the purpose of removing the down payment requirement is not to make homeownership more fair and accessible. The real purpose is to stimulate housing sales. Since the economy continues to be on life support even eight years after the last recession ended, stimulating housing sales is seen as a critical part of that support.

The overriding objective by the powers that be is to expand the homebuying customer base by removing as many obstacles as possible. The down payment requirement is widely seen as one of the biggest obstacles.

But the down payment requirement also serves as an important circuit breaker on the real estate industry. It limits the number of people who can buy a house right now, but it also ensures a steady flow of buyers in the future. Once those buyers have accumulated enough money for the down payment, they’ll be in line to be the future buyers who will support a stable housing market.

These efforts to relax guidelines serve primarily to move future consumption into the present. That contributes to a larger number of sales, which creates the kind of price spiral that we’re seeing right now. But just as was the case in the last housing boom, the dominoes are being set up for the next bust. Eventually, there won’t be enough new buyers, even with no down payment requirement.

Weakening of “Cash Reserve” Requirements

Allowing people to buy houses with no money down is a big enough problem in itself. But that’s not the end of the story. Another bedrock requirement of the mortgage industry was the cash reserve requirement. This held that the buyer needed to have an amount in liquid savings equal to at least two months of their new house payment after the purchase.

For example, if the new house payment – including mortgage principal and interest, property taxes, and monthly insurance allocations – was $1,500, then the borrowers were expected to have at least $3,000 in liquid reserves after closing.

The cash reserves were considered to act as a financial cushion in the critical first months after closing. That’s the time when new homeowners are often facing a barrage of new and unexpected expenses. The cash reserves were considered necessary to offset those expenses and prevent an early term default.

But the cash reserve requirements are being relaxed too. While the requirement is still there, there are now many mortgage types where cash reserves are no longer required.

Why is this a problem? A lack of savings almost dooms new homeowners to turn to credit.

Let’s say that a couple buy a house, and within weeks find that they have to replace the dishwasher and repair the central air-conditioning unit. They are looking at another $1,500 in expenses, but they have no liquid assets. Most likely, they’ll use credit cards, which will increase their monthly living expenses. In fact, unless they are able to get into the savings habit immediately after closing, they will increasingly turn to credit whenever they need extra cash.

This sets up new homeowners as entrenched members of the debtor class. Since there no requirement to establish a pattern of savings before closing, it’s unlikely to develop afterwards. Since savings are not a requirement, then credit becomes the default strategy whenever cash is short.

The Housing Bubble’s Back 101 – Incomes Aren’t Keeping Up with Increases in Property Values

So far we’ve been discussing changes within the mortgage industry designed primarily to artificially grease housing sales. But there’s a bigger picture development that can’t be ignored: incomes are not keeping up with increases in property values.

According to data from the Federal Reserve Bank of St. Louis real median wages were $57,423 in 2007, at the peak of the last housing bubble. For 2015, the latest year for which statistics are available, the median wage was $56,516, which is slightly below what it was during the last housing bubble.

Meanwhile, the median price of a house peaked at $262,600 in March of 2007 at the height of the last bubble. But in March of this year the median price has risen to $273,000, slightly higher than at the last peak.

So now we find ourselves in a situation in which house prices have reached or exceeded what they were in the last housing bubble. But incomes are no higher than what they were 10 years ago. If the economy couldn’t sustain that financial relationship 10 years ago, what makes us think that it will today? And what will happen if property values continue rising from where they are right now, but without equivalent increases in wages?

Will Relaxed Credit Standards and No Income Verification Be Next?

To be fair, mortgage guidelines have not yet been watered down to the levels that they were at in 2007. For example, mortgage lenders are still being tighter with credit guidelines than they were a decade ago. And perhaps more significantly, no income verification (NIV) loans are no longer permitted, at least not by the big mortgage agencies.

But that actually creates two potential problems. One is that house prices will become even more unsustainable, given the fact that the number of potential buyers is limited by credit and income restrictions.

But the other is even more ominous. In an attempt to prevent another collapse in house prices, the powers-that-be – who should know better from the last housing meltdown – might decide that they also need to relax credit and income standards in order to “save” the housing market once again.

If they do, we can see house prices rise to levels unimaginable just a few years ago, and even from where they are right now. Individually, they’ll climb so high that even people with NIV mortgages won’t be able to afford the monthly payments on their nonexistent incomes.

Despite all of the cheerleading by market optimists, we’re treading on very dangerous ground right now. And this is why I don’t think that now is a good time to buy a house.

Haven’t We Been Down this Road Before?

Logically, it would seem that since we’ve been down this road before, that we know better, and won’t repeat the same mistakes. But being human – and having a natural inclination toward optimism – we prefer to believe that the mistakes of the past were a one-time event and thoroughly unlikely to happen in the future. It’s even easier to make that assumption when everything seems to be going so well with housing, as it is right now.

But as the saying goes, those who can’t remember the past are doomed to repeat it. We seem to be on that exact and predictable trajectory right now. At a minimum, we are well on track for house prices to become so high that they become completely unaffordable. When we reach that point, house prices will have only one direction to go in – down.

Ironically, we haven’t even discussed the biggest potential nightmare for the current housing, which is higher interest rates. And we haven’t because that’s a discussion all its own. But suffice it to say that rising interest rates, when coupled with relaxed mortgage guidelines, is a recipe for another predictable disaster in housing.

What are your thoughts about the current housing boom? I know that it’s more pronounced in some markets than in others, particularly the coastal markets. But as we know from the last housing meltdown, the effects of another real estate crash will affect people living in both boom markets and more normal ones.

( Photo by Me in ME )

10 Responses to The Housing Bubble’s Back – Why It’s NOT Different This Time

  1. I do worry about the loosing of standards, but I need to comment that the price appreciation is a bit of a skewed picture. Here on the east coast in many areas the price of housing appears to have yet to fully recovered from the crash of 2008. Outliers like California make it appear that prices have ticked up, but that’s not true everywhere. I do wonder what that means when the loosing standards backfire. I.E does price crash back to 2008 levels or is it already like a limbo practically as low as it can go in some regions.

  2. I fully agree. I live on the East Coast, and it does appear that prices haven’t come back to 2007 levels even in most areas. But some areas have rocketed. There’s no way to know how this will play out in Housing Bust II, but I think we’re definitely in the danger zone right now. I think we’ll be OK if the price spiral stops now. But if it keeps powering forward from here we’re setting up a disaster.

    But you’re right, the national market is much less uniform than in the last bubble. Probably some areas will be hard hit in a slide while others will be only minimally affected. But if mortgages go back in the tank, that will affect all markets. Mortgage money will be harder to get, guidelines will be tightened again, and houses will become less liquid. That’s when houses will become a trap. Property values will fall, and people will be underwater on there mortgages.

    It’s a mess that could be avoided by more responsible lending, but that’s never what we seem to get. They keep juicing the market to create booms, always thinking that the bust that follows can be avoided. Economic reality may take longer to play out than we assume, but it always takes its course, no matter how invincible/infallible the leaders and experts think themselves to be. I saw this from ground level in the last boom, and I can’t believe it’s playing out again.

  3. It’s difficult to paint real estate with a broad brush. Real Estate is really a local issue. Here in Northern Nevada we have Tesla’s GigaFactory open and expanding. Apple is here building a huge datacenter and separate warehouse. Amazon has recently opened a huge new warehouse to replace a giant warehouse than ran out of room in a nearby town. Google just made a huge land acquisition (rumors are for self driving car testing).

    Anyway, in this locality there just isn’t enough housing right now….so rents and sales prices on existing homes is going up very quickly. Here it seems real growth is driving prices.

    I am wanting to downsize, yet with prices rising quickly it might end up costing me more to purchase a smaller home after I sell my larger home! We decided to sit tight until things stabilize.

  4. That’s certainly a unique situation. Unfortunately, organic economic/job growth isn’t driving the national housing market, low interest rates and a rising stock market are. If they reverse, housing will turn down fast, and maybe steep. I’d be real careful generalizing with the term “real estate is local”. That’s a rationalization that the real estate industry uses to explain why their particular geographic location is immune to macro trends. That assumption usually gets proven wrong as downturns drag on. In your case however it might hold true. That’s a lot of economic/job growth in a relatively thinly populated area.

    But even there, don’t be so sure that you’ll be completely insulated from a particularly nasty recession or housing bust. Companies do short circuit expansion plans/close facilities in deep recessions. That can fall even harder on a small community. Just look at the towns and smaller cities across the Midwest and the Northeast that have experienced plant closings. It can take them years to recover, and sometimes they don’t recover. For example, Tesla is still more of a beta than an established business, though I think you’re pretty safe with the Amazon warehouse – not much chance they’ll close that and move it to Asia.

  5. Maybe a bit off topic here…..but Tesla: I agree their car market is yet to be seen. In the big picture, they may ultimately end up being an electric storage company rather than a car company. They are doing amazing things with batteries. In fact, the GigaFactory doesn’t build cars, they build batteries.

    They have these things called “PowerWall” which is a giant battery that you hang on a wall in your garage. It’s purpose is for storing solar power collected during the day to use when the sun isn’t shining. If solar is going to take off, this is key.

    Again, off topic for real estate.

    Cheers

  6. Agreed, off-topic. But not necessarily irrelevant either. I think that the battery technology that Tesla is working on will have a future somewhere. But that future is still speculative, which is why I say it’s really more of a beta than anything else. There have been such companies in the past, and while a few go on to create and lead an entirely new industry, most end up being either taken over by larger and better directed companies, or they fizzle out and die for lack of relevancy.

    In the case of Tesla, the economic viability of electric cars has yet to be proven. They may not be gasoline dependent, but they are fully dependent upon fossil fuel being generated for electric power. In that way, they’re not really a solution to fossil fuel dependence – just oil dependence.

    Solar power is another question mark. It’s been around since the 1970s, but it hasn’t made a huge impact on the energy market, at least not in the US. The progress seems to be greater in Europe, which is much more dependent on foreign sources of fossil fuel, and therefore willing to publicly fund solar development.

    In the end, both electric cars and solar power still face very uncertain futures. We should also suspect that if the economy goes into a deep and prolonged funk, that progress on both will stall out. Neither are yet economically competitive with their more traditional alternatives. Don’t get me wrong, I’m rooting for both to succeed. If they do it could unleash a new and much needed round of organic economic and job growth. It’s just that neither has been proven to be conclusively headed in that direction yet. For example, who will be interested in either if oil goes down to $25 a barrel? If we’re flirting with $50 in a time of growth, a drop that far is easily conceivable in a recession.

  7. I agree mostly and it’s a topic i’m passionate about….but since it’s really way off topic for real estate market….let’s leave it there 🙂

  8. I realize that home prices are a bit bubblicious in my area. But I was wondering if I should take advantage of the appreciation I have seen. My house is about $100 K more than when I bought it (about a 40% appreciation). I have about 10 years left on a 15-year refinanced mortgage at 2.75%, so with the appreciation factored in, that leaves about a 30% Loan-to-value. Now, I know Dave Ramsey would say don’t go into debt, but our basement has pretty bad leaking issues and to fix it right would be about $16 K. Is this a good time to do home equity line of credit with introductory rate of 1.69% for a year at one credit union, after 3.99%? Or I could refinance into a special 12 year refinance for $149 fee at another credit union but with a slightly higher (3%) interest rate.
    I guess the bottom line is that it’s frustrating to have this illiquid asset and not being able to access the money without going through a lot of fees/paying interest/debt, etc. If I was a bachelor, I would be thinking about selling and moving to a cheaper area to really take advantage of the greater fool theory. But, as it stands, I have a family and established life here and don’t really want to move.

  9. You’re in a good position with both the accumulated equity and the short term on the mortgage. But you have to get the basement fixed, so an equity line is probably a good course of action. Just don’t get carried away with the equity line and start stripping the equity out of the house. I like the fixed rate refi option because interest rates are at historic lows. Since you have a family you should lean on the conservative side of things.

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