The term “housing bubble” is tossed around regularly these days – and not entirely without cause. Over the past year we have seen meteoric gains in housing prices and witnessed bidding wars on homes for sale. The leading measure of U.S. housing prices, the S&P CoreLogic Case-Shiller Index, reported a 10.4% annual home price increase for 2020. And it has been reported that roughly two-thirds of the people who bought a home in 2020 made an offer without actually stepping into the home and relying instead on video tours.
Despite (or perhaps because of) these trends, there are concerns that an over-exuberant housing market could be threatened by credit risks, unrealistic valuations, sharply rising interest rates or other problems.
Indeed, due to the COVID-19 pandemic and related job losses, about 2.6 million homeowners are currently enrolled in some type of forbearance program, according to recent data from the Mortgage Bankers Association, although the percentage of delinquent homeowners has been trending downward.
I believe there are significant differences between the U.S. housing market today and the bubble that contributed to the financial crisis of 2007-09. That said, there are some cautionary signals that should not be ignored. To quote a proverb often attributed to Mark Twain, “History doesn’t repeat itself, but it does rhyme.”
Here’s why it’s different
In contrast to the run-up to the financial crisis, mortgage products today are significantly more conservative. Rather than the no-income verification (aka “no-doc”) and low down-payment loans that proliferated then, most of today’s mortgages follow stringent underwriting guidelines.
People have more equity in their homes – some up to 7 to 10 years’ worth – and so are not likely to walk away from their homes and leave banks “holding the bag.” Total home equity in the U.S. housing market rose by $1.5 trillion in the 2020 fourth quarter, up 16.2% from a year earlier, for an average gain per homeowner of $26,300, per CoreLogic.
The banking system is also much less vulnerable to a bursting housing bubble today. Due to tightened capital requirements in response to the financial crisis, the Tier 1 capital ratio of all U.S. banks averaged more than 14% during 2020. And the high-risk variants of collateralized mortgage obligations, in which mortgages of low quality were packaged into securities, mislabeled with an “A” rating, and sold to investors, are a thing of the past.
Here’s what to worry about
Because of our extensive work as the largest quality control provider for lenders and others, we have a window on factors that all market participants should keep an eye on. Having performed post-close quality reviews on thousands of loans in the past year, we are seeing an increase in errors and a general sloppiness in the application, documentation and approval process.
These errors may be due to the accelerated speed at which originators are processing loans, as they try to capitalize on the refinance opportunity created by record-low interest rates. The tenure of loan underwriting personnel also may be a factor. Well over half — 60% — of mortgage underwriters have been in their current position for undefined. The average experience of a loan underwriter has plummeted, in large part a hangover from the last housing crisis, when many mid- and senior-level employees fled to other industries.
A second concern is the large number of people seeking to buy a home for undefined or who already own an investment property. If interest rates stay low, even more investors may be attracted to the housing market. There may also be a greater incidence of fraud, as some borrowers claim that their properties are owner-occupied to qualify for lower rates, while planning to rent the units. When the banks discover the fraud, borrowers will be faced with significantly higher interest rates.
Alternatively, if the rental income expected by these owners (whether legitimate or not) fails to materialize, their mortgages could be headed for default.
Finally, while the Federal Reserve and other market experts believe inflation will remain well-controlled, a material spike in inflation, pushing mortgage rates toward the high single digits mortgage rates toward the high single digits, could have a devastating impact on housing. The bond market would be the first to react to inflation, as it erodes bondholders’ future cash flows. The resulting increase in bond yields would then be reflected in mortgage loan rates.
Although the frenzied bidding wars for homes represent a real concern, the housing market is much healthier today than on the eve of the financial crisis. While roughly 5% (or 2.6 million) of U.S. homeowners are enrolled in some type of forbearance program, 95% of these properties are worth more than the loans, and owners will be able to sell their homes rather than hand over the keys to the bank. The financial system is better capitalized and less prone to offer higher-risk products.
Still, it will be important to watch for alternative data – such as quality-control lapses or a rise in loan applications for investment properties – that may raise concerns that the air is escaping from the housing market. It would be especially worrisome if there were to be higher-than-expected inflation at the same time that forbearance ends and properties came flooding onto the market.
Jeff Taylor is co-founder and managing director of Mphasis Digital Risk, the largest third-party service provider to the residential mortgage industry