In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine the health of the housing market and address the question, ‘housing bubble or no housing bubble?'

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Listen to the REconomy Podcast™ Episode 36:

“Not to mention that homeowners today are not as highly leveraged as they were during the previous housing boom. The mortgage debt-to-income ratio is actually near a four-decade low, while equity, as you just mentioned, is at a historic high in the fourth quarter of 2021. Our latest available data, the national loan-to-value, or LTV, ratio was about 31%, which is the lowest in over three decades. And in inflation-adjusted terms, homeowners in that same quarter had an average of over $300,000 in equity. That's a historic high.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 36 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, a certain housing-related search term has spiked in recent weeks, care to take a guess at what it is?

Mark Fleming - Hi, Odeta. Let me take a wild shot in the dark guess here. Housing bubble.

Odeta Kushi - Yep.

Mark Fleming - I'm having deja vu, because I think it was episode 11 when we discussed a similar topic. The trending search term then was, "when is the housing market going to crash" and that had spiked then. Of course, one really can't have a bubble without a bubble popping, aka a crash. And I think that's actually technically required for the formal economic term for a bubble.

Odeta Kushi - It sure is. And here we are again in the week ending April 2, the search term "housing bubble" spiked significantly compared with the previous week. That may have to do with recent research published by the Dallas Fed, which claimed that home prices are out of step with market fundamentals. So, that is the topic of today's conversation -- are we in a bubble? And, if so, when will that bubble burst? But, first, let me define a housing bubble, which can be generally described as an unsustainable period of house price growth generated by artificial demand, such as loose underwriting or speculative buying. Now that we've defined what a bubble is, I want to quickly touch on that Dallas Fed research. Mark, you and I both read the research and I'm curious to hear your takeaway.

Mark Fleming - Absolutely. That was required reading when it came out to be sure. The research and the underlying methodology does imply that prices are moving further away from what they refer to as their fundamental expectation of prices. And there is an element here of "you say tomato and I say tomato," when it comes to what the fundamental metric measure of prices should be. If one were perfectly economically rational, you see me smirking here in this podcast, then the fundamental price should be the discounted net-present value of the housing service called shelter that one gains from a...right?

Odeta Kushi - Yeah, if you're Spock, we know how economically irrational households all are.

Mark Fleming - Right? But, even if we assume that rationality, the assumption of the paper concludes that this divergence doesn't imply a correction, a quote from the paper. Based on present evidence, there is no expectation that fallout from a housing correction would be comparable to the 2007-2009 global financial crisis in terms of magnitude, or macro-economic gravity. Among other things, household balance sheets appear in better shape, and excessive borrowing doesn't appear to be fueling the housing market boom. In other words, Odeta, bubble doesn't imply bust. And I would generally agree house price appreciation does need to slow down, as the double-digit pace we've been experiencing is clearly not sustainable in the long run. But the high price appreciation today is not the same as saying a bubble. And it is, in fact, supported by fundamentals.

Odeta Kushi - Well, so let's talk about what that means, that price appreciation is supported by fundamentals. We say that a lot. And perhaps a good way to go about explaining this is to compare today's housing market with the housing market boom in the mid-2000s. Let's go through a couple of reasons why it's different this time. First and foremost, what's different is what's really driving price growth versus what was driving price growth in the mid-2000s. The primary reason driving up prices during the mid-2000s. housing boom was wider access to mortgage finance. Sometimes we refer to it as financially innovative affordability products, you had things like no-doc, doc stands for documentation, no-doc loans. Typically, to qualify for a mortgage borrowers need to submit proof of income, your W-2s, pay stubs, etc. During the last housing boom, it was more common to have these no-documentation mortgages that did not require income verification from the borrower, and simply required that the borrower provide lenders with a declaration that they can repay the loan. That's pretty risky. These loans are not common today. And there were other affordability products, such as teaser rates, fixed-to-ARM structures, and more of those that all facilitated bigger loans at the same monthly payment to keep up with growing home values, which is of course, one reason why house prices kept going up. That is not the case today. Lending standards are much tighter today than during the mid-2000s. It actually remains harder to get a mortgage today than pre-pandemic and the median credit score of borrowers approved for mortgages reached 778 in the fourth quarter of 2021, which is significantly higher than during the previous housing boom. In short, the price appreciation we see today is not a result of financial innovation. But that begs the question, what is it a result of?

Mark Fleming - I'm having deja vu again. Price appreciation in today's housing market is characterized by a shortage of supply. We've talked about this a lot in the last year. The supply of homes on the market remains extremely low. And the homes that hit the market sell quickly -- 18 days on market in the latest existing-home sales report from February. This is an indication that there's clearly more demand relative to supply. Demand is outpacing supply. As we say, the low inventory combined with lower mortgage rates, millennials aging into their prime home-buying years, and those tighter mortgage underwriting standards that you were just referring to, all are fueling price appreciation. That is very different than the price appreciation during the housing boom that peaked in 2006.

Odeta Kushi - Right, I mean, recall that the housing market has been underbuilt since 2009. And we're currently in the midst of a demographic boom. High demand against limited supply is Econ 101 for price growth. The pandemic accelerated this demand a bit as the Fed began quantitative easing to help the economy, which put downward pressure on mortgage rates. Not to mention that because everyone was spending more time at home, working from home, it prompted the need for more space and allowed for some geographic flexibility. So, the housing market started the pandemic with a supply-demand imbalance. But, over the course of that pandemic, the lack of inventory got worse, while demand got stronger. So, it's really no surprise that house price growth is still strong today. But does that strong price growth bode well for the housing market?

Mark Fleming - Well, it certainly makes it harder for first-time home buyers to buy. But it does provide a strong equity cushion for all the existing homeowners that are out there.

Odeta Kushi - How does that make this time different from last time?

Mark Fleming - Yes, equity. This time, it's different. The housing crisis in the Great Recession was fueled heavily by the fact that job losses due to the recession were paired with a significant share of homeowners who didn't have any equity in their homes. Remember that term being underwater. We call this the dual trigger, you need both the inability to pay and the lack of equity to cause foreclosure. But homeowners today have very high levels of home equity, which provides a cushion to withstand potential price declines, which we're not suggesting will happen, but also preventing housing distress from turning into a foreclosure in the first place. In fact, if distressed homeowners are required to resolve delinquency, given that they have these equity buffers, involuntary sales -- that's a nice way of economists saying please sell your home, homeowner -- are much more likely than foreclosures. Why give your equity to the lender in a foreclosure when you can sell the home. Remember the supply shortage issue we were just talking about, it won't be hard to sell your home, pay off your mortgage and take that equity with you.

Odeta Kushi - That makes a lot of sense. Not to mention that homeowners today are not as highly leveraged as they were during the previous housing boom. The mortgage debt-to-income ratio is actually near a four-decade low, while equity, as you just mentioned, is at a historic high in the fourth quarter of 2021. Our latest available data, the national loan-to-value, or LTV, ratio was about 31%, which is the lowest in over three decades. And in inflation-adjusted terms, homeowners in that same quarter had an average of over $300,000 in equity. That's a historic high.

Mark Fleming - Homeowners are awash in equity today, their balance sheets are much stronger than they were in the mid-2000s. And there's another difference that we haven't discussed. That's the lack of real speculative buying. Speculation can be measured by the number of investor sales in the market. The number of homes being flipped. It's true, there's more now, but not at the same levels as before. In the mid-2000s. People were buying homes and not really even bothering to make improvements, just hoping to flip it and sell it for the higher price in the near future. Speculative buying like that, and excessive use of leverage, poor loan quality, all of these things contributed to the last housing bubble. That's not the case today.

Odeta Kushi - Oh, and importantly, this time housing is not overvalued. Remember, we've talked about this measure before, but if housing is appropriately valued, house-buying power should equal or outpace the median sale price of a home. And the only period when the median sale price was higher than house-buying power was from 2005 to 2007, indicating an overvaluation of housing or a housing bubble. Today, house-buying power is significantly higher than the median sale price of a home, signifying that housing is not overvalued. Alright, so no bubble this time around, because a bubble implies a bust. But what is likely to happen? We're in a housing market with double-digit nominal house price growth and now rising mortgage rates. I mean, last I heard the average 30-year, fixed mortgage rate was above 5%.

Mark Fleming - It's a great question. So, if the comparison shouldn't be made to the housing boom and bust, then what would be a good comparison? I'm going to quote a great housing analyst here, Bill McBride. He had a recent blog post entitled, "Don't compare the current housing boom to the bubble and bust," and he makes a parallel to the 1970s. That's right, we're going back in our historical time machine. He says we should expect something similar to what happened in the late '70s -- a decline in real house prices, real meaning inflation-adjusted, seems likely. That does not mean a decline in nominal prices. And I also expect some decline in housing starts and new-home sales. With solid lending, nominal prices should be sticky downwards. We've used that term before. And I don't expect national declines in nominal prices. New-home sales -- this is me now, back to Mark, no longer Bill -- new-home sales are more sensitive to rising mortgage rates, so we may see those decline. But, as we've discussed in the past, house prices are downside sticky, and 9/10 of the housing market is not the new-home market. Rising prices and rising mortgage rates will undermine affordability. It will be natural to see some moderation in price appreciation. That's okay, given where we are with very high price appreciation today. As buyers pull back from the market and sellers adjust their price expectations, house prices will also adjust accordingly. But the shortage of supply relative to demand will remain and continue to keep house price appreciation positive. The underlying fundamentals, that we've just been talking about, of the housing market continue to support a natural moderation in house prices, rather than a sharp decline.

Odeta Kushi - Well, there you have it. We know that real estate markets tend to move in cycles, but not every housing boom ends in a housing bust. Alright, well that's it for this week's episode. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature in a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

We hope you enjoyed this episode of the REconomy podcast from First American. For even more economic content, visit firstam.com/economics. This episode is copyright 2022 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.