In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi compare the dynamics of today’s challenging housing market with the housing market crash of the mid-to-late 2000s and the housing market of the early 1980s.

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Listen to the REconomy Podcast™ Episode 75:

“The housing market did rebound from the 1980s, but it took some time. Inflation and mortgage rate stabilization were key back then. Because mortgage rates have increased further this October, we expect the housing recessionary conditions to linger in the near term. We're still waiting for that rate stabilization.” – Mark Fleming, chief estate economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 75 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American, and here with me is Mark Fleming, chief economist at First American. Hey Mark. Recently, we've been starting REconomy episodes by covering a current headline that pertains to the housing market. Now the one that I want to talk about in today's episode is not new to us. It's just resurfacing after the recent increase in mortgage rates. Care to take a guess?

Mark Fleming - Hi, Odeta. This is an easy one. History doesn't repeat itself. But does today's market rhyme with the housing market boom and bust of the mid-2000s?

Odeta Kushi - Bingo. There is chatter that today's housing market is starting to look like the housing market of the Great Financial Crisis or GFC as we'll use throughout this episode. Existing home sales in August were just above a 4 million seasonally adjusted annualized rate. But leading indicators, such as purchase mortgage applications, signal that sales may dip below 4 million for the first time since the depths of the Great Financial Crisis between July and October 2010. And certainly if you look at affordability measures, such as our own Real House Price Index, or RHPI, which measures the price changes of single-family properties throughout the U.S. adjusted for the impact of income and interest rate changes on consumer house-buying power, it's clear that affordability is now officially worse than it was at the peak in 2006.

Mark Fleming - Surprise, surprise. Higher mortgage rates alongside reaccelerating house prices will do that. But this housing market is fundamentally different than the housing market of the mid-2000s.

Odeta Kushi - Okay, I'm gonna ask you to explain why that is in a minute. But if this time is not like last time, can we compare today's housing market to any period in the past?

Mark Fleming - So glad you asked Odeta. We sure can. But we have to go way, way back to a decade that brought us some of the best music and films. My favorite decade.

Odeta Kushi - Oh, goodness, okay, I can sense that we are about to talk about the '80s. So I think I'll run run so far away.

Mark Fleming - Woah, nice Flock of Seagulls reference there. You know, you're getting really good at these '80s music references. I'm going to make a fan of you yet.

Odeta Kushi - I mean, look who I talk to every day. I'll get there. Now, as a warning, I don't think the discussion today will be particularly flattering to the '80s, or at least the early '80s housing market. So, in today's episode, we'll first talk about why the housing market is different from the GFC housing market. And then we'll talk about the similarities to the '80s housing market. So let's start with the mid-2000s comparison first. Mark, why is this housing market different from the last housing boom and subsequent bust?

Mark Fleming - Well, first, I would characterize the previous housing boom as a housing bubble, which can generally be defined as an unsustainable period of home price growth generated by excess or shall we say irrationally exuberant demand, and that excess demand can be a result of loose underwriting or maybe speculative behavior.

Odeta Kushi - Well, I think in defining a bubble you also define the housing market during that period. When you mentioned loose underwriting, the price appreciation experienced in the housing market during the mid-2000s was characterized by a surge in demand driven by wider access to mortgage financing, teaser rates, fixed to ARM structures, no down payment options - oh my - all facilitated bigger loans at the same monthly payment to keep up with the growing home values, which, of course, is one reason why house prices kept going up.

Mark Fleming - Yes, indeed, it's amazing how those things work like that. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out what's called an option ARM, which means that they could choose to make payments so low that their mortgage balances rose every month. Sub-prime mortgages increased dramatically from approximately 7-8% in the market in 2000-2003, up to approximately 18 to 20% in the market in 2004-2006. So a large increase in sub-prime loans, as they call them.

Odeta Kushi - And the other half of our definition included a mention of speculative buying. Housing speculation also increased during this period with the share of mortgage originations to investors rising significantly, from around 20% In the year 2000, to around 35% from 2006 to 2007.

Mark Fleming - And mortgage debt-to-income ratios also peaked in 2007, while the median credit score at origination for mortgages was just above 700 in 2006.

Odeta Kushi - Now conversely, in today's market, mortgage debt-to-income is sitting near historic lows, the median credit score at mortgage origination was 770 in the second quarter of 2023. And the ARM share of loan applications is about 9% compared to the peak of 37% in 2005.

Mark Fleming - That's right. Not only were people getting option ARMs back in 2005, but they were also getting those sub-prime ARMs with two- and three-year fixed periods, so lots of ARM activity. This time around, there is, shall we say, no financial innovation. In the mortgage market, pre-crisis style ARMs are discouraged by current regulations. Instead, borrowers today can choose from what I call classic vanilla ARMs with three-, five- , seven-, and even 10-year fixed periods. They offer lower interest rates than the traditional 30-year fixed rate mortgage, but are regulated for their ability to ensure the consumers ability to pay. No options in these ARMs.

Odeta Kushi - I don't know that we defined our acronym, ARMs, or adjustable-rate mortgages. Yes, we're just talking about limbs here now. So in total household balance sheets appear in better shape and excessive borrowing wasn't the source of the house price boom or sales boom in this housing cycle. The real reason for the house price boom and sales boom was super low, sub-3% pandemic mortgage rates, demographic demand from the millennials aging into their prime home-buying years, and a lack of housing supply. Super-charged demand against a limited supply of homes for sale is a recipe for rapid house price appreciation. History doesn't repeat itself and today's market doesn't rhyme with the housing market boom and bust of the mid 2000s.

Mark Fleming - Exactly. Today, the slowdown in sales transactions is a product of fast-rising mortgage rates. Recall that higher mortgage rates have a dual impact on the housing market. They obviously reduce affordability, all else held equal, but they also keep existing homeowners rate locked-in.

Odeta Kushi - That's right, more than 90% of existing homeowners are locked into mortgage rates below 6%. Now, rates are sitting above 7%, even approaching 8% as of late. So these homeowners do not have a financial incentive to sell. That's what we call the rate lock-in effect or, if you wish, the golden handcuffs of low mortgage rates.

Mark Fleming - More than 90%. Those are some some hefty handcuffs there, right. Existing-home sales activity is very low because you can't buy what's not for sale. But, interestingly, the lack of resale inventory is putting a floor on price declines. Demand continues to outweigh supply, even in an affordability-constrained market, which is putting upward pressure on house prices that we see nationally today.

Odeta Kushi - That's right. According to First American Data & Analytics House Price Index, house prices reached a new peak for the six month in a row in September 2023. Alright, so let's get into the comparison to the 1980s housing market. How is today's market similar to that of the 1980s?

Mark Fleming - Well, first, let's start with the obvious, which is a demographic comparison. In the late 1970s and early 1980s, baby boomers were aging into their prime home-buying years, providing a wave of demographic demand. Since millennials are the echo of the baby boomers and are currently aging into their prime home-buying years, that demographic picture in the early '80s mirrors today's housing market.

Odeta Kushi - And, of course, we can't forget that the macro-economic picture was similar in one specific way. In the late '70s and early '80s. Interest rates soared as the Federal Reserve fought to rein in the Great Inflation. Does that sound familiar at all?

Mark Fleming - Why, yes, yes, indeed, it does sound eerily familiar, Odeta. In today's fight against inflation, the Federal Reserve hiked interest rates to the highest level since 2001 earlier this year.

Odeta Kushi - We should clarify that the aggressive rate hikes during this economic cycle are nowhere near where rates had to go in the '80s. The target federal funds rate upper limit as we record today's episode is about 5.5%, significantly lower than what it was in the early '80s. And, as a result of tighter monetary policy and higher inflation, mortgage rates increased to a peak of 18% in 1981. One word. Woah.  Can you imagine? Having to get an 18% mortgage, but people still bought homes, by the way.

Mark Fleming - Hey, you know what, that 8% mortgage that we might see in the near future doesn't sound so bad.

Odeta Kushi - Yeah, suddenly it seems okay. Although, of course, we have to view that within the context of incomes and mortgage rates and house prices, as we always say.

Mark Fleming - Yeah, yeah, yeah. 

Odeta Kushi - So mortgage rates, you know, reached levels unseen before or since. 

Mark Fleming - Good point.

Odeta Kushi - Homes became significantly less affordable and home sales fell. By October 1982, inflation had fallen to about 5%. The Fed lowered the federal funds rate back down, and the 30-year, fixed mortgage rate fell alongside lower inflation and a lower federal funds rate.

Mark Fleming - And guess what? Existing-home sales fell nearly 50% from the peak in 1978 to the trough in 1982, before rebounding alongside those lower mortgage rates. And home prices surged by over 14% in 1978, then flatlined as year-over-year growth slowed to just barely 1% by 1982. Sound familiar? Downside sticky prices?

Odeta Kushi - History rhyming, perhaps? Today's market is similar in that home sales face more downward pressure than prices. Home prices climbed nearly 17% on an annual basis in 2022 before slowing to a 5% yearly growth rate in the second quarter of this year. Meanwhile, existing-home sales plunged by nearly 40% from the recent peak in January of 2022 to the latest August figure. As I mentioned earlier, demographic demand against a severely limited supply of homes for sale continues to put a floor on how low prices can go. But sales suffer as potential buyers are priced out and existing homeowners see no incentive to sell.

Mark Fleming - And the other similarity, of course, is the housing market today is in a housing market recession, very similar to that of the late '70s and early '80s, according to our housing recession indicator. Housing history rhyming. See what I did there? Housing history.

Odeta Kushi - Moving right along. There are, of course, differences in the housing markets as well. And we don't have all of the data that far back to make a full comparison. Nevertheless, the similarities from the macro-economic environment, the interest-rate environment, the demographics, and the changes to house prices and sales in response to Fed tightening and higher mortgage rates are important to highlight. But, where do we go from here? What have we learned?

Mark Fleming - Well, the housing market did rebound from the 1980s, but it took some time. Inflation and mortgage rate stabilization were key back then. Because mortgage rates have increased further this October, we expect the housing recessionary conditions to linger in the near term. We're still waiting for that rate stabilization.

Odeta Kushi - But industry forecasts predict that mortgage rates will moderate if the Federal Reserve stops further monetary tightening and provides investors with some more certainty. So mortgage rate stability, even if the stabilization occurs with rates at a higher level, is the key to an eventual housing recovery. All right. Well, that's it for today's episode. Thank you for joining us on this episode of The REconomy podcast. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.