Editor’s note: Guest post provided by scholar and the co-director of the Center on Housing Markets and Finance at the American Enterprise Institute (AEI), Dr. Lynn M. Fisher.
The US Economy and Housing Market
In this post, Adding Credit, but Too Little Housing Supply, Doesn’t Help in Boom-Time, I’ll briefly overview some economic, housing and mortgage market data from the first third of this year and then consider the state of US housing and mortgage markets. I’ll highlight the continued expansion of housing credit using data compiled by the American Enterprise Institute’s Center on Housing Markets and Finance and argue that in the absence of greater inventories of homes for sale, more leverage will simply serve to worsen affordability while increasing risk to borrowers. If wage growth picks up later this year, government agencies should use the opportunity to hit pause, and even reverse, recent trends in credit expansion.
First, Let’s Consider the Economy
Nearly 9 years into the US economic expansion, job growth picked up in the first third of 2018 relative to the last two years (chart 1). At the same time, tax reform and increases in government spending made bond and equity markets nervous about the prospect of faster than expected inflation. By mid-February, 10-year Treasury yields rose to about 2.8 percent from near 2.4 percent at year-end. Geopolitical tensions and rhetoric around trade added additional uncertainty for investors in bond and equity markets and on Main Street. However, Treasury yields did not pick up again until near the end of April, finally breaching the 3.0 percent mark.
The Fed, under new leadership by Chairman Powell, raised short term rates in March and signaled that two or three additional rate hikes are still expected this year. March meeting minutes reveal that committee members generally believe that inflation will move up to their target of 2 percent sometime in 2019. As expected, there was no rate increase at the May meeting, and the next increase is expected in June.
In combination with favorable demographic trends, the strength in job growth and the possibility of firming wage growth mean that housing demand will continue to expand over the course of the next few years, despite the anticipated increase in interest rates. The possibility of faster than expected inflation, however, also increases the likelihood of a recession over the next few years. This makes it a good time to reflect on the health of housing markets and the role of mortgage credit.
Chart 1: Source: BLS
Home Sales are Slowing
Our data shows that total home sales are decelerating at the national level. As shown in Chart 2, the combination of new and existing home sales increased by 9 percent in 2015 and 10 percent in 2016 before slowing to pace of just 5 percent growth in 2017. According to the National Association of Realtors, the inventory of existing homes for sale has fallen to historic lows, and many forecasters expect growth in existing home sales to slow even further this year, perhaps remaining about flat relative to 2017 due to a lack of inventory.
Chart 2: Source: AEI’s Center on Housing Markets and Finance
Since the beginning of 2012, single-family starts have grown at an average pace of 9 percent annually, and they totaled nearly 890,000 on a seasonally adjusted annual basis in the first quarter of 2018. The simple story from studying housing starts, however, is that they are unlikely to accelerate meaningfully. It is simply too costly to obtain and permit land, and local communities are unlikely to suddenly ease restrictions that might allow for more intensive homebuilding. So while more supply is coming, it will not quickly increase inventories of homes for sale nor relieve pressure on home prices in the near term.
One upshot of slowly adjusting supply is that since 2013, house price growth has outpaced wage growth, as shown in Chart 3. As can be seen in two prior episodes in the 1980s and then the boom that precipitated the recent housing crisis, sustained deviations of the two series has historically resulted in a correction. Since 2012, wages and salaries have increased at an average annual rate of 2.1 percent, while house prices have grown 5.3 percent annually on average, a pattern that is clearly not sustainable.
Chart 3: Source: FHFA, BLS
Expanding Credit, Shifting DTI Ratios and Risk
At the same time that a shortage of new homes and existing inventory is impeding sales and pushing up prices, the amount of mortgage credit available to consumers has expanded, further fueling price gains. At AEI, we track mortgage credit facilitated by government-sponsored enterprises, Freddie Mac and Fannie Mae (GSEs), and the Federal Housing Administration, Department of Veterans Affairs and USDA’s Rural Housing Service. We estimate that mortgages supported by these entities made up 81 percent of all mortgage loans originated by lending institutions in 2017.
Chart 4 shows that 27 percent of all agency and GSE loans originated in January had debt-to-income (DTI) ratios over 45 percent, up from 15 percent just 5 years ago. Beyond just the tail, however, the entire distribution of DTI ratios on newly originated agency/GSE loans has shifted over this period — the median DTI has increased to 40 percent from 36 percent. As of January, 46 percent of FHA purchase loans had DTIs in excess of 45 percent.
Chart 4: Source: AEI’s Center on Housing Markets and Finance
A further concern is the practice of risk-layering in which mortgages have multiple risky attributes. For a more complete picture of credit expansion and its implied risk, consider AEI’s National Mortgage Risk Index (NMRI), shown in Chart 5. The NMRI calculates the average expected stressed default rate for newly originated agency/GSE loans based on DTI, combined loan to value ratio, borrower credit score, and loan term and purpose. The stressed default rate reflects the performance of loans originated in 2007 with the same characteristics. This measure shows the sharp increase in risk over the past five years for FHA-insured loans in particular, which are largely provided to first-time homebuyers and involve considerable risk layering. By contrast, loans insured by the Rural Housing Service have become slightly less risky over this period.
The riskiness of loans securitized by Fannie Mae has also risen notably in the last 6 months following its decision in mid-2017 to allow DTIs over 45 percent without compensating factors. Fannie Mae’s share of newly originated loans with DTIs over 45 rose to more than 19 percent in January, up from just 6 percent of loans in September 2017. The uptake of higher DTI ratios was surprising, and in mid-March Fannie Mae implemented an update to Desktop Underwriter to reduce risk-layering. In the coming months, we will be able to track how effective the policy adjustment was in moderating risk.
Chart 5: Source: AEI’s Center on Housing Markets and Finance
Housing Markets Don’t Need More Credit Right Now
It is well known that housing markets have cycles in which house prices grow and then decline. Easing credit to facilitate sales in the upstroke of the cycle only exacerbates affordability issues and greatly increases the risk of a house price correction, especially when supply is not terribly responsive.
Only expanding our housing stock will provide more affordable housing. However, the accumulation of local government regulations, fees, codes and ordinances impedes the creative expansion of our housing supply, even in the presence of record-high prices. There are few short-term fixes, and it will take time to significantly expand our housing stock. While it is often argued that newly minted mortgages are well-underwritten, any increase in leverage for markets constrained by low inventories of homes for sale serves to increase the wedge between wages and prices and does not fix the underlying problem.
Should wage growth pick up as this year proceeds, the agencies and GSEs will be presented with an opportunity to rein in credit by allowing (real) wage growth to offset some credit tightening. The chances of wage growth are the best they have been due to the additional stimulus of tax reform and Federal spending on top of an already tight labor market. Given the point in the housing cycle and the increased likelihood of a recession in a few years, it’s a prudent time to re-examine credit policy.