Finance Friday - Ft. The Housing Market

Topics: Housing Market, Housing Affordability, Supply & Demand, MBS, Lewis Ranieri, Mortgage Rates

Are you thinking about buying a house, but frustrated because everything is so expensive? Are you unsatisfied by everyone telling you the reason for high prices is due to "supply chain issues" or because it's "just a hot market"?

Well, I'm with you. So, in order to explain why things are the way that they are, I created a bunch of pretty charts using a lot of not-pretty data. I trust you'll find it insightful.

Thanks, FRED, for all the helpful information! (IYKYK)

Aight, let's get into it:

Current State of Housing

Up and to the right has been the story behind housing prices for almost forever (except during the Great Recession and immediately following the COVID outbreak); since COVID, it's been even more so up and to the right.

On top of this, treasury rates declined sharply during the COVID-19 recession, but have since risen substantially due to quantitive tightening as a result of the Federal Reserve raising the Federal Funds rate and unwinding its balance sheet.

Up and to the right... right?

Well... Mortgage rates definitely got the memo.

Speaking of mortgages, I calculated a mortgage spread relative to treasuries to account for the "risk" priced into mortgage rates over recent history for 30-year and 15-year durations (15-year is interpolated based on 10 and 20-year treasury bond yields). As a refresher, credit spreads are the additional yield required on a bond/security over a risk-free rate (credit spreads price in the probability of default and loss given default of a risky asset).

Spreads on mortgage securities are v high. In fact, they are at some of their highest levels since '08 and the early 2000s. This could indicate that the probability of mortgage delinquencies and/or the loss given default on mortgages are higher - we'll continue this conversation shortly.

Estimated mortgage payments are included in the chart below; this is an estimated based on median home prices and 30-yr mortgage rates, assuming homeowners put 20% down to buy a house. The combination of higher mortgage rates and housing prices has led to a monstrous increase in monthly mortgage payments. Yikers. I'm feeling a bit light-headed... Sorry to all you newlyweds looking for a house to buy... Maybe next year?

Financial planners recommend that your mortgage should not exceed more than 28% of your pre-tax income. Based on our estimated monthly mortgage payment and the median household income, we can see that mortgage payments have clearly risen above 28% of pre-tax household income. Also, median housing prices are over 5.0x the median pre-tax household income. That white picket-fenced American Dream is more expensive than ever.

Housing prices have flattened out and are starting to fall in value. Despite the (slight) decrease in housing prices that we've seen thus far, homes are still extremely unaffordable due to whacky supply and demand, as well as the Fed's influence on mortgage rates.

A History Lesson

Mortgage rates have fallen significantly since the 1980s largely due to the invention of mortgage-backed securities. Big thanks to Lewis Ranieri for making housing affordable - wish he could strike again to fix housing affordability in the 21st century.

If you'd like a high-level overview, I'd recommend watching this (would recommend only watching until 1:05). If you want a deeper dive, maybe read what Wharton has to say about it. If you want to feel like you were a part of the bond craze of the '80s, maybe read Liar's Poker. If you want an explanation from yours truly, well, here it is:

Back in the 1970s, mortgages were individual securities that were largely funded by banks. Because of the relatively small size of mortgages and the large number of mortgages, many institutional investors remained out of the market because they didn't have the capacity to do analysis on thousands and thousands of individual mortgages. Enter Lewis Ranieri. He created mortgage-backed securities (MBS) in the 1980s - effectively, an MBS is just a ton of mortgages that are sold in a basket; this increases diversification and reduces risk, while still maintaining a strong return profile. We love that. As such, it made it easier and more efficient for institutional investors to participate in mortgage markets. Because there was more capital flowing into the mortgage market, mortgage rates began to decrease. Because more people wanted access to mortgages, banks could underwrite more mortgages, bundle them up under an MBS, and sell them to institutional investors for a fat fee. The affordability of mortgages increased the amount of mortgage debt outstanding, while simultaneously increasing housing prices. The amount of mortgage debt is $19 trillion as of Q3 of 2022.

Supply and Demand Imabalance

1. "SuPpLy ChAiN iSsUeS": Upward Pricing Pressure

Due to a variety of supply chain issues, prices for construction projects have increased significantly. Here's an update on construction prices:

Yes, prices are coming down, but dang, their absolute values are still extremely inflated. For a full overview of recent changes in prices, here's the latest BLS PPI report.

2. Issues with Builders: Upward Pricing Pressure

Because of rising input prices, homebuilders are facing financial difficulties. When building a home, home builders will require an initial deposit up front that is nonrefundable. The builder will take that deposit and funds from a construction loan to finance the costs of building the house; those construction loans are short-term and have a high-interest rate. Here's a good overview of the dynamics of building a house.

Here's what's been going on as of late:

Cancellations for many large home builders have increased to 20% - 70%. As such, many firms have reported that absorption rates have fallen over Q3 2022. Because individuals are purchasing houses at a slower rate, that could force homebuilders to carry their high-interest construction loans for longer (which are likely larger in size due to escalating input costs). These factors, paired with elevated input costs and waning housing demand, have reduced homebuilder sentiment significantly, from 84 to 31 from December 2021 to December 2022.

We can also see the impact of adverse pressure on homebuilders through housing starts, which have declined over the second half of 2022.

3. Waning Demand: Downward Pricing Pressure

Demand for housing has been gradually deteriorating, largely due to spiking mortgage payments on new houses. As mentioned in point 2, absorption rates have gradually increased, as have the number of new listings over the number of home sales (net housing supply). This metric indicates how long the current new for-sale inventory would last (in months) given the current sales rate if no additional new houses were built. As shown in the chart, the number of listings over the number of sales has gradually increased throughout 2022, but has stagnated over the third quarter of 2022. This is likely due to (a) homeowners attempting to take advantage of high prices and (b) falling sales due to the substantial increase in monthly mortgage payments.

"Hey Honey, Can We Afford This?"

I'm just going to point us back to this chart right here:

Housing is v expensive, however, household wealth is still very high since increasing significantly following the COVID recession. These high levels of wealth have likely empowered individuals to reduce their savings rate in light of inflationary pressures that have increased costs for goods and services.

Despite high interest rates, growing mortgage payments, and deteriorating economic conditions, delinquency rates are historically low, with only credit card debt delinquencies increasing as of late.

Conclusion

Housing is (as I've already said) extremely expensive. Despite wage increases, mortgage payments have significantly outpaced wage inflation to the point where housing is the most expensive it's been in recent history in both absolute and relative terms. Despite the extremely expensive nature of houses, prices for houses have barely decreased due to (a) high housing input costs and (b) tight supply because homebuilders can't keep up with demand due to supply chain issues. As was a surprise to me, delinquency rates are extremely low, which stems from a high absolute level of household wealth that increased significantly over COVID.

I'd like to look to the future for a moment (please remember, I'm not a genie and I have no crystal ball, so outlooks are based on our interpretation of current events and data points and how they'll look in the future). Housing prices are extremely expensive and, though we can make the argument that demand still outpaces supply, I would argue that something is going to have to give in terms of prices; for those of us who don't have inelastic demand curves, the current housing market does not make economic sense, especially with significant layoffs and an impending recession. Plus, there are indications that demand for housing is slowing.

I care about you and your financial well-being, so I would strongly urge you to think twice before buying a house. Can you really afford it? Are you going to stretch yourself too thin? What happens if you lose your job? I don't like being a debbie-downer, but I want you to financially flourish. If you want to talk about this, please let me know. Better yet, talk to your financial planner (or get one if you don't have one).

In Summary...

• Housing is extremely expensive.

• Mortgage payments have risen to extremely high levels as a result of high housing prices and high interest rates.

• Increased prices on materials for houses and issues for homebuilders have helped keep housing prices elevated.

• Delinquency rates on mortgages are low due to wage inflation and historically high levels of household wealth.

• Housing demand has started to soften, which, paired with a restoration of normally functioning supply chains and falling housing input prices, could cause housing prices to decrease.

• Ensure that you can financially afford a house before you buy it, especially considering the economic condition we are in.