Housing market activity is crashing—and it threatens to push the U.S. into recession just like it did in 1981 and 2008
BYLANCE LAMBERT October 25, 2022 at 2:06 AM PDT The go-to line this year from analysts and economists alike is that “the Fed will push until something breaks.” Increasingly, it’s looking like that “something” might be the weakening U.S. housing market. “Las Vegas is one of the leading indicators for [home] price action in the housing market, like we saw in 2008 and the recent frenzy. We are absolutely feeling the heat here. The buyer pool has, for the most part, dried up,” Kristen Riffle, a real estate agent in Las Vegas, tells Fortune. But it’s not just bubbly markets like Las Vegas and Boise that are feeling the pain: This housing downturn is picking up steam nationwide. In fact, as of last week, mortgage purchase applications are down 38% on a year-over-year basis. That marks the lowest reading since 2014. Simply put: Housing activity is crashing. Let's be clear, though: This "crash" in housing activity—or as Fed Chair Jerome Powell calls it a "difficult correction"—didn't appear out of thin air. It's by design. The Federal Reserve flipped into inflation-fighting mode this spring with hopes that elevated interest rates would cause activity to slump in rate-sensitive sectors like housing. The Fed's reasoning for slowing the housing market boils down to two words: demand destruction. Historically speaking, mortgage rates spike as soon as central banks go into inflation-fighting mode. That mortgage rate shock causes sales for both existing and new homes to fall. As builders cut back, demand for both commodities (like lumber) and durable goods (like refrigerators) then declines. It also causes real estate and construction layoffs. Those economic contractions then quickly spread throughout the rest of the economy and, in theory, help to weaken the labor market and tame high inflation. “The most frequent way we enter into recession is the Fed raises rates to fight inflation. The leading indicator for this type of recession is housing,” Bill McBride, author of the economics blog Calculated Risk, told Fortune this summer. “It [housing] is not the target, but it [housing] is essentially the target.” Of course, we're already seeing these housing-spurred economic contractions. Homebuilders are cutting back. Real estate firms are trimming headcounts. And some regional housing markets, like Boise and Seattle, have already slipped into a home price correction. "Realtors are feeling it big-time, as well. I put in a call to the Greater Las Vegas Association of Realtors, and the employee I spoke with said that they were averaging about 300 new members every month. This month she had estimated 120; however, she has been processing about 30 realtor withdrawals a day," Riffle says. That means every day around 30 real estate agents in Las Vegas alone are calling it quits. Now let's rewind back to the intro of this article. When analysts say "the Fed will push until something breaks," they're implying the Fed's inflation campaign is going to continue until either inflation abates or something pushes the economy into a recession. That "something" could be distress in the bond market, or perhaps liquidity issues at major financial firms. But there's also growing concern that the "something" could be the housing market. 1981 and 2008 There's nothing unusual about a housing downturn helping to trigger a recession. Look no further than economist Edward Leamer’s 2007 paper titled “Housing Is the Business Cycle.” Leamer found that 80% of post–World War II recessions came after a “substantial” housing slowdown. But when analysts talk about housing being what "breaks," they're talking about a housing downturn not just helping to cause the recession but being the underlying cause. The most notorious historical examples of this are 1981 and 2008. Back in the early 1980s, Fed Chair Paul Volcker famously tackled the inflationary run that had started in the ’70s. The central bank achieved its goal but only after spiking mortgage rates—which climbed to 18% in 1981—created a housing downturn so sharp that it drove the entire economy into recession. While home sales and building levels both cratered, home prices actually remained fairly stable throughout the 1981 housing downturn. The 2008 housing crash, of course, was a different story. Unlike 1981, the 2000s housing downturn was brought on by a housing bubble. That slowdown started in 2005 after a series of Fed rate hikes. Over the subsequent years, it would escalate into a full-blown housing bust that brought on the Great Recession. Unlike 1981, the 2000s housing crash was underpinned by a perfect storm of rampant overbuilding, deteriorating household finances, historic levels of overvaluation, and toxic subprime mortgages. While the 2022 housing market downturn doesn't fit squarely into either the 1981 nor 2008 camp, it does share traits from each. Just as in 1981, the 2022 housing market has deteriorated in the face of a historic mortgage rate shock. And similar to 2008, the 2022 housing market has once again become detached from underlying economic fundamentals. A historic affordability shock. That's the best way to describe why the housing market might be the "something" that breaks. The Pandemic Housing Boom—which saw U.S. home prices climb 43% in just over two years—coupled with 7% mortgage rates has simply pushed affordability beyond what many would-be borrowers can afford. Relative to incomes, it's actually more expensive to buy now than it was at the height of the housing bubble. Whenever mortgage rates rise, some would-be borrowers—who must meet lenders' strict debt-to-income ratios—lose their mortgage eligibility. When mortgage rates spike from 3% to 7%, it translates into millions losing their ability to purchase. There's no doubt about it: The housing market entered into a downturn back in the summer. That said, the economic contractions aren't yet at the level you'd expect to see before a Fed-induced recession. Something stands in the way: homebuilding. On one hand, single-family housing starts are down 18.5% on a year-over-year basis. On the other hand, homebuilders remain busy. A combination of supply-chain constraints and an eagerness to cash in on the Pandemic Housing Boom led homebuilders to massively ramp up production over the past two years. That backlog is so big, they are still working through it. And as long as builders and contractors remain busy, it will slow down the spike in construction job cuts that normally come before a Fed-induced recession. Heading forward, economists and analysts alike believe the housing market will continue to deteriorate. This year, Wells Fargo projects sharp declines in new-home sales (-10.5%), existing-home sales (-7.4%), single-family housing starts (-7.3%), and housing GDP (-10.1%). Then, in 2023, Wells Fargo expects another drop in new-home sales (-6.5%), existing-home sales (-13.1%), single-family housing starts (-12%), and housing GDP (16%). If Wells Fargo's forecast—which also predicts a 5.5% decline in U.S. home prices in 2023—comes to fruition, it would mean that the housing market downturn reaches a level that historically occurs only during recession. While the housing downturn appears to be on a trajectory that could push the U.S. economy into recession, nothing is certain. If inflation eases, the Fed could pivot policy before a recession becomes locked in. There's also the theory that a significant drop in residential investment—which makes up 4.6% of GDP—wouldn't be as impactful on today's less housing-dependent economy. While it's true that private investment topped out at a much higher share of GDP in 2005 (6.7%), we're actually slightly above the share seen in 1981 (4.4%). In other words, don't underestimate housing. But "recession" or "no recession," the housing industry is clearly feeling the pinch of the tightening cycle. It's hard to see that changing anytime soon. "I have literally nothing under contract. I'm a long-hauler, but I'd be lying if I said I wasn't nervous," Kira Mason, a real estate agent in Philadelphia, tells Fortune.
What is a 2-1 Rate Buy-Down?
What is a 2-1 Buydown? As interest rates climb, temporary buydowns have become an avenue that some sellers and buyers may consider. A 2-1 buydown program is a concession offered by sellers to incentivize buyers. A 2-1 buydown essentially allows borrowers to make a lower mortgage payment for the first two years of their loan, and payments go back up to normal, on the third year of the loan. If you’re seeking ways to reduce your monthly mortgage payment before purchasing a home, a 2-1 buydown could be a potential avenue. We’ll explore exactly what a 2-1 buydown is, how it works, and the pros and cons to help you make a decision. What is a 2-1 Buydown? A 2-1 buydown program is a type of financing offer to reduce your interest rates for the first two years of a mortgage. If you opt for a 2-1 buydown, that means as a buyer, your interest rate is reduced by 2% the first year and 1% the second year. By the third year of the mortgage term, the interest rate goes back to the original interest rate on the loan. But with a 2-1 buydown, buyers have reduced payments for the first two years. How does a Temporary Buydown Work? A temporary buydown is a closing concession available for primary and second home purchases. It enables borrowers to have a lower interest rate for the first two years of purchase and ease into their mortgage payments. The builder or seller will fund a temporary buydown, but it’ll need to be included as an agreement in the purchase contract, and the real estate agent negotiates it during the offer process. The prepaid sum is paid during closing into the escrow account. The lump sum is held in a custodial escrow amount and is applied to the buyer’s payment. The buyer will have a reduced monthly payment, and the difference in interest rates comes out of the escrow account. The first year, the interest rate is lowered by 2 percentage points and 1 percentage point the following year. Temporary Buydown Scenario Let’s look at a temporary buydown scenario* to help you understand what it’ll look like in action. Let’s say you’re buying a $450,000 house with a 20% down payment for a mortgage loan of $360,000 and an interest rate of 7% and APR of 7.094%. A monthly principal and interest (P&I) payment would be about $2,395.05. With a 2-1 buydown, your interest rate would decrease by 2% from the original rate for the first year. So, with a 5% interest rate, your monthly P&I amount would be $1,932.56. The following year, your interest rate would go down by one percentage point from the original rate, taking it to 6%. The monthly P&I amount you’d be paying would be $2,158.38. Your payment would then be at the original 7% interest rate from the third year onwards, taking your monthly P&I back to $2,395.05. Bear in mind that this scenario doesn’t factor in taxes and insurance, so your actual monthly payment amount will vary, but you can see the difference between years 1 and 2 versus year 3 and after. Running these different scenarios can help you better forecast what you’ll be paying for the first 2 years versus the third year onwards to understand if it’s the right decision for you. Pros and Cons of a Temporary Buydown? The first thing to point out with a temporary buydown is just that, it’s temporary. Initially, it can be a pro that you’re paying lowered mortgage payments the first two years. However, if your income doesn’t match the payment amount in the third year of the loan, it can become a serious con. That’s why it’s essential to consider the impact of the monthly payments once they resume at the original interest rate from the third year onwards. A temporary buydown can benefit both sellers and buyers, but it’s more likely to occur in a buyers' market where there are many properties available but not enough buyers. For buyers, this is a bridge for a market with high rates and gives them an opportunity to buy now, when interest rates are high, with the ability to refi later if rates go down. If they don’t go down and continue to go up, then at least they’ve locked in a lower rate right now. For sellers, it enables them to move properties faster and keeps them from staying on the market too long. For buyers, the reduced monthly payments can help manage initial housing expenses. Via Cross Country Mortgage
The Real Estate Collapse of 2023
By Douglas A. McIntyre Increasingly, experts who cover the real estate market look for a collapse of prices, and sales, in 2023. Almost the entire reason is interest rates, which are near 7% for 30-year fixed-rate mortgages. The number may top 8% next year. This would be a two-decade high. Mortgage rates were near 3% last year, which made homes unusually affordable. This helped fuel the housing market boom not matched since 2005. That one ended in the housing collapse of 2007/2008. That will not happen with the next collapse. Mortgage qualifications are much more stringent than they were 17 years ago. And the entire financial system will not crater as it did during the Great Recession. Foreclosure figures will be low, even though home sales and values will drop.The logic behind a collapse in housing prices is partly that cheap mortgages created a land rush for people who wanted new homes. Many of these migrated from large and expensive real estate markets on the coasts, such as New York, San Francisco and San Jose. Many of these people moved inland to metros such as Phoenix and Boise. This rush, in turn, pushed prices in these smaller cities up quickly. Home prices in several areas rose 30% or more year over year each month. Even before the rise in mortgage rates, demand had priced these markets beyond the reach of many buyers. The difference between the monthly payment on a $400,000 home (about the U.S. median house price) can be hundreds of dollars a month between a 3% mortgage and one at 7%. Add this to home values that already have soared, and millions of people have to shift their strategy about home purchases. Mark Zandi of Moody’s recently told Realtor.com, “The housing market is the most interest-rate-sensitive sector of the economy. It’s on the front lines of the fallout from the Fed’s efforts to bring down inflation. Another wall real estate buyers have to climb is the overall rate of inflation, which the consumer price index has put at over 8% recently. This erodes the overall buying power of many people as the cost of essentials, including food and travel, rises quickly. Household budgets are under siege. Purchasing power, in general, falls to pieces. Home prices will dive next year, particularly in expensive markets. The Federal Reserve will take most of the blame. Its efforts to fight inflation through interest rate increases have driven mortgage rates that have made too many homes unaffordable. 247wallst.com
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