Just 11 years after the last housing bubble burst, the United States is in the midst of yet another boom — both caused by errant federal housing policy and inflated by regulatory malpractice.
For decades, Congress has mandated any number of credit-easing policies because they appear to make buying a home more affordable at seemingly no cost. But, as the last housing bust proved, there is no free lunch. These mandates result in unsustainable price increases and price volatility by increasing demand when supply is constrained. This same process is being repeated today. But the cost is anything but free as these mandates make housing less affordable and promote instability.
Regulators enforce these mandates by requiring agencies like the government-sponsored enterprises Fannie Mae and Freddie Mac to loosen credit standards in order to garner more business with higher-risk borrowers. In the last boom, the Department of Housing and Urban Development forced the GSEs to compete for subprime borrowers with both the Federal Housing Administration and private lenders.
Yet this federally mandated credit easing coincided with a seller’s market — when there is less than six months of for-sale inventory at the current sales rate. In a seller's market, the seller has pricing power because the supply of homes is low relative to overall demand. Therefore, credit easing was quickly capitalized into higher — not more affordable — home prices. The added buying power merely allowed lower-income buyers to inflate the price boom, at the expense of a greater debt burden and higher risk. Since the marginal buyer determines not only price levels, but also the degree of volatility in the market, the result was financial instability.
In the current boom, regulators are repeating these same mistakes. Take, for example, the Consumer Financial Protection Bureau’s ability-to-repay rule, which emerged in response to the financial crisis. This rule established the “qualified mortgage,” a type of loan created to ensure that potential buyers can afford their mortgage. Even though a QM cannot have risky features such as balloon payments or an interest-only period and caps the debt-to-income ratio at 43%, it has crucial flaws. There are no minimums placed on credit scores, no maximums placed on loan-to-value ratios and no limits on risk layering, which is when low credit scores are combined with high LTVs, a 30-year amortization term and high DTIs. QM is all but safe. During the last financial crisis, there were widespread defaults among loans that would meet the qualified-mortgage standard today.
To make matters worse, the consumer bureau has allowed Fannie and Freddie and the FHA to exceed the qualified-mortgage debt-to-income limit to further expand the pool of eligible borrowers. While this decision was applauded by industry lobbying groups for the housing industry, it made QM loans even riskier.
The GSEs are also being forced by the Federal Housing Finance Agency to compete with the Federal Housing Administration for high-risk borrowers. In December 2014, the GSEs, at the behest of the housing finance agency, started to originate loans with as little as 3% down — something the FHFA had told them to stop doing under previous leadership. More recently, the housing finance agency pushed the enterprises to increase their DTI limit to 50%, further away from the original QM standard.
An even earlier jolt to lending came from monetary policy. In late 2012, the Federal Reserve
As a consequence of market conditions and credit easing, home prices started to rise rapidly. Since their trough in 2012, home prices have risen at an annual average rate of 5.5%, far more rapidly than incomes or inflation. At the lower end of the market, where leverage has been expanded the most, prices have recently risen at twice that rate. Thus again, so-called affordability policies geared toward first-time buyers have made entry-level housing less — not more — affordable.
With levels of supply even lower today than during the last boom, the current run-up is already in its midstage — and will likely continue. But as the earlier boom has shown, everything that goes up must come down. The further prices deviate from market fundamentals, the more painful the eventual price correction will be for homeowners. Regulators have again endangered the long-term health of the entire housing market.
Ultimately, more supply is needed to bring the market back into equilibrium, but that takes time and is unlikely to happen soon. In the meantime, regulators need to reduce leverage by reversing some of the procyclical policies they have implemented in recent years. If not, regulators will have no one to blame but themselves for another housing bust.
