During the last financial crisis, the housing market was ground zero. It’s much more on the periphery this time, and the effects of the lockdown will be more like a stall than a crash.
The 2008 financial crisis was brought about entirely from the collapse of the housing market, or more specifically, the collapse of the credit market that was based upon the timely repayment of home loans.
No one wondered whether the housing market was going to take a big hit from that crisis, as the housing market was the crisis itself, and when it crashed, it reverberated outward, taking the banks down and then the economy itself to a significant degree.
A single thing was behind all of this, and it wasn’t escalating home prices, it was the default rate of mortgages. There were two main factors involved, which were rising interest rates combined with the inability of a lot of borrowers to repay mortgages that they never should have qualified for in the first place.
The lending industry took on a lot of bad debt, and a lot of these mortgages required that housing prices continued to rise to be able to use the equity that was built up from this to subsidize the inability of borrowers to repay their mortgages from their own resources.
This was a time where the economy was growing at a little faster pace than the Fed was comfortable with, and their putting interest rates didn’t exactly sit well with the strategy of not worrying if you can afford the mortgage payments because you can just borrow more once your mortgage comes up.
These higher rates not only increased the cost of borrowing for those who couldn’t even afford the lower rates, it also served to temper the upward movement of prices that this real estate Ponzi scheme depended on.
Housing prices peaked in March of 2007, then they started backing off. We had three distinct factors at work at this point to bring down the house, which were the effects of Fed policy to cool down the economy as a whole, the rising interest rates causing less new home purchases, and the mounting level of mortgage defaults, which was well underway at the time.
It was the defaults that ended up melting down the housing market in the end, greatly increasing supply and lowering prices, with the lowering of prices creating a massive domino effect on defaults. The real damage to the economy was caused by all the bad debt, by way of shrinking the money supply so much even with the best efforts of the Fed and Congress to try to fix things.
As we battle our way through a new financial crisis, and wonder how the housing market will bear it, we might think that another housing market collapse may be on the way, or the market may be exposed to significant damage at least. This time around, things are completely different though, and while this latest crisis does give us plenty to worry about, the housing market should be among those least affected this time around.
Comparing the 2007-08 housing crisis with today can serve to be instructive, to show the differences, and then look to what else we may expect as this situation we’re in now with our economic lockdown unwinds.
The last time around, the Fed rate went from 0.75% in 2003 to 5% in 2006, and it wasn’t until the fall of 2007, with housing prices already falling, that they adjusted it down. Over a period of three months, the rate declined by a full point to 4%, but the house was already on fire and this was way too little too late to stop it from burning down.
It took all of 2008 to get the rate down to the zero that it is now, as the housing market fire turned into an inferno that engulfed the entire economy. The fire department should have been called much earlier, and they should have sent a lot more fire trucks to fight this massive blaze, and even though this would not have prevented it, it could have slowed the fire enough so that we may have been able to get it under control sooner and limited the damage more.
This time around, interest rates started much lower, and the fire department was called in preemptively, with rates going right to zero even before anyone smelled smoke in their homes. The Fed rate directly affects adjustable-rate mortgages, which move up and down with the prime rate of banks, which move with the Fed rate, and adjustable rate mortgages were reduced to the minimum right off the bat with these moves.
It was the adjustable rate mortgages that came under so much pressure last time around, and when the crisis hit, they were 5% higher during most of 2007 than they are now, in the critical initial stages of a crisis where the fire starts and then can rage out of control if not addressed properly.
These subprime mortgages that ended up bringing us down saw their rates increase by up to 4.25% over their term, and given that these mortgages were already so tenuous, too tenuous at the time to ever have been considered, this rate rise turned out to be disastrous. These borrowers were given teaser rates to get them into their homes, where when they expire, they would have to pay the market rate, and if they couldn’t afford the much lower rates at the time, they surely could not afford rates much higher.
We have put this Ponzi scheme behind us since, and given that this was the cause of the last crisis, that in itself distinguishes that housing crisis from whatever we may be up against now.
Fixed rate mortgages don’t follow the Fed rate like adjustable rate ones do, but they are also considerably lower than back then. Fixed rates peaked at 6.74% in the summer of 2007, and they are now at record lows of 3.26%, down from the 4.85% of last October. This all serves to make not only new home purchases cheaper, but more importantly in the time of a financial crisis, allows people to refinance their mortgages at much friendlier rates to help bail themselves out of trouble if needed.
This is important as it mitigates the default rate of unsecured personal debt, especially amounts that have accrued as a result of the lockdown. Without this ability, a lot more borrowers would find themselves in over their heads and would be put in a position where they would be unable to service this debt once they got back to work.
Refinancing Can Be a Powerful Weapon Against Debt Problems
Refinancing not only allows homeowners to amortize this debt along with what they already owe on their mortgage over 30 years, greatly reducing the monthly payments on the refinanced debt, it also allows them to refinance it at much lower rates, and most importantly for the economy, reduces the amount of these loans that default and get written off by lenders.
Unsecured defaults are a separate category and a different matter than mortgage defaults, but the two are related, and if we get a lot of unsecured defaults, this shrinks the money supply and can impact the mortgage market as well by way of its impact on the economy as a whole.
Home equity is a form of stored wealth, wealth that can be marshalled in times of need. While some take a dim view of equity take-out, and this can certainly be abused when people do this for more frivolous purposes, it is a very valuable tool to mitigate financial damage that already has occurred, and serves as a valuable remedy to overcome the sort of challenges that people face today.
Due to the temporary nature of this shutdown, and especially since this crisis has been by decree and not by way of natural economic causes, as all other crises have been, lenders have been much more accommodating toward it.
If is actually in the self-interest of lenders to do this, as they dislike defaults as much as we do, maybe more, and while it’s too much to ask them to suspend your payments in the hopes that you might find another job, if you already have one and are just waiting for your state government to let you get back to work, it is clearly in the best interests of all to let you just defer your payments.
Not only would lenders pay the price for these defaults, foregoing future interest on these mortgages that could be paid back with a little forbearance, if banks start foreclosing on people, we could be right back in 2008 again. The last thing banks need is another 2008 on top of everything else going on now, and extending the amortization of these mortgages actually has them making even more money from them, so this was an easy decision for them to make.
Banks are also showing more flexibility when it comes to new lending to those temporarily off work due to the pandemic, and this also makes sense for them to do, especially if you are refinancing internal debt. Those outside the banking industry don’t generally realize how much of a difference this makes, but it only makes sense that a bank will be much more flexible in lending to you to get better terms on money you already owe them than money you owe someone else.
With internal debt, banks will usually not care about how bad your financial situation is when it comes to your looking to refinance it, and this makes sense as well, because their saying yes puts them in a better position regardless. If you’re about to default on unsecured debt that you owe them, they would much rather secure it and be able to collect it by way of foreclosure, if necessary, rather than having to write it off and sell it to a collection agency for far less than full value, and even will permit new unsecured loans to reduce your payments and your interest to avoid your defaulting.
This is a big reason why it is often better to keep all of your debt in one place, and especially if you have a mortgage. Banks prefer that you pay everything that you owe them, and will bend over backwards to help you with this. They care far less about money you owe other lenders, and aren’t too bothered if you default to someone else, and this can even be desirable for them as it can take the load off of your paying them back.
Lenders are not only allowing borrowers to defer payments on their mortgages, they are doing the same thing with unsecured debt as well, for the same reasons. Once again, they would rather wait until you are back at work when it is very likely that this will happen fairly soon, where they just charge you interest in the meantime, than seeing you default and see them lose. It’s better to make more money than lose money, so this arrangement clearly benefits them as well.
When banks or other lenders extend a loan to you, they do so with the reasonable expectation that you have the capacity to make the payments, which requires a stable source of income. Being out of work isn’t a stable source of course, and there is usually risk involved that you will lose your job, but being out of work temporarily is not the same thing, it is merely a delay in this capacity that may be expected to resume as normal in a lot of cases once the event is over.
This is why lenders are also being more flexible when it comes to lending even more to these folks, and this applies to mortgage financing as well, especially when both the lender and the borrower are made better off by it. For those who have been furloughed, it’s been business as usual for the most part, as it this situation did not exist, and it’s because this really isn’t the same thing as people being thrown out of work entirely.
This Shutdown Could Cause Banks to Rethink Their Rashness a Bit
The lending industry isn’t quite as unyielding as some have thought, even though they could probably benefit from being more flexible overall, but perhaps a silver lining to this dark cloud that we are under may see lenders take a more pragmatic approach to avoiding defaults now, as this type of deferral is an entirely new thing to them.
This isn’t to say that deferrals should always be extended, but there are clearly situations where the risk of doing so would be on the lower end of the scale and someone who loses their job but has good prospects for getting back to work soon could be treated differently than someone who is already working but is in so far over their heads that default is imminent. Defaults should only be pursued as a last resort as no one wins with this and we could perhaps use more forbearance in some situations at least.
There is some math that banks can do to measure the risk involved in carrying this debt a little longer, versus the probability of the benefits involved in allowing their clients to climb back on board by resuming working in a reasonable amount of time. Banks do these sorts of calculations all the time, but need to ensure that foreclosure decisions are made when it actually is in the best interest of the bank.
What stands out even more is the way that mortgage lenders wash their hands of foreclosed properties and dump them on the market at distressed prices due to their urgency to sell. Banks will tell you that they aren’t in the real estate business, but this doesn’t mean that they need to be completely impatient and both invoke additional hardship on their clients, though evaporating their equity, the difference between the market value and what they owe, the price that they are sold at often has the bank experiencing losses as well.
It’s not that banks are completely unwilling to be more flexible, but the goal should be to work with clients more than they do and take a more proactive role in assisting if possible, so that these unsavory events could be better avoided, and when they do occur, the damage to the parties could be reduced when possible.
As far as the housing market itself goes, it is in a state of suspension right now like so many other things. The housing market itself isn’t anywhere near as notable as a lot of people think anyway, and is just one sector among many in our economy, albeit one that is still pretty important.
We could benefit from reform that would place foreclosed properties in the hand of a trustee, where reasonable means and oversight could be enacted, rather than allowing banks, who have no financial interest in any excess value, to destroy this wealth when they find it expedient, with the owner having no one to represent their remaining financial interest.
In the greater scheme of the real estate market, while commercial real estate has been thrown into an absolute crisis, home sales have basically just been put on hold. It’s not that the loss won’t be felt, but given that this is simply being forestalled, with people not transacting due to fears of the coronavirus mostly, when the fear subsides, and when people get back to work, this is expected to return to near normal at least.
The majority of the people out of work now are low wage earners that aren’t really in a position to buy anyway, so this shutdown hasn’t affected the residential real estate market as much as some may think, and the slowdown has been more of a voluntary thing than anything.
With both supply and demand being put on hold so much, like the people waiting to return to work, the residential real estate market has self-isolated, waiting for conditions to improve enough to have this market resume unfettered.
New home construction has taken a little dip, given the reduced demand right now, but that is expected to resolve as well in time. The Fed’s rate cuts last year did spur it, and the contraction from the pandemic merely erased that and has us now back to the level of last summer. Since this was in fine shape then, this is not a concern, and is actually a healthy response since we don’t want to overload the market with excess supply when it isn’t ready for it, which would depress the overall market.
While there will be some big losses on the commercial side, things are not as bad as they may appear at first glance, because these commercial mortgages can be deferred and re-amortized just like residential ones can. It’s not that there won’t be pain to bear, but not anywhere of a magnitude that should concern us that much, as commercial lenders are as eager to avoid defaults as the residential lenders are.
While a lot of rent is not being paid, the temporary nature of this crisis will allow us to ride out this storm much better than with a deep-seated and enduring crisis, and while there will be damage, it will be nothing like what usually happens when we get in this sort of trouble.
As costly as this pandemic may end up being, both in human and economic costs, we can at least comfort ourselves with the fact that the housing market will mostly be spared by this, by our working as hard as we have to avoid a level of defaults that could take this crisis from just a temporary one to one that is left to bring down the house again like it did in 2008, significantly adding to our economic pain and making this crisis last far longer. This particular house stands pretty solidly right now, thankfully.