The upward trajectory of U.S. housing prices have prompted discussions of whether conditions are overheating to an unsustainable level. Now, the Federal Reserve appears to be weighing in about whether a so-called bubble exists in the housing market.
The Federal Reserve Bank of Dallas recently updated its measure of real estate market valuations, known as exuberance indicators, finding that prices in the U.S. real estate market have been above its critical value threshold for five consecutive quarters as of Q2 2021, the latest release. That is the first time it has experienced an episode of exuberance since 2007, according to data from the Dallas Fed, said Jared Coulter, a research analyst for the Dallas Fed.
Usually referred to within the Fed, the so-called exuberance indicator monitors overvaluation risks in the mortgage market known to affect the larger economy.
Gov. Bowman’s take
The central bank is a long way from sounding the alarm, however. In November, U.S. Federal Reserve Governor Michelle W. Bowman acknowledged that risks and resilience coexist in the housing market.
Home supply issues created by shortages of materials, labor, and developed lots, are unlikely to reverse materially in the short-term and likely will cause “higher inflation from housing for a while,” Bowman said at a Women in Housing and Finance event.
Home prices have increased at a moderate rate since 2012, but since mid-2020, price growth has accelerated significantly. In September about 90% of American cities had experienced rising home prices (often substantially) over the past three months, Bowman said.
“These sharp increases raise the concern that housing is overvalued and that home prices may decline,” Bowman said. “Historically, large home price increases are somewhat less concerning, if they are supported by economic fundamentals rather than speculation.”
In 2015 Efthymios Pavlidis, an economics professor at Lancaster University in the U.K., introducing the exuberance indicator in a co-authored paper, “Episodes of Exuberance in Housing Markets: In Search of the Smoking Gun.” The paper notes that five quarters is the minimum duration necessary to be classified as a period of exuberance.
Applying caution to price valuations
Mortgage-backed securities industry observers are already factoring overheated housing prices into their assessments of bonds backed by home loans. In its “U.S. RMBS Sustainable Home Price Report” (Third-Quarter 2021 Update), Fitch Ratings estimates that national home prices are 10.5% overvalued on a population-weighted average (WA) basis, analysts wrote. Fitch calculated sustainable home price for 400 different Metropolitan Statistical Areas (MSAs).
“Fitch is taking on average a 10% haircut nationally on the value when assigning ratings to mortgage debt, to protect against potentially assigning ratings in a bubble type environment,” Kevin Kendra, a managing director at Fitch Ratings who oversees the North American RMBS group. “Yes, we see overvaluation in the market and most of it is driven by drastically increasing home prices in the past year.”
Fitch increased its overvaluation estimate primarily to reflect a rapid home price growth, which continued to outpace improving economic fundamentals in 2Q21, according to the report. National home prices grew approximately 4.5% in 2Q 2021 as annual growth of 19.7% marked the highest rate in history as of July 2021.
“Favorable mortgage rates and the demand/supply imbalance caused home prices to continue to accelerate, while underlying sustainability fundamentals such as income and unemployment are not keeping pace,” Kendra said.
How the market differs from 2008
Other housing experts remain confident that no housing bubble exists – certainly not to the degree as when the market collapsed in 2008 with devastating economic consequences. Rick Sharga, an executive vice president of Realty Trac, for instance, says robust mortgage underwriting, an all-time high borrower credit quality, and outstanding loan performance are keeping the market on sound footing.
Data show serious mortgage delinquency rates peaked in Q3 of 2020, and have come down every month since, he said. Of the seven million-plus loans in forbearance, less than 1% exited via a short sale, deed-in-lieu, or foreclosure. Up to 85% of the borrowers who entered into a deferral or loan modification continued to stay current.
In the Great Recession less than 50% of borrowers stayed current after a loan modification, he said.
True enough, the early lockdown days of the pandemic triggered a significant uptick in second home purchases. Historically low-interest rates, combined with many buyers’ ability to make large mortgage down payments made their monthly payments relatively affordable, Sharga added.
A significant movement from high-priced markets such as San Francisco, San Jose and Seattle to less expensive areas has enabled buyers to pay above current market value, he said. Furthermore, the purchase share of residential homes by single-family rental (SFR) investors in 3Q2021 increased to 16%, from about 11% in 2020, he said.
“Paying the full market price, or even a little over it, is just built into the investor's financial models.”
Also, some of the high end markets that are seeing listing price reductions today, likely will see price corrections in 2022, he said, such as Los Angeles or Boise where prices increased by 45% in 2021.
This is not 2008 déjà vu
In 2020, real home prices increased 18%-20% nationally, with market-to-market variations, depending on the local supply-demand dynamics, Kendra said.
“Do I think it’s a bubble or something [similar to what] we saw in 2008? We are not there yet, certainly not on a year-over-year basis,” he added.
Market fundamentals, mortgage policy reforms adopted after the crisis and subdued investor activity relative to previous economic cycles are keeping the market strong, Bowman said in her remarks at the event.
“Another reason to be less concerned about the recent escalation in home prices is that we do not see much of the decline in underwriting standards that fueled the home price bubble in the mid-2000s,” Bowman said.
