By: Liz Strait, PhD
Introduction
Following our post last week about the commercial real estate market, we now turn to the residential housing market. In this market, as with the commercial one, there has been talk about the possibility of a crisis. Some markets are experiencing low inventory and, thus, higher prices, while other markets face weak demand and high inventory. With the Fed’s most recent interest rate hike, there is also increased uncertainty regarding the future of the housing market—buyers may be waiting for rates to drop, while sellers may be unable to sell.
Some key trends discussed in this post are: increased borrowing costs, housing market gridlock, zombie loans, and an HELOC boom. Regardless of whether your clients are directly affected by any of these, they are all indirectly affected by the news and bigger implications of these trends. As a Financial Professional it is important to know the ramifications of different market trends and how they may affect clients—both individually and at a higher level.
Background
The Ripple Effects of COVID-19
In the context of the residential housing market the most important downstream consequences from the pandemic are: (1) financial hardship assistance; and (2) inflation. During the pandemic, many borrowers benefitted from expanded forbearance and financial assistance options. As those programs end, defaults and foreclosures that would have happened years ago are now happening in larger numbers. Regarding (2), supply chain disruptions caused by lockdowns led to reduced product supply, which, in turn, increased prices, and sustained inflation. To combat inflation, the Federal Reserve Board has raised interest rates eleven times since March 20221.
Increased Borrowing Costs
In the residential real estate market, home foreclosure rates are steadily increasing. In fact, foreclosure filings (defaults, scheduled auctions, and repossessions) in May 2023 were 14% higher than in May20222.This is largely due to the increased cost of living (inflation) and the end of COVID-19-related debt relief programs (i.e., student loan debt, forbearance programs). This means that some, if not most, of this increase in foreclosure starts was anticipated—relief programs seemingly delayed the inevitable for many households, as current foreclosure rates are on-par with those witnessed pre-pandemic. However, the rising cost of living is resulting in foreclosures as well. While inflation has started to decrease it is still almost twice what it was pre-pandemic—leading the Fed to state it will likely keep interest rates high until inflation is closer to 2%. This means that as debts come due after years of forbearance and the costs of living outpace any increases in income, foreclosure filings will likely continue to rise. This is not an ominous sign of a reemerging housing crisis as there is one very important factor that sets now apart from the situation in 2007-2008: low unemployment. This will buoy many homeowners’ financial health, keeping the housing situation far from crisis level.
Gridlock
For the single-family housing market, one of the greatest issues is gridlock. The problem is best represented by this statistic: only 9%of all mortgages currently in existence have an interest rate above 6%, despite interest rates having been above 6% since August 20223. This suggests a relatively small number of mortgages have been initiated in the last year. This is because millions of current and potential homeowners took advantage of the extremely low rates available during the COVID-19 pandemic. Borrowers with these exceptionally good rates are waiting for rates to go back down before selling—if they were to sell or refinance now, the cost of homeownership would increase exponentially. Thus, they have no incentive to sell their house. This has led to a large drop in supply—new listings are currently 27% lower than they were just a year ago4. This reduced supply has led to a further increase in the cost of buying a new home—not only are borrowing costs higher, but purchase prices have also become inflated. While the rate can eventually be renegotiated (via refinance), the purchase price cannot be refunded when supply returns to more normal levels. For this reason, purchase price attractiveness is more important than interest rates (assuming rates will normalize at some point in the near future). There are now two good reasons not to buy or sell (increased borrowing costs and increased list prices), which only perpetuate the gridlock.
Zombie Loans
Another interesting trend in the residential mortgage-backed securities market is the reemergence of some Non-Performing Loans or NPLs. NPLs are loans in delinquency of at least 30 days and still accruing interest or delinquent loans in non-accrual status. These loans are often off-loaded by banks to investors—both individuals and Wall Street firms like Goldman-Sachs. This means the banks have written off the loans, but borrowers technically still owe on them. Investors can buy these NPLs for significantly less than their face value—hoping to make a profit by turning the loans into reperforming loans. Many of these NPLs date back to the aftermath of the housing crisis and have been non-performing for many years—so long, in fact, that most borrowers forgot they existed or assumed they had been closed. This is when NPLs take on “zombie” status—borrowers believe the debt has been cleared, but then the loan returns several years later5.
Even though the current ratio of NPLs to non-delinquent loans is very low, this ratio was over five times higher in 2009 following the housing crisis and remained above 3% until 20136. It is from this large pool of NPLs that zombie loans are currently emerging. Zombie loans have reappeared because they have become more attractive to investors in the face of dramatically increased home prices (higher home prices result in greater home equity). Since second mortgages are only paid off if equity remains in the home after the first mortgage lender is paid, higher home values make NPLs more lucrative because as home equity increases the chances of collecting any money at all are much higher. Even individual investors are holding hundreds to thousands of NPLs in the hopes of generating passive income (via reperformance), receiving a lump sum payout in the face of settlement or foreclosure, or reselling the loan to another investor once it has become reperforming.
HELOC Boom
An increasing number of homeowners are tapping into their accumulated home equity via Home Equity Lines of Credit (HELOCs)—new HELOC originations increased by 34% from 2021 to 20227. Higher interest rates have made refinancing less attractive, leading many to turn to HELOCs. And lenders have encouraged this by making such funds more easily available to combat the dearth of refis (many banks had made HELOCs harder to get because they are considered second mortgages and, as such, represent increased risk for banks as they are only paid off after primary mortgage obligations are met).
Source:Federal Reserve Bank of St. Louis (FRED)
Notes: (1) This is the first time we've seen an uptick in HELOCs since the housing crisis. (2) The gray box indicates the Great Recession (December 2007 – May 2009).
However, the increased interest rates also make HELOCs more costly—most are set up with variable interest terms so that, as the Fed increases rates, the associated borrowing costs also increase. This adds up quickly for homeowners with sizeable equity. Homeowners are generally using this liquidity to make investments—in property or otherwise. However, the high interest rates make the potential investment opportunities less attractive, meaning some HELOC holders have interest payments that aren’t being covered by increased income. At least anecdotally, it appears homeowners taking out HELOCs are more focused on the access to liquidity than the borrowing costs that may make that access prohibitively expensive.
End Notes
[1] Nowacki, Lauren. “2023 Fed Rate Hike Impact on Mortgages, Home Buying and More.” Rocket Mortgage, Jul 04 2023, https://www.rocketmortgage.com/learn/fed-rate-hike.
[2] Wile, Rob. “Home Foreclosures Are Rising Nationwide, with Florida, California and Texas in the Lead.” NBC News, 9 Jun 2023, https://www.nbcnews.com/business/economy/home-foreclosures-rising-in-us-where-which-states-rcna88394.
[3] Swaminathan, Aarthi. “Only a Tenth of Mortgages Have an Interest Rate above 6% — That’s a Big Problem for the U.S. Housing Market.” MarketWatch, 14 Jul 2023, https://www.marketwatch.com/story/only-a-tenth-of-mortgages-have-an-interest-rate-above-6-thats-a-big-problem-for-the-u-s-housing-market-36d1029e.
[4] Marx, Sarah. “Share of Mortgages in Forbearance Drops in June.” HousingWire, 17 Jul 2023, https://www.housingwire.com/articles/the-share-of-mortgage-loans-in-forbearance-decreased-by-5-basis-points-in-june-2023-relative-to-may-2023-to-0-44-from-0-49.
There is reason to think supply may go up—at least in certain areas—relatively soon. Data on Airbnb bookings has shown some movement away from non-urban locations that became quite popular during COVID-19 back to cities. This reduced demand lowers the prices hosts can charge in less popular areas. This is most problematic for individuals or companies who bought larger numbers of properties in a concentrated area to capitalize on low borrowing costs and changing travel trends. Owning a swath of less popular properties may no longer be profitable—leading holders to off-load some of their properties. This increases supply in the housing market, which has no effect on the cost of borrowing, but does put downward pressure on purchase prices. See: Morris, Chris. “Is Airbnb Crashing or Not? It Depends on What Data You Look At.” Fast Company, 13 Jul 2023, https://www.fastcompany.com/90922430/is-airbnb-crashing-or-not-it-depends-on-what-data-you-look-at.
[5] It is important to note that not all NPLs are zombie loans—some NPLs are written off and further collection is never attempted. Even more importantly, there are statutes of limitations that prevent collection after a certain amount of time (usually less than 10 years, but it varies by state). This means that many zombie loan holders are pursuing borrowers unlawfully (and the Consumer Financial Protection Bureau, or CFPB, has taken notice: https://www.consumerfinance.gov/about-us/blog/zombie-second-mortgages-when-collectors-come-for-long-forgotten-home-loans/).
[6] “Non-Performing Loans as a Share of Total Gross Loans in the United States from 2009 to 2022.” Statista, https://www.statista.com/statistics/211047/percentage-of-non-performing-loans-held-by-us-banks/.
[7] Ballentine, Claire, and Paulina Cachero. “US Homeowners Are Tapping $9 Trillion in Real Estate Wealth.” Bloomberg, 15Jul 2023, https://www.bloomberg.com/news/articles/2023-07-15/rising-real-estate-prices-make-helocs-popular-for-owners-tapping-equity.
[8] How “bad” do consumers tend to feel? Twice as bad as if it were an equivalent gain. So, if the price of eggs increases by $2, that feels like a loss of $4. This comes from loss aversion and explains why increasing prices has to be done thoughtfully since consumers will respond much more negatively to price increases than they will respond positively to price decreases. In the context of mental accounting and pricing, the reference price is the reference point that determines whether something is a loss or a gain. In other words, the reference price is how we know whether someone will feel loss aversion or not.
[9] U.S. Bureau of Labor Statistics, Average Price: Eggs, Grade A, Large (Cost per Dozen) in U.S. City Average [APU0000708111], retrieved from FRED, Federal Reserve Bank ofSt. Louis, https://fred.stlouisfed.org/series/APU0000708111.
[10] While home prices are relatively strong (especially compared to when the pandemic lockdowns first started lifting), there are major metropolitan areas that have seen significant decreases in average prices over the past year. These include (1) San Jose/Sunnyvale/Santa Clara, CA (-13.7%); (2) Anaheim/Santa Ana/Irvine, CA (-5.1%); (3) San Francisco/Oakland/Hayward, CA (-14.5%); (4) San Diego/Carlsbad, CA (-2.8%); (5) Boulder, CO (-2.6%); (6) Seattle/Tacoma/Bellevue, WA (-6.3%); (7)Portland/Vancouver/Hillsboro, OR (-2.4%); (8) Reno, NV (-10%); (9) Salt Lake City, UT (-6.1%); and (10) Austin/Round Rock, TX (-13.5%). See: “Median Sales Price of Existing Single-Family Homes for Metropolitan Areas.” The National Association of Realtors (NAR). https://www.nar.realtor/research-and-statistics/housing-statistics/metropolitan-median-area-prices-and-affordability.
[11] The finding of positive illusions originally came from this paper: Taylor, S.E.; Brown, J. (1988). "Illusion and well-being: A social psychological perspective on mental health". Psychological Bulletin, 103 (2): pp. 193–210. Additional components and consequences are discussed here: Kruger, Justin; Chan, Steven; Roese, Neal (2009). "(Not so) positive illusions". Behavioral and Brain Sciences. 32 (6): pp.526–527.