Curb Your “Exuberance” – Dallas Fed Warns Of Building A Housing Bubble

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published on 21 April 2022 – 14:37
Written by Edward Smith

Following unprecedented surges in property prices, researchers are closely studying what they fear may be a bubble. Pent-up demand has created a cycle that feeds off of what they consider “market fundamentals”.

At the same time, industry players are confident about the scrutiny of home loans, separating today’s market from an era 15 years ago when almost anyone could get a mortgage. However, what most can agree on is to learn from the lessons of the Great Recession, the market has legs to lean on if this bubble bursts.

Feeding frenzy

The Federal Reserve Bank of Dallas published an article last week titled “Real-Time Market Watch Reveals Signs of U.S. Housing Bubble Brewing.” He says the “exuberance” of investors paying above a home’s appraised value is driven by a “widespread belief that today’s sharp price increases will continue.”

“This self-fulfilling mechanism leads to price growth that can become exponential (or explosive), causing the housing market to gradually misalign with fundamentals until investors become cautious, policymakers intervene, that the flow of money to housing will dry up and that a housing correction or even a bust will occur,” the report read.

It takes more than a rise in prices to indicate the presence of a bubble, said Dallas Fed Senior Research Economist Enrique Martinez-Garcia, one of the study’s authors.

Price-to-rent and price-to-income ratios started behaving abnormally in 2021, Martinez-Garcia said. These ratios compare house prices to rental income and an area’s average personal income.

“We look for markers in the data that are consistent with how actual house prices or related measures of profitability (housing price to rent ratio) or affordability (housing price to income ratio) would behave differently when their momentum is driven by a bubble,” Martinez-Garcia said. “That is, when their momentum is driven by the expectation of continued house price gains in the future, even when market fundamentals no longer appear consistent with those gains.”

A similar desire for investors was reflected in the run-up to the 2008 housing crisis, when ‘fear of missing out’ raised expectations of return on investment.

This kind of investor exuberance can create a self-fulfilling prophecy of real estate values ​​out of step with fundamentals. The “fundamentals” they look at are disposable income, mortgage rates, construction costs and land availability, all of which govern supply and demand.

“That’s pretty strong evidence for us of a red flag in housing as an investment,” Martinez-Garcia said.

Comes down to demand

Even though homes are sometimes selling for $30,000 to $50,000 above the listing price, the fact that people are willing to pay that price means it’s worth it to them, said owner John Vartanian. of Clovis-based MAV Mortgage, a mortgage lender and bond market analyst. Loans backing these purchases are strong, Vartanian added.

“The core problem is just supply and demand, prices are going up but they’re not going up to a level that people can’t afford because otherwise they wouldn’t go up that much,” Vartanian said.

As the Great Recession approached, lenders did not require much verification of income. There were even cases with no documentation in loan applications. These were called “docless loans,” Vartanian said. This is not the case in this market.

“People quickly equate the house price hike to 2008, but they’re two different animals,” he said.

Post-pandemic, the self-employed looking for accommodation faced the most scrutiny, having to provide bank statements and proof of income, Vartanian said.

“Until that supply is determined, you’ll have more demand than you have for supply and that’s what’s driving it – not the ease of funding,” he said.

Read Indicators

Martinez-Garcia said there are three indicators the Federal Reserve is analyzing that could show a bubble is developing. It is expected that in response to inflation and lower disposable income, house prices will slow.

“If expectations for future house prices and price gains continue to be strong, this could provide further evidence that the rise is increasingly out of step with market fundamentals,” Martinez said. Garcia.

In the Fresno market, there has been strong pent-up demand for homes, said Steve Flach, president of the Fresno Association of Realtors and director of sales for Guarantee Real Estate’s Fig Garden office.

Many buyers were outbid by aggressive bids. This created a large pool of people trying to enter homes, Flach said. Between February and March, the number of homes sold in Fresno County increased 29.6%, from 920 homes sold to 1,192.

And while many have become frustrated with their inability to buy a home, there are still buyers who want to play in an overheated market. Money in the Central Valley goes much further than in other parts of the state. This attracted a lot of buyers to the area.

Martinez-Garcia also looks at the impact that monetary policy tightening should have. Decreasing access to cash should drive buyers away from the market as the price of borrowing becomes more expensive.

The Federal Reserve plans to raise the federal funds rate six to eight times by March 2023. Long-term loans such as mortgages generally track the short-term rate that banks lend to each other. Since January, the standard 30-year loan has increased from 2% to 5%, Vartanian said.

Martinez-Garcia said if the exuberance continues despite rising mortgages, it could indicate a housing bubble.

Fed responses to inflation will not solve supply problems, Vartanian said.

Even by eliminating half of the buyers of a house, competitors continue to bid against each other.

inflation factor

The third thing Martinez-Garcia is looking for is the impact of shipping disruptions and construction costs. The concern is that if demand cools, prices could continue to rise rapidly if supply is tight again, Martinez-Garcia said. Even higher gas prices could push up real estate prices in places like Texas, where returns at the gas pump fuel economies dependent on the energy sector.

At the very least, what researchers fear is that as prices rise, low-income buyers and first-time homebuyers will be squeezed out of the market. “But when the silver dries up, it can lead to a price correction,” Martinez-Garcia said.

Andres Jauregui, director of the Gazarian Real Estate Center at Fresno State and professor of real estate at the Craig School of Business, views income as market vulnerability.

Incomes rose, but faster inflation lowered real income, Jauregui said.

These declining real incomes make homes less affordable. Developers are trying to get houses online, but “you can’t build houses overnight,” Jauregui said.

With homes becoming less affordable and mortgage rates rising, Jauregui predicts price growth will slow. Jauregui thinks house prices will start growing at a more modest 5-8% rate.

Real estate experts predict growth of 5-6%, Flach said. He could see 8% to 10% in the local area.

What the experts can agree on is that the average buyer has proof that they can afford the homes they live in. In 2008 mortgages were issued that should never have been taken out as people bought beyond their means, Jauregui said.

If those lending guidelines change – allowing people to qualify on an unsustainable basis, then Vartanian said he would start to worry.

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