Can the American Dream be Fixed?
Back in February of 2023, we wrote about the housing affordability problem. Unfortunately, the situation has failed to improve and we are seeing more policy prescriptions to ‘fix’ the housing market. Will they work? History suggests that they will not. Markets need to re-balance and that will take time.
Ever since the early 2000’s, when the policy was ‘everyone should own a home’ and incentives were put in place allow more people to own their own home, the housing market has been in a state of turmoil. Whether it was over building, under building, sky rocketing prices, or price collapses, the housing market has been unable to reach any sustainable equilibrium.
The chart below shows the problem quite well. The first hump is the subprime bubble. After that bubble burst, the market never fully corrected, most likely because of very aggressive monetary policy following the 2008 banking crisis, otherwise known as QE. This policy was designed to drive down long-term interest rates in the effort to prevent a deflationary event as the banking sector retrenched.
But those lower rates had the effect of lowering mortgage rates dramatically. Those lower rates made homes more affordable and prices began to rise again. What is particularly concerning is that this second bubble is actually larger than the first bubble! What we are experiencing today is not a repeat of the subprime crisis, but it is the natural evolution of the policies used to overcome the subprime crisis. The issue today is that with interest rates back up and prices so high, homes have become unaffordable for a large swath of the population.
Today we have a situation this country has never faced before. In the years from 2009 until 2023, when interest rates finally began to rise, home buyers and home owners financed or refinanced into very low fixed rate mortgages, as they should have. According to Redfin, 82.4% of homeowners are locked in at rates below 5%, and 62% have rates under 4%. With mortgage rates between 6% and 8% over the last two years, The housing market has locked up because if you have one of those low rate mortgages, you are generally unwilling to give up that advantage by selling your home. The result is that there are very few homes for sale. That tends to keep home prices high despite circumstances (i.e., higher interest rates) that would normally produce lower home prices.
The gig economy is making matters worse, in our opinion. There is plenty of talk around about a housing shortage because as the subprime crisis hit and prices and housing demand collapsed with the economy, relatively few houses were built for many years. This is generally given as the reason for the housing shortage, but if you go back a bit further, homes were massively overbuilt leading up to the subprime crisis. Looking at data back to 2000, the number of housing units added is essentially equal to the number of new households, created, so in theory, there is no real ‘shortage’. We suspect the missing link in this story is the gig economy; the Airbnb’s (ABNB) and VRBO’s of the world, which have made real estate investment more available to the masses. Each home purchased by a budding real estate entrepreneur, is one home that is no longer available as a permanent residence.
Where does that leave us today? The answer is “in a difficult position”. The price of housing and income levels were closely tied for many years. In the chart below, we see the consistency of that relationship from 1972 through 2000. However, at the turn of the century, that relationship began to break down as the subprime bubble inflated with home prices rising much faster than incomes (blue line) as compared with the old trend (purple line). If the 20th century trend held, it would imply that the median home price should be about $335,000, not the actual $426,000. Said differently, in 1990, the median home price was about 4.1 times median household income. In 2023, the median home price was about 5.3 times household income. That makes a huge difference in housing affordability.
The reason this imbalance has held for so long was the extraordinarily low interest rates over most of that time frame. With interest rates in the process of normalizing, it isn’t illogical to think that this imbalance must be corrected. Despite a small improvement in 2023, it is very clear that some 25 years after the trouble began, the housing market remains way out of balance.
What’s the solution? We can think of several possibilities, but each one has its problems
- Home prices correct (a lot) – With so few homes for sale, it’s hard to envision prices coming down, outside of a recession, which would reduce demand.
- Median income rises (a lot) – A sharp increase in wages would make homes more affordable, but also be highly inflationary. AI holds the promise of increasing productivity and therefore real wages, but that is unlikely to develop quickly or predictably.
- We have to build a lot of new housing units. Houses aren’t built in a day. It would take a substantive long term effort to fill the current gap and if the gap is filled, prices would be expected to come down. That’s not a good incentive for builders.
- Interest rates go back down closer to zero – This would certainly make homes more affordable, but this is precisely the policy that has played a major role in creating this problem. Besides, since the Fed lowered rates 2 weeks ago, the 10 year Treasury rate (which determines mortgage rates) has been rising. If that continues, mortgage rates could be headed higher, not lower.
None of these options are simple and, except for a massive increase in productivity, none are very attractive either. What we do know is that a locked housing market can’t continue forever. One way or another, the housing market must return to a more reasonable equilibrium between home prices and incomes. Otherwise, the American Dream of home ownership could be dead.
An important lesson here is the post pandemic world has largely normalized from a health care perspective, but from an economic perspective, the extreme policy actions taken since the subprime crisis and straight through the pandemic still need to be ironed out. We all want the economy to normalize, but it is important to remember that we remain a long way off from that goal. There are still portions of the economy that are not functioning properly, largely because government interventions have interrupted normal market function.
Have a great week!
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The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
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Home Prices, Housing Shortage, Interest RatesBy: Adam