Fed watching red-hot housing marketplace for monetary stability dangers

It’s beginning to look a lot like 2007 in the U.S. housing market, and the Federal Reserve Board has taken notice.

Home prices, the number of first-time buyers and the share of properties being bought as nonprimary residences are all at or near the cyclical highs of the mid-2000s housing bubble, Fed. Gov. Christopher Waller said during a Thursday webinar on U.S. and Israeli real estate hosted by Rutgers and Tel Aviv University. He called the growth in the housing market a “singular feature of the U.S. expansion since the COVID-19 recession.”

“An important question I will keep my eye on is whether the sharp and ongoing increase in home prices poses risks to financial stability,” Waller said.

The market of today is different from 2007 in some key ways, he said. Underwriting standards are tighter, leverage use is moderate, and there is less speculation from builders and investors. Also, borrowers are, overall, on steadier footing financially and the banking system is well prepared for a sudden drop in prices.

Banks are well prepared for a housing-related shock, with a variety of liquidity sources at their disposal, but those fallbacks are not available to the various nonbank lenders and servicers that have entered the market during the past 15 years, Fed Gov. Christopher Waller says.

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“In last year’s stress test, which featured a severe global recession that included a decline in home prices of over 20%, we projected the largest banks could collectively maintain capital ratios at more than double their minimum requirements — even after withstanding more than $470 billion in losses,” Waller said.

For these reasons, Waller said, the housing market likely doesn’t pose an imminent threat to financial stability. Yet, while banks are well prepared for a shock, with a variety of liquidity sources at their disposal, those fallbacks are not available to the various nonbank lenders and servicers that have entered the market during the past 15 years, Waller noted. 

A wave of refinancing activity kept many nonbank lenders solvent during the pandemic recession, as did a credit facility provided by Ginnie Mae. But moving forward, Waller said, steps must be taken to bolster those entities against future housing market downturns.

“In the end, forbearance never reached the high level that many analysts expected,” he said. “But, looking ahead, this experience points to the importance of building resilience among nonbanks engaged in mortgage lending and servicing.”

Along with financial stability, housing costs are also of critical importance to the Fed’s goal of maintaining price stability, Waller said, as it is a significant factor in the key indexes used to track inflation.

Housing services account for about 15% of the personal consumption expenditure price index. Shelter also accounts for nearly a third of the basket of expenditures in the headline consumer price index and 40% of core CPI. Because of this, the central bank’s Federal Open Market Committee will watch trends in this space as it makes decisions about future increases to its benchmark federal funds rate.

“With housing costs gaining an ever-larger weight in the inflation Americans experience, I will be looking even more closely at real estate to judge the appropriate stance of monetary policy,” Waller said.

Prices of for-sale homes have risen by 35% since the beginning of the pandemic, Waller said, a faster rate than the U.S. saw during the height of the mid-2000s cycle.

Waller attributes part of this price growth to a national undersupply of homes. Last year saw the most housing completions since 2007, but labor shortages, supply costs and local land use regulations are poised to keep production in check for the foreseeable future, he said, with annual construction still 100,000 units short of meeting demand.

The Fed’s efforts to prop up the economy during the early days of the pandemic also contributed to price growth. By keeping the target range for the federal funds rate at its lower bound and purchasing mortgage-backed securities, the Fed was able to keep borrowing costs low, Waller said, with 30-year mortgages falling about one percentage point from January 2020 to January 2021 then holding steady around 3% through most of last year.

Low costs helped usher in first-time buyers at a rate not seen since before the global financial crisis, Waller said. Similarly, the share of properties purchased as second homes hit 5%, up from its 2014-19 average of 3.5%.

Meanwhile, the costs of new leases on rental properties have also outpaced historical averages and broader inflation, with single-family rents up 12% year over year and multifamily rents up 15%.

Overall, housing costs have outpaced wage growth and are taking up a greater share of household budgets, with the heaviest burden falling on low-income groups, which dedicate more than 40% of their spending to shelter.

The FOMC raised the funds rate by 25 basis points last week, the first increase since 2018, and committed to making similar bumps six times before the end of the year to rein in inflation. Earlier this week, Fed Chair Jerome Powell said he was open to raising rates more quickly, if need be.

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