It was a mere 12 years ago that the freefall of the housing market nearly took down the entire U.S. economy.
The housing market crash of 2008 still strongly resonates in the nightmares of those who follow the economy –– even more so for the homeowners of the estimated 10 million homes that foreclosed between 2006 and 2016.
Today, a healthcare crisis is the storm of economic destruction rampaging through America. It is not surprising that the effect of COVID-19 and its aftermath on the U.S. housing market is closely watched. As bad as things are, it can certainly get worse if the U.S. housing market becomes one of the fatalities of COVID-19 due to mass foreclosures.
Thus, we attempt to balance a very tricky equation. On the one side, we have the sad circumstances that are driving American homes into distress and possible foreclosure, and on the other hand, efforts to mitigate this potential disaster.
If we examine the elements of this equation, we see on the negative side:
- Over 22 million jobless claims filed with an additional fifteen million jobs losses expected to be documented in the next report
- Nearly 3 million mortgages already in forbearance
- Purchase application data showing more abundant year-over-year deficits each week
- Lenders tightening credit, restricting the types of loans offered, and some lenders going out of business
On the positive side of the equation, we have the following counter-measures:
- Over $8.3 trillion of disaster relief and monetary assistance being distributed from the government for unemployment claims and business loans to help stabilize the economy until the lockdown protocols are removed.
- Forbearance programs that give distressed homeowners three to twelve months of a delayed mortgage payment to avoid foreclosure.
Eight existing advantages
Fortunately, in addition to government assistance and forbearance programs, homeowners have some organic upper hands in this cycle that may help to mitigate foreclosures, including the following eight advantages:
1. The U.S. housing market was healthy before the coronavirus crisis. We had strong growth in existing home sales, new home sales, and housing starts before the economy shut down. Purchase application data was at cycle highs showing double-digit year over year growth up until March 18, and inventory levels were low.
2. The most prominent demographic patch is now between ages 26-32. These folks are on the brink of homebuying age and will still need a house once the stay at home orders are removed.
3. The high-level of nested equity. Those who bought homes between 2010 and 2017 have enough equity to sell their homes without going into foreclosure. Housing tenure is now over 10 years, so the built-in nested equity is substantial. Compare this to the period of 1985 to 2007 when the average tenure was five years. This is a significant difference that is rarely mentioned in discussions on the relative strengths and weaknesses of the housing market.
4. Today’s homeowners have a history of good cash flow. Before the recent crisis, homeowners had better cash flows and had already refinanced to lower mortgage rates. For years, they had fixed low debt costs in an economy of raising wages. While it is never easy to sustain a job loss, homeowners today are in better economic standing to ride out this crisis than in the previous financial meltdown of 2008.
5 & 6. The lack of exotic loan debt structures and the high number of homes purchased with cash in the last ten years. Since 2010, only a small percentage of the mortgage market is comprised of nontraditional loans, which tend to be the highest risk and the first to foreclose in a stressed market. Added to this is the high number of “no-risk” homes – those purchased with cash. Throughout the economic expansion, 20 to 30% of homes were purchased with cash. This means at least 20 to 30% of homes in the current market have no risk of foreclosure regardless of how horrible the rest of the economy gets. This buffer of no-risk homes will offer some protection against a “snowballing effect” of foreclosures.
7. We have not had a large number of cash-out refinances, as we did from 2003-2006, which drained equity from homeowners, making them more at risk for foreclosure during an economic downturn. Equity extraction also meant homeowners were less likely to qualify for home equity lines that could be tapped during times of financial stress.
8. Mortgage rates are lower now than they were in the previous cycle. As long as rates stay below 4.5%, housing demand will be stable, which prevents inventory from increasing leading to a collapse of home prices.
Are these advantages enough to save the housing market?
The question remains if the government interventions and intrinsic economic advantages of the last cycle will be enough to prevent the snowballing of homes from distressed to foreclosed as we saw in the previous period.
Always the optimist, I am betting they will. But even if we believe that the balance of the two sides of the housing market equation favors survival of the market over collapse, make no mistake; we will see foreclosures.
The scale and duration of the foreclosures will depend on how long the stay-at-home protocols continue. The longer the lockdown, the more long-lasting the damage will be to our economy.
Regardless of the duration, the foreclosures will not hit the market until 2021, with all the forbearance in play and possible future actions by the government to shore up the market.
The simple truth is, we can’t save all the companies, return all the jobs or prevent all the foreclosures no matter how many dollars we throw at the problem. While I still believe the massive upfront damage in the housing market will be suffered by renters, we should expect to see more foreclosures in 2021 than the low levels of foreclosures we had in the previous expansion.
The late-cycle lending thesis proposes that the homes with the highest risk of foreclosures are those purchased towards the end of economic expansion. The lack of selling equity combined with a job loss recession can force a homeowner to a short sale or foreclosure. Homes purchased with FHA loans in 2018, 2019 and 2020 are certainly the most at risk in this period. They don’t have the nested equity that home buyers from 2010-2017 have.
Contrary to the widely held myth that lending is too tight in the American housing market, up to a month or so ago, you could purchase a home with an FHA loan with a 620 FICO score, a 3.5% down payment and a debt to income ratio up to 43%. The first wave of FHA home buyers from 2008-2015 has either moved into a conventional loan or have a lot of nested equity. The number of low FICO score (640 and below), low down payment loans made since 2009 is small, but it is this group of new loans that are at the most significant risk for foreclosure in 2021.
Since the coronavirus, most lenders have made FHA lending standards more stringent by raising the FICO score limits. This was a necessary move to prevent future foreclosures by the most at-risk home buyers. You may recall that one of the factors that increased mortgage foreclosure risk in the housing bubble years was the FHA Down Payment Assistance program. The 2012 FHA solvency act had to be passed by Congress to bring stability to FHA lending.
Once the pandemic is over, I expect lending standards will ease slowly over time. Regardless of how dire the economic landscape may be during this current recession, we need to be thankful that we stuck to realistic lending standards, instead of succumbing to the dark temptation of easing lending to accommodate more risky loans over the last ten years. We cannot prevent late-cycle residential lending.
But, we should be proud that as a country, we never went back to facilitating the widespread adoption of risky loans that are prone to default even without a job loss recession. The intrinsic economic advantages we have built up over the past 10 years may be what saves us from a severe foreclosure problem in 2021.