Editor’s note: Erik Lundh is Chief Economist at The Conference Board. The opinions expressed in this comment are his own. Read more opinion at CNN.
A much-feared correction in US home prices is underway. While this may feel like déjà vu, the drivers behind the recent surge in prices and the current downturn in the housing market are different than they were in the 2000s. This time, the US financial system is better prepared and a national crisis is less likely.
It’s true that US homeowners should brace themselves for an ugly 2023. After years of underinvestment and suppressed supply, U.S. home prices surged a staggering 45% between January 2020 and June 2022 as low interest rates and the rise of remote work spurred demand. For comparison: In the run-up to the real estate crisis, which began 16 years ago, prices rose by 30% in the same period.
But the housing bubble of the 2000s was underpinned by predatory lending, poor underwriting, adjustable rate mortgages and rampant speculation. Americans believed that housing was a great short-term investment and that prices would only keep going up. As is well known, this turned out not to be the case.
Later that year, as interest rates rose through 2006, prices finally began to fall and homeowners defaulted on their mortgage payments. As prices continued to fall, homeowners rushed to sell their homes, creating a feedback loop that spread throughout the housing market. The ensuing financial crisis was triggered by mass defaults on low-quality mortgages wrapped in mortgage-backed securities. These assets suddenly became nearly worthless, throwing the financial system into crisis.
Additionally, years of unbridled demand prompted builders to overbuild in the early 2000s, flooding the country with a surplus of homes. As a result, it took years after the Great Recession for demand to work through the enormous housing stock that had accumulated. This in turn crushed the housing industry and caused a chronic underbuild in the years that followed.
Fast forward to today, and the situation is very different: Home prices are falling because the Federal Reserve is raising interest rates to quell inflation. This, in turn, has pushed up mortgage rates. While the average interest rate on a 30-year mortgage fell sharply last week, it’s still more than double what it was a year ago (3.10% a year ago versus 6.61% today). These rates make financing new home purchases unaffordable for many buyers, causing demand to slacken and prices to fall.
Fortunately, demand and supply fundamentals may limit the downside in US home prices. Millennials, the largest generational cohort since the baby boomers, are aging and looking to buy their first home. Unfortunately for them there isn’t enough to get around. But that means high prices, even if they start falling and will continue to fall, are likely to be a bit sticky. Essentially, millennial demand is likely to help keep prices from going into freefall — like they did in 2008. It is highly unlikely that this decline will trigger another financial crisis.
In addition, new regulations were introduced in the years following the 2008 financial crisis. Banks now need to be better capitalized; lending standards are much stricter, resulting in higher quality loans; most mortgages are fixed rate; and financial derivatives such as asset-backed securities are better regulated. All of this props up the financial system against another housing recession.
Other helpful trends include the surge in refinancing activity over the past few years combined with extremely low interest rates. This squeezed monthly payments for many homeowners and made servicing their mortgages easier.
Also, Americans have more equity in their homes than they did before the last financial crisis. In fact, loan-to-value ratios, which measure the size of a mortgage relative to the value of a home, have fallen to just 42% for US mortgages — a 12-year low. Rather, this creates a “cushion” for falling prices before property values fall below the credit that underpins them. So when a home sells at a loss, it’s likely to hit homeowners before it hits the banks.
The ongoing home price correction will impact the US economy, but lower home prices should help contain high inflation. Indeed, this will come at the expense of economic growth as construction activity is already slowing rapidly and consumer confidence (and spending) are likely to suffer as well. But we’re unlikely to be heading for a repeat of 2008.