“Las Vegas is one of the main indicators of [home] price action in the real estate market, as we saw in 2008 and the recent frenzy. We are absolutely feeling the heat here. The buyer pool has, for the most part, dried up,” says Kristen Riffle, a real estate agent in Las Vegas. Fortune.
but it’s not just bubbling markets like Las Vegas and Boise who are feeling the pain: This housing recession is gathering steam across the country. In fact, as of last week, mortgage purchase applications are down 38% year over year. That marks the lowest reading since 2014.
In short: real estate activity is collapsing.
However, let us be clear: this “shock” in real estate activity, or as Fed Chairman Jerome Powell calls it a “difficult correction”He didn’t appear out of nowhere. It is by design. The Federal Reserve went into inflation-fighting mode this spring in hopes that high interest rates would cause activity to slump in rate-sensitive sectors like housing.
The Fed’s reasoning for slowing the housing market boils down to two words: demand destruction. Historically speaking, mortgage rates rise as soon as central banks go into inflation-fighting mode. That mortgage rate shock causes existing and new home sales to fall. As builders cut back, demand for both staples (like lumber) and durable goods (like refrigerators) declines. It also causes real estate and construction layoffs. Those economic contractions then quickly spread throughout the rest of the economy and, in theory, help weaken the labor market and control high inflation.
“The most frequent way we get into a recession is for the Fed to raise rates to fight inflation. The main indicator of this type of recession is housing. Bill McBride, author of the economics blog Calculated Risk, said Fortune this summer. “It’s [housing] not the goal, but [housing] it is essentially the goal.”
Of course, we’re already seeing these housing-driven economic contractions. Home builders are cutting back. Real estate companies are cutting the number of employees. And some regional housing markets, like Boise and Seattle, have already slipped into a house price correction.
“Real estate agents are feeling it big, too. I made a call to the Greater Las Vegas Association of Realtors, and the clerk I spoke with said they averaged 300 new members each month. This month he had estimated 120 yet she’s been processing about 30 real estate withdrawals a day,” says Riffle. That means that every day about 30 real estate agents in Las Vegas alone are quitting.
Now back to the introduction of this article. When analysts say “the Fed will push until something breaks”, they are hinting that the Fed’s inflation campaign will continue until inflation abates or something pushes the economy into a recession. That “something” could be problems in the bond market, or perhaps liquidity problems at major financial firms. But there is also a growing concern that the “something” could be the real estate market.
1981 and 2008
There is nothing unusual about a housing slump helping to trigger a recession. Look no further than economist Edward Leamer’s 2007 article titled “Accommodation It is the economic cycle”. Leamer found that 80% of post-World War II recessions followed a “substantial” real estate downturn.
But when analysts talk about housing being “broken,” they mean that the housing downturn not only helps cause the downturn, it is the underlying cause. The most notorious historical examples of this are 1981 and 2008.
In the early 1980s, Fed Chairman Paul Volcker tackled the inflationary run that had begun in the 1970s. The central bank achieved its goal, but only after skyrocketing mortgage rates, which rose to 18 % in 1981.created a housing recession so sharp it pushed the entire economy into recession. While home sales and construction levels plummeted, home prices actually remained fairly flat during the 1981 housing recession.
The real estate crash of 2008, of course, was a different story. Unlike 1981, the housing crisis of the 2000s was caused by a housing bubble. That slowdown began in 2005 after a series of Fed rate hikes. In the years that followed, it would escalate into a full-blown housing crisis that sparked the Great Recession. Unlike 1981, the housing crash of the 2000s was underpinned by a perfect storm of rampant overbuilding, deteriorating family finances, historic levels of overvaluation, and toxic subprime mortgages.
While the 2022 housing market downturn doesn’t squarely fit into either the 1981 or 2008 camp, it does share characteristics of each. Just like in 1981, the 2022 housing market has deteriorated in the face of a historic shock to mortgage rates. And similar to 2008, the 2022 real estate market has once again broken away from underlying economic fundamentals.
A historic affordability shock. That’s the best way to describe why the housing market could be the “something” that breaks.
The housing boom during the pandemic, which US home prices rose 43% in just over two years-With 7% mortgage rates it has simply pushed affordability beyond what many potential borrowers can afford. Relative to income, it’s actually more expensive to buy now than it was at the height of the housing bubble.
Every time the Federal Reserve goes into inflation-fighting mode, mortgage rates will rise. However, the size of this increase in mortgage rates, which has seen mortgage rates rise from 3% to 7% this year, has caught the industry off guard. Historically speaking, mortgage rates trade about 2 percentage points above the 10-year Treasury yield (currently trading at 4%). That spread is about 3 percentage points right now. The reason? As the Fed backtracks on buying MBS, investors…who assumed that 2022 mortgage borrowers will refinance in the future and thus reduce their yields— were not eager to purchase the MBS securities.
This divergence between Treasury yields and mortgage rates has caused some industry insiders to call the “broken MBS market.” Ironically, the broken “MBS market” has put the US real estate market at greater risk of “crashing.”
No doubt about it: The real estate market entered a recession back in the summer. That said, economic contractions are still not at the level you’d expect to see before a Fed-induced recession.
Something stands in the way: housing construction.
On the one hand, single family homes started they are down 18.5% year over year. On the other hand, homebuilders remain busy. A combination of supply chain constraints and a rush to cash in on the pandemic housing boom led homebuilders to massively ramp up production in the past two years. That delay is so big that they are still working on it. And as long as builders and contractors stay busy, it will slow the surge in construction job cuts that normally occur before a Federal Reserve-induced recession.
Looking ahead, both economists and analysts believe that the housing market will continue to deteriorate.
This year, Wells Fargo Projects sharp drops in new home sales (-10.5%), Existing Home Sales (-7.4%), single-family homes started (-7.3%) and housing GDP (-10.1%). Then in 2023, fargo wells expect another drop in new home sales (-6.5%), Existing Home Sales (-13.1%), single-family homes started (-12%), and housing GDP (sixteen%).
If the Wells Fargo forecast, which also predicts a 5.5% drop in US home prices in 2023, comes to pass, it would mean that the housing market decline reaches a level that historically only occurs during the recession.
While the housing slump appears to be on a trajectory that could push the US economy into recession, nothing is certain. If inflation subsides, the Fed could change policy before a recession is locked in. There’s also the theory that a significant drop in residential investment—representing 4.6% of GDP— would not have such a large impact on today’s less housing-dependent economy. While it is true that private investment accounted for a much larger share of GDP in 2005 (6.7%), we are actually slightly above the share seen in 1981 (4.4%). In other words, don’t underestimate housing.
But “recession” or “no recession,” the housing industry is clearly feeling the effects of the adjustment cycle. It’s hard to see that changing any time soon.
“I literally have nothing under contract. I’m a long-haul carrier, but I’d be lying if I said I’m not nervous,” says Kira Mason, a real estate agent in Philadelphia. Fortune.