ViewPoint: Spotlight: Housing Market Overview: Challenges to the Housing Recovery


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Housing Market Overview: Challenges to the Housing Recovery

Despite some positive trends, the outlook for the housing market has remained mixed over the past year. After increasing for 28 consecutive months, home sales began to decline year over year in October 2013 as a combination of raising interest rates, rapidly increasing home prices, and uncertainty surrounding the government shutdown forced many prospective home buyers to stay on the sidelines (see chart 1).

Home prices have remained under steady upward pressure as a result of an overall inventory shortage in most markets, ending the year up by 9.9 percent from last year (see chart 2).

Meanwhile, interest rates began to trend upward in 2013 as the Federal Reserve signaled a slowdown in asset purchases. After reaching a low of 3.3 percent in October 2012, the 30-year fixed-rate mortgage began to rise throughout 2013, rising to around 4.5 percent in December (see chart 3).

As interest rates and home prices rose in 2013, increases in household incomes and wages did not keep pace, which resulted in a decline in housing affordability and suppressed housing demand (see chart 4). (The Atlanta Fed's Real Estate Research blog also discussed housing affordability recently.)

Likewise, rising prices have weakened the market opportunity for investors purchasing properties, which has led to a steady decline in the investor share of home sales during the past year. The investor share of home sales peaked at 23 percent in February 2013 before slowly declining throughout the year, reaching a low of 16 percent by September (see chart 5).

Still, there are some positive tailwinds going into the peak selling season of 2014 that should be considered. First, job growth, while still stuck in first gear, has remained steady and—with much of the uncertainty related to the federal budget and the health care law behind us—should strengthen this year. Despite challenging weather conditions during the beginning of 2014, interest in home buying has remained relatively resilient and most measures of buyer traffic are increasing, as is expected at the beginning of the peak selling season (see chart 6).

Although the number of distressed properties is diminishing, the volume of nondistressed housing inventory on the market is increasing as improving equity positions are enabling more homeowners to list their homes for sale. Meanwhile, rising home prices and the lack of low-priced distressed properties to purchase are reducing competition from investors in many markets. As such, the overall national months' supply of housing inventory as well as the months' supply in most markets has increased (see charts 7 and 8).

Though existing home inventory levels are higher (up from a low 4.6 months supply in July 2013 to 5.49 months' supply by January 2014), they remain within equilibrium levels (between four and six months' supply) and there does not appear to be any danger of the overall market becoming oversupplied. Inventory levels are actually rising from very suppressed levels and are now becoming more balanced, which should ease upward pressure on home prices moving forward. As such, home values are expected to increase at a slower pace over the next year.

Homebuilders have remained increasingly optimistic about sales in 2014, despite the recent slowdown in activity experienced during the second half of last year. (The Atlanta Fed's SouthPoint blog recently discussed homebuilder survey results.) In 2013, housing starts did rise, ending 2013 up 26 percent over 2012 (see chart 9).

However, during the height of the 2013 selling season, builders reacted to limitations in labor and lot supplies by raising prices, which slowed sales velocity (see chart 10).

Although some speculate that builders may have been too aggressive in pricing, which, combined with rising interest rates, drastically slowed demand/closings, most builders experienced strong margins throughout the year (see chart 11).

Many within the new-home industry interpret the slowdown in activity in 2013 as simply a pause, as buyers reacted to higher prices and interest rates and to political uncertainty and more modest job and income growth. Moving forward into the peak selling season of 2014, builders expect demand to recover and are shifting gears from increasing margins to increasing volume as many have announced plans to open more communities in the coming year. Though most do not consider price cuts likely, offering increased incentives to attract buyers, especially within the weaker submarkets, is a possibility.

Mortgage and credit availability
Though stabilizing now, the rise in interest rates that took place in 2013 resulted in a sharp decline in refinance mortgage demand, forcing many institutions to make significant cuts in their mortgage operations. Refinance applications in 2013 were down 65 percent from a year ago, and purchase applications were only down by around 11 percent after rising by double digits through most of the year (see chart 12).

Although some lenders are considering exiting the mortgage sector altogether, others are adjusting their strategy and shifting toward purchase mortgage originations. With increased competition vying for market share within the purchase mortgage space, some lenders are beginning to loosen underwriting standards, removing overlays, and increasing incentives in order to remain competitive.

The Mortgage Bankers Association's Mortgage Credit Availability Index, which measures credit availability at larger wholesale lenders and investors, increased by around 2 percent in January, demonstrating that mortgage credit availability is improving overall. Likewise, the Federal Reserve's January Senior Loan Officer Survey also showed a slight loosening of mortgage credit standards at larger institutions, while standards tightened at smaller institutions (see chart 13).

Still, this easing of standards and slowly increasing credit availability has not been seen across the board. According to a study from CoreLogic, the distribution of loans by loan-to-value and debt-to-income (DTI) ratios originated during 2013 had returned to more normal levels (that is, levels experienced in 2003 prior to the bubble in housing), indicating that underwriting in these particular areas was more balanced.

On the other hand, the share of mortgages originated with low credit scores (i.e., subprime), low documentation, and those with adjustable rates is virtually nonexistent in today's mortgage market, which means that underwriting in these areas remains very stringent (see chart 14).

At the same time, the credit quality of applicants applying for a mortgage continues to decline. The average FICO scores for both closed loans and denied applications have dropped steadily over the past year and, while the average back-end DTI for denied applications as remained at around 43 percent, DTIs for closed loans continue to rise (see chart 15).

Combined with the fact that the volume of purchase mortgage applications has maintained a downward trend since rates began to rise, it appears that lenders are becoming more willing to lower standards/overlays in order to expand credit availability.

Effect of the QM rule
Although the full effect of the implementation of the Qualified Mortgage (QM) rule, which went into effect on January 10, 2014, is not yet clear, early indications provide a mixed picture. The QM rule requires that lenders verify a borrower's ability to pay by including the full documentation of income, assets, and employment at origination. QM standards also include a 3 percent limit for points and fees; a maximum term of 30 years or less, and a cap of 43 percent on the back-end DTI ratio, among other requirements. Mortgages eligible for purchase by a government-sponsored enterprise would also be considered a QM, regardless of the DTI ratio. Mortgage instruments that include risky features such as interest-only mortgages, negative amortization schedules, or balloon payments, would not be considered QM. Mortgages that meet the QM standards and that are not "high-priced" (i.e., subprime) are given a safe harbor against litigation, and a high-priced QMs would be subject to a rebuttable presumption.

The CFPB has indicated that 95 percent of current mortgages would meet the QM standards. Furthermore, borrowers who may not initially qualify for a QM could make adjustments to how they took a mortgage that would change their loan to a QM. Such adjustments could include bringing more equity to the table, buying a smaller house, taking a smaller mortgage, or adjusting the terms to make the loan meet the qualifications.

Many lenders and investors began to implement QM standards last year and, so far, according to a recent survey of mortgage originators conducted by Zelman and Associates, the implementation of QM does not appear to be having a significant impact on loan production or credit availability. Although concerns have risen in some markets, most builders have not reported buyers having difficulty obtaining mortgages due to QM.

Still, many lenders and market participants have expressed concerns. Originators have been concerned that the 3 percent cap on points and fees makes some mortgages such as loans for homes priced between $100,000 and $160,000) less profitable to originate. Likewise, smaller banks, particularly those in rural or underserved markets, are considering only originating QM loans or exiting the mortgage business completely because of their inability to compete, which has raised concerns about the availability and cost of credit in those markets.

The two primary borrower segments that are most likely to be affected by QM standards include business owners/high net worth individuals who may have difficulty proving their income and/or may have high DTIs and those with poor credit profiles. Many institutions, including Bank of America, JP Morgan Chase, and Wells Fargo, have already indicated that that they will do interest-only loans, while others plan to provide products to borrowers who fit the business owner profile.

Competitive pressures and the need to increase revenue may force many banks to further loosen some underwriting standards to attract borrowers who do not meet all of the QM standards. The biggest barrier for most lenders in deciding whether or not to do non-QM loans, particularly for smaller lenders who are not able (or willing) to hold portfolio mortgages, is determining if there will be a sufficient secondary market for non-QM loans. At this point, investors have been all over the spectrum on non-QM loans, and it is too early to tell where they will land. Despite the uncertainty, many in the industry believe that, over time, there will be an investor market for non-QM loans, which will make it easier for more lenders to offer non-QM products.

However, borrowers with poor credit profiles (such as low-to-moderate-income households that tend to have low credit scores and/or higher DTI ratios) may find their financing options more limited due to QM standards. Though the Consumer Financial Protection Bureau indicates that a large percent of the current mortgage market would be unaffected by QM, it should be noted that many lower-credit-quality households are not currently in the home buying market. Should the buying mix begin to normalize (for example, follow trends experienced prior to the housing bubble), a significant portion of lower-credit-quality borrowers would find it difficult to qualify for a QM. Additionally, some have raised concerns that the QM standards—particularly the 43 percent DTI cap—would disproportionately affect minority and ethnic borrowers (see exhibit 1).

Source: LPS

Time will tell what the full effect of the QM rules will be. For now, it appears to be pushing smaller banks to the margins of the mortgage market and increasing the market opportunity for larger institutions. Also, although it does appear that non-QM loans will continue to be made, it is not clear to what extent, or which segments of the market will benefit. Regardless, it appears that non-QMs will, in many cases, be challenging to obtain and more expensive.

By Domonic Purviance, a residential real estate market analyst, and Madeline Marsden, a senior financial policy analyst, both in the Atlanta Fed's supervision and regulation division