Many experts say that some real estate markets in the US are overvalued. The question that naturally comes up is whether we are in another housing bubble and if it will burst and lead to another economic downturn.
It is true that a lot of the financial machinery that made mortgage backed securities a decade ago that led to millions of foreclosures is still in place. But there are some differences between the current housing market and the one in the mid-2000s that led to the last crash.
Complex debt instruments including mortgage backed securities, collaterized debt obligations and credit default swaps turned the housing crash last time into a financial crash. But the underlying problem was not nearly as complex as that: It was just that low and moderate-income people got mortgages easily on which default was probably not just probable but inevitable.
In the early 2000s, the construction industry in housing-built houses fast and there was an oversupply of homes. To get people to buy the homes, lenders were giving credit to people who should not have had it. The mortgages were written so that the rates would reset after a few years. Rates went up, and people could no longer afford the mortgages.
The process was encouraged by Wall Street, which was catering to high demand for mortgage backed securities. The frenzy caused home prices to go up, and everyone in the mortgage origination chain was getting rich on all the transaction fees, without any regard whether the mortgage payments were being made. When interest rates on subprime loans went up in 2007, defaults soared and the whole system crashed.
Today, it is true that all of this financial machinery is still in existence. But there is a big difference. Subprime loans with adjustable rates are not being written nearly as much. This is not really because there is more restraint by mortgage lenders and Wall Street. It is more because of the current housing market that is quite different from the one in 2005.
These days, many parts of the country actually have a housing shortage that is causing home prices to rise. Homes for sale in some of the hot markets are causing bidding wars with people with the most cash or best credit getting the home. It is unlikely that a realtor is going to sell the home to someone who needs a subprime loan when they can choose between several good offers.
Also, about 90% of the mortgage backed securities today are offered by Freddie Mac, Fannie Mae and Ginnie Mae. This is compared to about 50% in the run up to the last crash. These entities have strict guidelines for the mortgages they will put into mortgage backed securities.
Of course, most mortgage lenders do not hold the loans they produce. They eventually sell them to Fannie Mae or Freddie Mac so they can make more loans. They are making money off of this transaction and not from the mortgage payments. But they will not be able to sell the loans to Fannie or Freddie if they fail to conform to their rules. So, banks and mortgages lenders are generally being forced into better lending practices. For example, if a mortgage lender wants to sell a loan to Fannie or Freddie, the income of the borrower must be carefully verified and shown that they can afford the home.
While things do look stable in 2018 on the mortgage front, it does not mean things cannot change. One of the amazing parts of the housing crash was how quickly that bubble inflated, and many experts absolutely missed it. Adjustable rate loans became much more common in 2005, and three years later, the crash happened.
There has been an increase in subprime mortgage bonds this year issued by private lenders, but it is much smaller than 15 years ago. In the first half of 2017, there was $2.6 billion in subprime mortgage backed securities issued in the $53.5 billion mortgage backed securities market. But in 2006, there was $1.5 trillion in subprime mortgage debt. So, if the new subprime mortgage bonds did fail, it would be a blip on the radar, not a crisis.
It is possible that we could see a housing bubble, but because of the changes in lending practices and mortgage securitization, the bubble if it burst probably will not be nearly as severe as a decade ago.