The Housing Correction Cycle Has Begun

This blog post is from 2022 and may be outdated. For the latest insights, visit our main blog feed. 

“It’s déjà vu all over again.”
- Yogi Berra

As the final months of housing data trickle in to complete the full 2022 housing picture, some familiar patterns are emerging. Despite significant differences between current economic conditions and those surrounding the housing bust preceding the Great Recession, there are similarities in home sales and price trends between then and now that could have implications for how this correction cycle unfolds.

Since January, home sales have fallen for ten straight months, yet home prices continued to rise through the first half of the year. In June, they peaked and abruptly began declining, according to the Case-Shiller Home Price Index and other home price indicators.

This is similar to what happened in 2006 as the housing boom transitioned into the housing bust that led to the financial crisis and Great Recession.  Back then, home prices peaked seven months after sales had begun to fall.  Prices remained flat for about a year and then began to fall steadily in 2007.  This time, the lag is only five months, and although it is still early in the correction cycle, the price decline already appears to be coming faster than before.

Another view of home price cycles can be seen in the relationship between home price and household income.  Households can only buy houses if they have the income (or wealth) to support the purchase.  Back in the early 2000s, easy credit and an explosion of risky home loans triggered a housing sales boom that drove prices above what most households could afford.  Most recently, the trigger was society’s reaction to Covid-19.  Government response measures included interest rate cuts and stimulus checks. These answers, combined with a household demand shift toward increased homeownership, set off a sales boom that led to another surge in home prices, driving them unsustainably higher than household incomes.

In the Great Recession correction cycle, home sales levels fell -56% from peak to trough in a decline that took just over five years (61 months) to play out. For home prices, the peak-to-trough decline was -26% and lasted for nearly 6 years (71 months).

Economic conditions were different then.  Once home prices began declining in 2007, risky borrowers in risky mortgage loans began defaulting in significant numbers which accelerated declines in both prices and sales in a reinforcing vicious cycle.  The defaults and foreclosures rippled through mortgage lenders and were magnified by the collapses of the markets for mortgage-backed securities (MBS) and their derivatives.  The contagion spread through the entire financial system, not just in the U.S., but also abroad, and led to the wounding and failure of many financial institutions, a frozen credit market – not just in housing, but in everything—and ultimately a worldwide Great Recession.  The home sales industry, where the recession had been triggered, was one of the last major industries to recover, about two-and-a-half years after the recession had ended.

We expect this correction cycle to be neither as dramatic nor drawn out as the last one because economic conditions are different today.

1. The financial system is stronger and better capitalized after post-Great Recession reforms.  Systemically important financial institutions have higher reserve requirements and more oversight aimed at reducing the risk of another financial crisis.  
2. Most of the riskiest lending has been eliminated. Option ARM loans and low teaser rate loans are gone.  According to Inside Mortgage Lending statistics, “expanded credit” lending, which had comprised 36% and 39% of originations in 2005 and 2006, has averaged less than 2% over the last decade and has never been higher than 2.8% during this period.
3. Lenders have been much tighter with credit in recent years, so the borrower pool (and thus, mortgage debt outstanding) is of much higher credit quality and less likely to default. 
4. Building has been so slow for so long that prices will not be threatened by excess inventory as they were in 2007, some of which came from over-building and some from the growing supply of foreclosed homes.  In fact, pent-up demand for housing still exists and continues to worsen; it is just constrained by affordability issues.

However, the correction won’t be without some pain.  In October, annualized home sales levels (existing homes plus new single-family homes) had already declined -31% from this year’s January peak and -35% from the peak in 2020.  We expect sales to fall further from the current level of 5.1 million per year but not as far as the 3.7 million low in 2010.  We still see a modest recession in 2023, so the sales trough might not hit until sometime in 2024.

Home prices have just been falling since midyear and will likely fall furthest in markets that have been the hottest in the latest boom.  Nationally, we see a peak-to-trough decline by less than the -26% decline of the previous correction, but it could be near -20%.

Probably the biggest factor influencing how the current housing correction evolves is how the Federal Reserve’s battle with inflation plays out.  How far, how fast, and how long monetary policy is tightened will be one of the primary drivers affecting the timing and severity of the coming recession – and unfortunately – not in ways the Fed or anyone else can accurately predict.  All that will impact the shape and timing of the housing market correction.

In summary, we expect the recovery of home sales and prices in the current correction cycle will be shorter and less deep than the Great Recession correction cycle, but we believe it will need to go through a similar path.

Coming soon:  iEmergent forecast update