Change comes with the territory in a cyclical business. But in the mortgage banking business, even the cycles are different from decade to decade. A quick review of the booms and busts during the 1980s reveals they produced quite different housing market conditions than we can expect in the 1990s. The result is change on top of change.
THE RESIDENTIAL HOUSING MARKET HAS BEEN AND ALWAYS WILL BE A CYCLICAL INDUSTRY. During the past 30 years, there have been six major downturns in residential construction. The back-to-back recessions of the early 1980s were the last time new construction activity was as weak as during the 1990-1991 recession. But the early 1990s' recession was simply the most recent reminder of the pain associated with a business tied to the cycles of the economy.
The fact that housing is a cyclical business is well understood. But what perhaps is not so well understood is whether the peaks and valleys of the cycle are similar decade after decade--or whether there is change going on within the cycles themselves. We can begin to assess this question by looking at the housing market patterns that have occurred in the last decade versus the current.
How are market fundamentals different today from what they were during the late 1985 and early 1986 episodes, when builders were running at full capacity, buyers were submitting offers at or above asking prices and real estate agents were making more money than investment bankers? The answers lie in pent-up demand, solid increases in the level of employment, changes in the tax law and the fortunes of the thrift industry.
The bust 1980s style
From 1979 to 1982, the unemployment rate increased from 5.8 percent to 9.7 percent and mortgage rates climbed above 15 percent--a lethal combination for the housing market.
The recession of 1981-1982 came at a time when the baby boomers were graduating from college and beginning to form households in growing numbers. During the 1980-1982 period, a total of 3.5 million housing units were started in the United States, but 4.3 million new households were formed. As a result, we experienced a three-year period of excess demand for new housing units. Allowing for units removed from the housing stock due to obsolescence, demolition and natural disaster, cumulative excess demand during this period was in the range of 1.5 million and 2.0 million units.
While the housing market was depressed during the early 1980s, Congress and the Reagan administration decided to bestow several gifts upon the real estate industry. For the commercial side of the residential market, the depreciable life of structures was shortened to 19 years. Furthermore, passive losses in real estate could be used against an investor's earned income, thus attracting considerable funds from wealthy individuals into speculative investments and transforming the market to a more liquid one.
The new tax law of 1981 (the Economic Recovery Tax Act) raised the break-even vacancy rate for multifamily structures. This was the main reason multifamily construction reverted to growth a full year before the single-family segment of the market. After the accelerated cost recovery system was in place, Congress turned its attention to the plight of the S&L industry. These regulated financial institutions dedicated to serving the housing industry held poorly diversified portfolios and got hammered every time market interest rates rose above the legal limits they were allowed to pay on deposit accounts.
Thrifts held in their portfolios seasoned, 30-year, fixed-rate home mortgages that had locked-in very low interest rates, while at the same time these same institutions were paying out high current-market rates to attempt to hold onto the deposit accounts they needed to fund their businesses. Furthermore, market rates offered on money market accounts just created by Wall Street were drawing away depositors in droves from both thrifts and banks. To address these issues, the caps on thrift deposit account rates were phased out and S&Ls were allowed to reduce the percentage of their portfolios dedicated to single-family mortgages. Many thrifts responded by channeling a lot of funds into multifamily and commercial office lending.