Dr. Doug Duncan, Fannie Mae's Chief Economist gave his Economic Forecast in June 2023. Dr. Duncan is the recipient of the prestigious Lawrence R Klein Award for Most Accurate Forecaster Over The Past 5 Years, he was also named by Bloomberg and BusinessWeek as one of the Top 50 Most Powerful People in Real Estate. Learn from one of the smartest economists in the U.S., who advises the U.S. government and the Federal Reserve on real estate matters. He delves into the topic of bank failures, and sheds light on what lies ahead for interest rates.
Full video recording: https://bit.ly/43YaODA
Slides: https://bit.ly/444rIAo
What is the underlying theme for economic activity over the succeeding years?
The economy is a dynamic organism and every single action that you take impacts the direction and the intensity of the economic activity. If you're not out there trying to understand what people are doing, you are missing the bigger theme.
Each year, I spend time in December and January thinking about what is likely to be the underlying theme for economic activity over the succeeding years. The reason I do that is because it's a check against ourselves, I want to know whether at that time period, if we had a good feel for the major impulses that were underway in economic activity, in particular housing, because as the business Fannie Mae is in. And then we use that to test ourselves across the course of the year, we ask ourselves what did we miss, if anything, or if we just made a lucky guess? But it's also something that we can hang the discussion on when we're talking with people. This presentation is for awaiting improvements and affordability. It's not just affordability and housing that rise in interest rates means affordability across the economy, credit affordability, that kind of issue. It's intended not just to focus on housing, though it certainly does apply to housing.
So far, I would give us a "B", at best, even though we started the bandwagon on the fact that fundamental factor in housing would be a shortage of supply back in 2014, even we underestimated the mismatch between supply and demand when interest rates made a significant rise. The supply is an issue, there's still intense competition all across the country, though I'll show a map that shows red or falling prices largely dominate the West, and green or rising prices dominate the East and Midwest. As it's always true, all real estate is local and you have to understand local markets to build the big picture.
The Fed is focused on the question of inflation, which went much faster and much farther than it was anticipated. We had anticipated a rise, but we did not anticipate how far it went. When the Chair of the Fed noted that, from his perspective, this was transitory, I looked up the word transitory in the dictionary and, from that definition, life is transitory. We don't believe that, but we do believe that there are some bottlenecks in supply chains because of the risks of Covid and the institutions are going to have to adjust their practices to ensure the safety of their workforce. But once that's in place, some of those bottlenecks will go away but we believe there's something more fundamental than that.
Housing market supply issue.
We believe that geopolitical change is going to lead to the restructuring of supply chains and that's time consuming and expensive. The Fed is going to be leaning against the restructuring of supply chains, and you're seeing the stories emerge now about how difficult it is to replatform your company from one country to another country to strike relationships around shipping and transportation. Restructuring those things can be time consuming and expensive. We felt like that we got ahead of that before others did. That's going to be a contributor to the underlying rate of inflation for some time.
The Fed has been very focused on the labor market, we're back to, for prime working age 25 to 54 year olds, everything that we had prior to the pandemic, and we're actually back to the participation rate of around the year 2002 or thereabouts. Employment participation was high. Obviously, the Fed raised the Fed funds target pretty substantially. Average hourly earnings in 2022 had a burst of growth in incomes. That's a little misleading in that, it's a summary of those people that do have jobs and service sector employees bring less money and there was a slower return of service sector workers to the market, which meant that average rose because of the truncation of participation in the service worker, so it's a little bit misleading. There were stories that had emerged around 2010 that the millennials have learned the lesson from foreclosure crisis and they wanted 300 square foot apartments with amenities.
Why are we still living with that supply shortage today and will continue for some time?
Once a month we survey 1,000 households to represent the US population. The 2008 recovery was the most difficult recovery in the US since World War II. If you're going to have a job, you're going to be working and living in a central city where they don't build single family detached houses, they build apartment buildings with amenities. What they're saying is we want a job, and when we have a job we can build a credit record and then eventually, we're going to get partnered up, form a household and buy a house. That's exactly what they've done. You can see they are not yet at the peak median home buying age, that's still a couple of years off. They started driving the demand curve in 2015 and by that time, the builders were already behind the curve, and we're still living with that supply shortage today and will continue for some time.
As far as men's workforce participation, it has been declining since the 1960's. It was disguised until the year 2000 by the rise of women's participation in the workforce, which peaked in 2000. Once that peaked, it revealed the fact that men's labor force participation had been declining. To me, that is a societal problem that is as of yet unaddressed. We're near all-time peaks of adult children living with their parents, part of that is the housing supply problem, there's not a place to live in. There's also still a significant supply issue in the apartment building space.
The housing stock is close to its lowest point over the last four years. There's a big rise in available new homes and it includes lots that are available for sale for development. Two years ago there were about 1 million realtors and about 1 million existing homes for sale.
What is the relationship between housing and the business cycle?
There is a typical relationship between housing and the business cycle. As the Fed tightens in response to the rise of inflation, interest rates go up. Housing is very interesting since the first thing that happens is residential investment start to slow; then, new home sales start to slow because builders are building less, and so there are less being sold, and then existing home sales start to slow. When the recession is in full force and the Fed eases interest rates, construction starts to pick up, new home sales start to pick up and existing home sales start to pick up, so there's a predictable relationship. But that was not the case in 2007 to 2009 because the center of the financial problem was the decline in underwriting standards in real estate, that was the core of the issue.
Permits for single family construction have fallen as a response to the Fed raising rates. We've basically doubled interest rates over the last year. We forecast house prices on a quarterly basis, and the primary application within the company is establishing a balance for allowance and losses, that is probably the most important variable for us, from a management perspective. But our view is that the calibration has a lot of volatility to it, so we have forecasted in alignment with our public statements, our filings. If you were to look back six months at our forecast, you would have seen that our view was that over a two-year time period we thought home prices would fall about 10% nationally. With what we've seen in the last few months, that number has been half of that, about 5%, which suggests that the supply shortage is a lot more powerful than you would have thought given how fast house prices appreciated on prior years. We had tremendous appreciation, in some markets, 40% or more over a two year period, those markets are coming down a bit, but nothing close to 40%. Part of that is because transactions are not taking place because over 90% of all outstanding mortgages today are at least 100 basis points below our current interest rate, 79% are 200 basis points below the current interest rate, those loans are going nowhere and that has impacted several places. One of them is it has accentuated supply shortage because people are locked in, they're not willing to give up those mortgages, it has also slowed the pace at which mortgages prepay in the Feds portfolio. The Fed is the single largest holder of mortgage-backed securities in the world. Banks and other depository institutions, as a rule, are about 21% of all outstanding mortgage-backed securities.
We ended 40 years of declining interest rates. For the last six or eight years, I have been pointing out to bank leadership teams that they have no one in senior leadership, who had ever managed a bank in a rising rate environment, and that they might want to think carefully about that. Some had board of director members and senior members that have been through some of that, but we have had 40 years of declining and then flat, or near zero interest rates. Business models and mental frameworks had aligned to that reality and it might be difficult to recognize risks that exist in arising environment. Of course, there were a couple of banks in Silicon Valley that had a little bit of difficulty.
Silicon Valley Bank Failure
Part of the failure of Silicon Valley Bank development was that $42 billion dollars left the bank in six hours. There's probably a reason to think more deeply about how technology has changed the speed of things and whether or not the institutional structures that we have in place are resilient to the enabling of rapid changes like that.
What did we learn?
1. Technology does change behaviors, people can with a few strokes on their cell phone, relocate their financials to another institution, and that was very little time for the affected institutions to respond. Bank regulation is probably going to have some review.
2. We proved that there's a class of banks in the United States that are too big to fail, about a dozen of them. The hot money from Silicon Valley mostly flowed to those institutions, it had nothing to do with yield, it had to do with safety, because they're paying 25 basis points of interest in accounts. It wasn't about yield, it was about safety.
3. Those too big to fail institutions don't do well in local markets, otherwise we wouldn't be talking about regional banks and commercial real estate. About 75 or 80% of commercial real estate credit lies in the portfolio of the small and midsize regional banks, which means that the big banks don't matter. That's important because those institutions are key to the health of those local, smaller and regional markets. There is already some talk about change of capital requirements, but imposing additional capital requirements on those midsize firms will probably aggravate the disadvantage that they've already had in terms of the cost of capital. If you're too big to fail, the risk premium that you have to pay for people to do business with your bank is lower. We'll see where regulation comes on that, but those a couple of very important things on that topic.
Right now, the spreads in the mortgage space are historically wide. If you look at the spread between the ten year treasury and the coupon yield a mortgage-backed security, it's far wider than normal. Part of that is risk, if the market sees a potential recession coming on, delinquencies rise, representing increased risks, so the market is priced on that risk. But when the Fed exits, if you go back in history to the print industry they were by definition designed to hold mortgage credit, when the print industry died, it went into the GSE portfolios and when the GSEs got in trouble and their portfolios were constrained, then it shifted to the Fed. The question is, to whom does it go next? That's an open question, and I don't really answer that. People say, it will go to private investors. Okay, that may be, but what yields will they require? How will they behave over the business cycle, and how will that impact volatility in the real estate space? I think that's an open question. We're working on it from a research perspective and talking to a lot of people that have ideas on that. I don't know the answer yet, but I don't think that by and large it will be foreign investors because of the geopolitical issues.