No one understands the housing market

Now that house prices are starting to come back down, but interest rates are going up, so people still can’t afford houses, there are going to be tons of theories about why the housing market is doing what it’s doing. Unfortunately most people don’t understand that market, so those theories are all going to be wrong.

To understand the housing “market”, you have to keep several things in your head at the same time:

  • Supply of and demand for houses (a mostly local phenomenon)
  • Supply of and demand for mortgages (a completely distinct market)
  • Local, state, and federal policies that influence or create both those markets

Houses are expensive. They’re so expensive that for most of the history of the US, only rich people owned them. That started to change in the 1940s, when several federal policies converged. Once was the creation of the Federal National Mortgage Corporation (Fannie Mae) in 1938, which was created to allow banks a way to sell the mortgages they created, creating a “secondary market”. The second was the GI Bill, which made mortgages easier and cheaper for (mostly white) returning WWII soldiers. That, combined with the huge amount of capital that flowed into the US in the aftermath of the destruction of most of the industrialized world in WWII, ignited the US housing market.

In the 2020s, most houses are purchased with a mortgage, because most people can’t afford to buy houses outright. That means that that the market for mortgages (created in the 1940s) matters as much for what homes are built as the housing market. And those markets aren’t the same thing.

The US mortgage market is international. Financial institutions all around the world buy and sell mortgage securities, which are bundles of hundreds or thousands or hundreds of thousands of mortgages, speculating on whether they’ll rise or fall. But for them to do that, they need to understand what’s in those securities. Since every home is different, that’s a major challenge.

So when a lender is deciding whether, and how much, to lend to a prospective buyer, they’re not just looking at the buyer’s risk of default. They’re also looking at how easily they can sell that resulting mortgage on this secondary market – a market with completely different needs and interests from the housing market.

This has a huge effect on what kind of housing is available. Houses that get a mortgage have to fit certain characteristics that can be easily described and subdivided. Principal on the loan and the interest rate, sure; but also things like square footage, number of bedrooms, buyer’s credit rating, and lots of other characteristics have to match what the mortgage market expects, so they can package the loan up with lots of other loans like it.

This is part of the reason why lots and lots of proposals to make more affordable housing are dead in the water. Solutions like tiny houses and co-housing just do not match what the mortgage industry is looking for. Unless you’re building apartment buildings (a completely different lending market), a builder has to build houses that have the characteristics mortgage purchasers (not just mortgage originators) are looking for.

There are millions of US housing mortgages being traded on the secondary market. It’s that scale that provides the cash that keeps houses being built. And it’s in part the needs of that market that drive what is built.

Of course, while the mortgage market is international, the housing market is local. Houses aren’t built “in the US”; they’re built on former agricultural fields on the outskirts of Minneapolis. Local jurisdictions have a lot of power in regulating their own markets. And local jurisdictions are run by elected officials, who are beholden to the people who already live in those jurisdictions.

As it turns out, people have a strong preference to keep their environment from changing. This means that people who have lived in a single family home next to a field or a forest usually want to see that field or forest stay there. And if it is going to change, they want it to turn into something familiar – more single family homes. Local politicians, being beholden to these residents, then write those requirements into law.

Enforcing those requirements with building inspectors and planners requires money. Since local residents see new development as a change to their community that they didn’t ask for, it seems “fair” to them that the newcomers should pay for the regulation, rather than the current residents. So increasingly we see planning and building departments funded via fees levied on development, rather than paid out from the general fund which comes from overall taxes. These fees can be in the tens of thousands of dollars.

Of course, the laws of supply and demand still apply. Mortgage buyers and local jurisdictions can wish for certain kinds of mortgages and development all they want, but they can’t make the demand appear. What they can do is keep the kinds of mortgages and developments the don’t want from appearing.

Local jurisdictions tend to regulate against any development that might attract unwanted poorer people (or, historically and often to the present day, black or other unwanted racial and ethnic groups). That reinforces the influence of the mortgage industry, which wants simple mortgages in terms it can parse and analyze, with a preference for higher credit scores (especially in the aftermath of the 2007-2008 housing bust). And all this is backed up by the influence of impact and other fees on new development, which drives up the cost of new construction.

Tiny houses haven’t taken off, not just because local jurisdictions often don’t want them, but because mortgage companies can’t securitize and sell them. Co-housing is hard to build because there’s no national market for financing co-housing units. Cheaper single family homes are getting scarcer because when a builder is charged $40k in fees per unit, they can’t make any money selling anything other than at least upper-middle-class housing.

Most housing reform is doomed because would-be reformers don’t understand how the housing and mortgage markets interact. We’ll only get more affordable housing in the US when we come up with a solution that works for both markets.

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