The housing market isn't behaving as it should.

Mortgage rates refuse to climb, even though the Fed is cutting back its efforts to keep them low. Home sales are sluggish, yet prices are rising. And new home construction is lagging, even though demographics suggest there should be large numbers of new households coming into the market and seeking homes.

What's going on? A new analysis from Freddie Mac provides some insights into why the market is behaving as it is, and suggests why things may be changing in the very near future.

Fed buying fewer securities, but from a shrunken supply

On the matter of mortgage rates, the general expectation was that they would be on a steady march toward 5 percent once the Fed backed off its quantitative easing program, if they hadn't already topped that mark. Instead, rates have stalled out after an initial sharp rise, even currently dancing around their lowest levels of the year.

What's happening, according to the office of Freddie Mac chief economist Frank Nothaft, is that even as the Fed is scaling back its purchases of mortgage-backed securities - the tool it's been using for keeping rates low - mortgage demand has been falling as well, due to a sharp drop in refinancing.

As a result, there are fewer mortgages available to bundle into securities. So the Fed is actually buying a larger portion of the mortgage securities that are on the market, even though its buying fewer securities in total. But the overall effect is to continue to exert downward pressure on rates. Freddie Mac currently expects 30-year rates to end the year around 4.6 percent, down from 5 percent-plus previously forecast.

Lack of inventory driving home prices

Home prices usually fall when sales are weak. However, prices have been showing strong growth even as sales remain lackluster. Freddie Mac figures show home prices were up 8 percent in the first quarter of 2014 compared to one year earlier, even as home sales were down 6.3 percent over the same period.

The problem, according to Nothaft's office, is one of supply and demand. There simply aren't that many homes being put up for sale. In March, the ratio of homes for sale compared to total U.S. households dropped to its lowest level in more than 30 years - meaning high demand for a small supply of homes.

The analysis suggests several reasons for the lack of homes for sale. First, a large number of homeowners remain underwater on their mortgages - owing more than the home is worth - and are reluctant to sell and take a loss. Second, many of the rest either purchased or refinanced their homes in the past few years, when mortgage rates were at all-time lows. As a result, they're reluctant to give up that very attractive rate and move into a different home.

A reduction in the number of distressed properties for sale as the nation moves out of the foreclosure crisis has also limited supply, according to the report.

Fewer young people forming households

The third issue that isn't behaving as one might expect is household formation, which is a prime driver of housing demand as young people set out on their own. But housing formation has averaged only 500,000 per year since the start of the Great Recession, compared to about a million a year in the decade before that.

Demographics predict there should be a large number of new households forming now, owing to a sharp increase in the birth rate around 1990 that lasted until about 2007, meaning large numbers of young adults coming on to the scene right now.

But a weak labor market means that many of them continue to live with their parents until they can establish financial independence. At the same time, many who have decent jobs came out of college with heavy loads of student debt, which prevents them from taking on a mortgage as well.

What's missing? Jobs.

The big factor that would change this picture would be job growth, according to Freddie Mac. People can't buy a home if they don't have any money. The analysis is optimistic on this point, noting an increase of 288,000 jobs reported in April.

Freddie Mac is projecting economic growth at a decent 3 percent rate for the rest of the year, which should translate into an additional 200,000-250,000 jobs per month, which it expects will spur new household formation and therefore new home construction, increasing the housing supply.

Published on July 6, 2010