US Housing Market Experiencing Turbulence

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

A soaring housing market has buoyed the US economy, but a gradual descent may become a free fall. While we don’t (yet) expect the housing slump to push the economy into a recession in 2007, the risk is rising.

New housing figures tell a grim tale of declining sales, stagnant prices and a record number of homes no one wants to buy. Sales of previously owned homes, which make up 85% of the market, fell 11% in July from a year earlier, to the lowest level since 2004. Sales of new homes, which make up the rest of the market, fared even worse: they plunged 21% in July from a year ago, and have fallen or been flat every month this year. Virtually every housing indicator is pointing alarmingly downward; the big question is how far and fast the market will fall. If sellers panic and inventories of unsold homes keep rising, house prices may actually start falling nationally for the first time since the Great Depression.

Will the housing market really collapse? Probably not, although the size of the bubble that has enveloped the US economy couldn’t have been much bigger. House prices have risen by almost 70% since the start of 2000, and the value of all American homes has increased by $9trn, to $22trn. That helped offset the $8trn loss in equity value after the stock market bubble burst in 2000, allowing consumers to keep spending. As our sister publication, The Economist, has noted, home prices in real terms have risen at least three times as much as in any previous housing boom, making this the biggest asset bubble in American history.

House Prices

That said, it isn’t clear how much further the market will drop. Wages are rising and mortgage lending rates have fallen for five straight weeks—at 6.48%, the cost of a 30-year home loan is low historically. For the broader economy, house prices are key: as the value of homes has climbed, consumers have borrowed against their rising equity, splurging on cars, furniture, electronics and anything else they could get their hands on. Such spending has, until recently, kept the economy growing at more than 3%, above its long-term average. House prices, though, are looking shaky: a year ago they were rising at an annual rate of 10-15%, but July’s average sales price of $230,000 (for both existing and new homes) was unchanged from a year ago. (See chart)

What does this mean for economic growth? Nothing good. The International Monetary Fund estimates that an inflation-adjusted slowdown in house-price growth from last year’s 10% pace to zero will cut personal spending growth by 0.5-1 percentage points after one year. But the IMF’s figures only consider the effects on wealth accumulation, not on more practical measures such as the amount of cash Americans withdraw from their homes to spend. Freddie Mac, the second-largest buyer of mortgages in the US, expects borrowing against the value of homes to slide this year to around $170bn from $244bn in 2005. How addicted are Americans to borrowing against their homes? Almost 90% of the Freddie Mac-owned mortgages that were refinanced in the first quarter resulted in new loans that were at least 5% higher than the original loans. Weaker home prices, let alone falling ones, will make that kind of borrowing less common. So will higher interest rates: home-equity loans are typically linked to the prime lending rate, which has risen as the Federal Reserve has increased its benchmark rate.

Inventories are Soaring

Will prices stay weak?   If inventories are any guide, they should. The stock of unsold existing homes in July was the highest since 1993, and the number of new homes waiting to be sold was at a record. Although the jobs market is reasonably strong, the economy is slowing and surveys show Americans are increasingly concerned about their economic welfare. Potential buyers are also staying out of the market because they’re afraid they won’t be able to sell their current home. All of that, along with higher interest rates than a year ago, has curbed home buying, and the flood of unsold houses suggests supply will outstrip demand for some time. That’s a recipe for weak prices.

The home-building industry has suffered as sales have declined. A share-price index of the biggest US home builders has fallen 35% this year, and Toll Brothers, a luxury builder, reported a 19% fall in third-quarter profit this week, the first drop in four years.

Although the outlook is grim, it need not be fatal. Two other countries that experienced housing booms, Australia and the UK, have emerged from the experience with little real damage. In both cases home prices stagnated but never fell much. The same could happen in the US, especially if long-term bond yields–and hence mortgage lending rates—remain in check. But we are increasingly worried that bond yields are poised for a jump. The yield curve has been inverted for most of the last six months, and any suggestion that inflation is accelerating—and there are signs of this—could lead to higher long-term rates.

The Economist Intelligence Unit this month lowered its forecast for economic growth in the US next year to 2.2% from 2.4%, in part because of slower consumer spending as the housing bubble fizzles. Investment by companies awash with cash will offset some of the consumer slowdown, and stronger economic growth in Europe and much of the emerging world should boost US exports. But none of that will matter much if the housing market collapses.

Federal Reserve officials, including Chairman Ben Bernanke, are worried about housing, and would be prepared to cut interest rates if the economy heads into a tailspin. But they are also concerned about inflation, which would require just the opposite rate response. Tough times for the Fed, and for the once-buoyant housing market.

Whilst every effort has been taken to verify the accuracy of this information, The Economist Intelligence Unit Ltd. (http://www.eiu.com/) cannot accept any responsibility of liability for reliance by any person on this information.