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Real Estate And The Economy
Tuesday, July 8, 2008
We are now halfway through 2008 - a good time to reassess where the economy stands and the prospect for more turmoil in the credit markets. While the economic analysts who missed the housing bubble have been anxious to proclaim its end, the reality is that we have only just begun.
The fundamental factor in this story is, and always has been, the housing market. The United States had more than $8 trillion of wealth wrapped up in the housing bubble - that's $110,000 for every homeowner. This is real money, even in the United States. There is no way that losing this amount of wealth in two or three years could not have a huge impact on financial markets and the economy.
Though they have both received substantial media attention, the timing of subprime or Alt-A resets are very much secondary. Mortgages go bad because properties are under water. People owe more, and often much more, than their homes are worth. This leads to widespread defaults and foreclosures no matter what kind of mortgage homeowners hold, as not many people are willing to pay off a $300,000 mortgage on a home worth $200,000. That is the situation that we are seeing in many of the former bubble markets.
At this point home prices are plunging, and there is no reason to think they will recover any time soon. The most recent data from the Case-Shiller 20 City Index (the best series available) shows that real home prices were falling at over 25% per year in the most recent three-month period. In the worst-hit markets, prices are falling at close to 40% annually.
While this rate of deflation may slow, prices will certainly not stop falling until well into 2009. Foreclosures increase the supply of housing on the market, even as many homeowners put off selling. At the same time, demand is constrained by a weakening job market, higher interest rates and tighter lending standards.
The market is likely to get worse before it gets better. Many homeowners who have delayed selling will find their prospects increasingly difficult as time passes. In some cases they have delayed a move which they would have otherwise undertaken for family or employment reasons. In other cases, they are paying mortgages on two homes. Over time, more of these homes will be put on the market.
On the other side, the federal government is now directly or indirectly providing financing for 80% of new mortgages. With the Federal Housing Authority, Fannie Mae and Freddie Mac already facing financial difficulties due to losses on defaults, it is only a matter of time before they must begin restricting new mortgages. When this happens, the market will likely take an additional hit.
The further deflation of the housing bubble will mean hundreds of billions of additional losses on mortgages and mortgage-backed securities. Since these losses will more often be occurring on prime and jumbo mortgages, the loss per mortgage will be larger on average than was the case with subprime. In other words, we are just at the beginning of the mortgage write-downs.
The loss of housing equity will also lead to higher default rates on other consumer debt (car loans, credit card debt, and student loans), since families no longer have equity in their homes as a fallback for other types of loans. These losses, together with rising losses on non-residential real estate, which also had a bubble, will place enormous stress on the financial system.
In terms of the economy, most of the weakness to date has been due to the collapse of the housing market and, more recently, a downturn in non-residential construction. The economy has yet to feel the impact of the lost housing wealth on consumption. This will surely come, and it will likely be much larger than the direct effect of the housing contraction.
So what will we see going forward? Tax cuts will spur consumption, at least through the summer months. Their effects will probably fade as early as September or October. The temporary boost in consumption will not be enough to stem job loss, which will likely continue near its current rate until the effect of the stimulus wears off. Cutbacks in state and local spending will change this source of growth into a drag on the economy by autumn.
This bad news will be amplified by the hundreds of billions of additional write-downs of debt associated with bad mortgages, credit card and auto loans. The fall in the dollar will lead to higher import prices, pushing inflation and long-term rates higher. While the dollar must decline much further to bring the trade deficit into line - and ultimately provide the basis for recovery - the short-term effect of higher inflation and higher interest rates will not be pleasant.
In short, when it comes to bad news on the US economy, we're just at the beginning.
By Dean Baker