As 2007 began, one overarching question hung in the minds of everyone from investors to economists to policymakers: Will the housing recession sink the economy? The housing boom and bust is easily the defining feature of this business cycle. The slump is unique in that no housing downturn of this size has ever occurred outside of a general economic recession. This time the market collapsed under its own weight from past overbuilding, speculation, and soaring prices, not because of the classic triggers, such as prohibitive mortgage rates, tight credit, and rising unemployment. So far, the economy has absorbed the blow, but it has not been painless.
At this midway point in the year, it's worth revisiting housing's plight in light of all that has changed. So far, there have been some surprises, including a weaker-than-expected economy through the first quarter and lost hopes for Federal Reserve cuts in interest rates. And new housing-related risks have popped up, including higher long-term interest rates and, most recently, financial-market fallout from the meltdown in subprime lending, both of which have left investors increasingly nervous over how it will all play out.
Still, the housing recession seems most likely to remain confined to the housing sector—but with some new caveats. Higher mortgage rates mean the slump is now certain to drag on longer than previously expected. That implies a heavier direct impact from falling home construction on overall growth in the second half. In addition, the indirect effects, via declines in home prices and the spreading problem with subprime loans, deserve new attention. All in all, these risks raise the stakes.
RIGHT NOW, ECONOMISTS ARE SPLIT on the direction of the economy in the second half, and the housing outlook is the wedge between those expectations. On average, the 51 forecasters surveyed by Blue Chip Economic Indicators believe the economy will grow 2.8% annually over the final two quarters of the year, but expectations vary sharply. The 10 most bullish economists see growth at a sturdy 3.4% annual rate, while the 10 most bearish expect a pace of only 2%. As a result, the two groups have inflation and interest rates heading in opposite directions. Housing will most likely be the swing factor in deciding who's right.
The half-point climb in fixed mortgage rates, from 6.1% in early May to 6.6% at the end of June, based on data from the Mortgage Bankers Assn., will certainly hit housing demand, but not too hard. For example, it raises the monthly cost of the maximum conforming loan of $417,000 (above which the loan is considered "jumbo" and carries a higher rate) from $2,527 to $2,663. For a prime borrower willing to shell out that much per month, an extra $136 will not be a major burden, but it's enough to mean some home buyers will not meet the income requirement to qualify for a loan.
Even before the rate rise, May sales of both new and existing homes fell from April. Demand for new homes dropped 1.6%, retracing some of the big 12.5% increase the month before. May sales of existing homes dipped a small 0.3%, but the level was the lowest in four years.
As mortgage rates increased in June, builders' sentiment, already reeling, sank to the lowest reading since the 1990-91 recession. Lennar Corp, (LEN ) the nation's biggest homebuilder, had been expected to eke out an earnings gain for its second quarter but instead posted a loss on June 26 and suggested another loss was likely for the third quarter. Like many builders, Lennar is trying to control its inventories, partly through sales incentives, which, for Lennar, have more than doubled this year, to $44,600 per home from $20,200 in 2006.
BUT EVEN MARGINALLY SOFTER DEMAND will make bloated inventories a growing problem for the broader economy. The stock of new homes waiting for buyers affects both construction activity and prices. Unsold existing homes are the chief reason for sliding home values, which will cut into household wealth and make refinancing troubled loans more difficult.
The number of months required to sell the stock of new homes ticked up to 7.1 in May, compared with an average of 6.4 months for all of 2006 and 4.5 months in 2005. The supply data for existing homes are more worrisome, jumping from 8.4 months to 8.9, the highest level since 1992. From 2002 through 2005, before the bust, supply averaged about half that.
Not surprisingly, prices continue to head south, and the drop is accelerating, a trend that will most likely continue in coming months. The Standard & Poor's/Case-Shiller index of existing-home prices fell 2.1% from a year ago. Over the past six months, the annual rate of decline has been an even faster 4.8%. Economists prefer this index because, unlike some popular measures, it controls for shifts in the mix of sales, which can distort the total, and it includes a variety of underlying mortgages, such as subprime loans.
THE NEW HOUSING-RELATED DANGER in the outlook is tighter financial conditions. Lenders have already lifted their standards for mortgage borrowers: a lot for subprime customers, a little for prime loans. Rising foreclosures and growing subprime troubles on Wall Street will result in even tighter standards that will shut more potential home buyers out of the market.
But there is a broader concern. The possibility for more financial implosions, like the subprime mess at Bear Stearns (BSC ), could spread through the credit markets, making other corporate and consumer borrowing more costly. Also, the ripple effects could depress stock prices, which would hurt both businesses and households (see BusinessWeek.com, 6/26/07, "Stocks: Numbers Do Lie").
That's a worst-case scenario, but what's clear is that all this will add new downward pressure on home sales and construction in the second half. Housing starts had begun to stabilize in the second quarter, with the average starts in April and May actually running above the first-quarter level. The same was true for new-home sales. Now, the housing drag on economic growth, instead of diminishing in the third quarter, is likely to reintensify.
However, unlike the past year, any new hit from housing will come as other sectors of the economy are strengthening. Manufacturing is gaining strength as businesses rebuild their inventories. Capital spending is reaccelerating after its slowdown late last year, and consumer spending is holding up well.
In fact, resilient consumers are the chief reason housing has not sunk the economy, and the key has been strong job markets. For example, in the states where home prices had grown the fastest prior to the bust, homebuilding has plummeted. However, analysts at JPMorgan Chase (JPM ) note that the unemployment rate in all but one of those states is lower now than it was two years ago. The jobless rate in Florida, a poster child for the housing bust, has fallen even more than the national average. The implication: Unless the housing bust reaches the labor markets, consumers and the rest of the economy will keep chugging along.
By James C. Cooper