Housing's Stiff Headwinds

BusinessWeek economist James Cooper points out that financial market strains will keep recoveries in housing and the economy at bay for a long time

The end of the housing slump is easy to map out; getting there is the hard part. Even under normal circumstances, working through the current glut of overbuilding would be a drawn-out affair, with painful consequences for the economy. What's not normal is that this housing debacle has ripped the economy's financial fabric, with growing fear that more damage lies ahead.

This "financial storm," as Federal Reserve Chairman Ben Bernanke described it on Aug. 22, has made it harder not only to take out a mortgage but also to get any kind of loan. "Its effects on the broader economy," he noted, "are becoming apparent in the form of softer economic activity and rising unemployment." It's a vicious cycle: A stronger economy depends on housing, but the housing slump is eroding financial conditions, which are in turn undermining recoveries in both housing and the economy.

Think of a housing turnaround as a two-part story. Part One will be an upturn in construction of new homes. That's crucial to ending the direct drag on the economy, which has subtracted a full percentage point from growth in real gross domestic product over the past year. Part Two will be a firming of prices in the existing home market. That's the key to restoring stability in the credit markets and stanching the losses in consumer wealth.

However, this recovery process is at the mercy of the financial storm. For example, through the first half of 2008 the housing outlook was improving. Mortgage rates were falling, and prime loans that conformed to Fannie Mae (FNM) and Freddie Mac (FRE) guidelines were flowing nicely. July sales of both new and existing homes rose, and demand seemed to be stabilizing. Then came the latest financial shock at Fannie and Freddie, which is shrinking the market even for prime loans. Mortgage rates have risen more than half a percentage point since June, cutting into affordability. Now, new weakness in demand seems likely in coming months.

That's unfortunate, because the trends in sales and starts of new homes through July were reducing builders' inventories. In the case of single-family homes built for sale, starts fell below sales last year, and the gap has been widening ever since. As a result, builders' inventories of new homes have shrunk 23% over the past year. However, it would still take 10.1 months to sell those homes at the current sales rate. About five months is normal. Starts will have to fall considerably further and stay low for at least several more months. So, while the direct drag on overall GDP growth from construction losses is on track to ease a bit, its downward pull will continue through yearend.

On the price front, the trend is still bad, but less bad. Through June, the Standard & Poor's (MHP) Case Shiller 20-city price index for existing homes fell a record 15.9% from a year ago. However, the month-to-month declines have been getting progressively smaller for four months in a row.

Still, inventories remain huge, and rising foreclosures are swelling the numbers. Taking seasonal moves into account, inventories of existing homes appear to have plateaued, but at a record 11.2 months' supply. Plus, the current sales rate is propped up by distressed sales of foreclosed properties, according to quarterly data from the hardest hit states. Given this glut of unsold homes, more price declines, especially in the boom-bust areas of California, Florida, and Nevada, are all but assured. That will lead to more mortgage defaults and falling values of the financial securities linked to them.

The stresses caused by Fannie and Freddie will drag out both phases of the recovery well into 2009, with the danger that another credit-market implosion could create more problems along the way. One positive sign: RealtyTrac says that last quarter, bank repossessions as a share of foreclosures jumped to 30%, indicating that progress has been made in purging bad loans from the system. The problem: This purging—and its impact on bank finances and lending—still has a long way to go.

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