How Housing Could Derail the U.S. Economy

Housing led the U.S. out of seven of the last eight recessions. This time it may kill the recovery.

On Aug. 24 the Chicago-based National Association of Realtors reported that July sales of existing homes plummeted 27.2 percent from June, the biggest monthly drop since recordkeeping began in 1999. Sales of new homes dropped to the lowest level on record.

The July numbers are another sign that home sales have collapsed following the expiration in April of a federal tax credit for buyers. The manufacturing-led expansion could theoretically take up the slack—except manufacturing is on the wane, too, with jobless claims rising and factory orders actually dropping once aircraft orders are excluded. "If foreclosures continue to mount and depress home prices, that could send the economy back into a recession," says Celia Chen, an economist who tracks the industry for West Chester (Pa.)-based Moody's Analytics.

Housing's impact on the economy goes far beyond homebuilding. Spending on home construction and items such as furniture and white goods accounted for about 15 percent of gross domestic product in the second quarter, according to Moody's Analytics. When values soared in the mid-2000s, people used the boost in equity to pay for cars and vacations. In the recessions before the latest downturn, housing sales started to improve eight months before recovery, generating the jobs and the feel-good factor needed to get the economy going again. The opposite is happening now. Sales of new houses fell in five of the eight months before the economy started to grow again in 2009.

Today 14.6 million Americans are out of work, and homeowners are struggling to hold on to their properties. One in seven mortgages was delinquent or in foreclosure during the first quarter, the highest on record dating to 1979, according to the Washington-based Mortgage Bankers Assn. Foreclosures probably will top 1 million this year, says RealtyTrac, an Irvine (Calif.)-based data company.

Federal efforts to help have had little success. Of 1.31 million loan modifications started under the Obama Administration, 48 percent were canceled by the end of July, the Treasury Dept. said on Aug. 20. More than half of the households that had worked out modifications with their banks defaulted again within 12 months, the Office of the Comptroller of the Currency said on June 23.

Shadow inventory, or the number of homes repossessed or in default that eventually will be offered for sale, stood at 7.3 million in the first quarter, says Laurie Goodman, an analyst in New York at mortgage-bond broker Amherst Securities Group. As those properties hit the market, prices will come under even more pressure and buyers will wait for better deals. "The only thing that's going to fix the housing markets right now is a work- through of what excess supply is on the markets and an improvement in unemployment," says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia. "That is a very, very long-term process."

The few who are house hunting are taking their time. Marion and Jim Lasswell say they spend most weekends looking at homes for sale near Raleigh, N.C. His engineering job at iRobot is secure, the couple's credit is good, and they have saved enough for a 20 percent down payment, Marion Lasswell says. "We're still watching prices drop," Lasswell, a 38-year-old registered nurse, says. She adds that they won't buy "until there's an awesome deal." Home prices tumbled 33 percent from their July 2006 peak to the low in April 2009, according to the S&P/Case-Shiller 20-city index. They may drop an additional 20 percent by 2012 if the economy slips back into a recession, according to Moody's Chen.

Federal Reserve policymakers on Aug. 10 made their first attempt to shore up the recovery by pledging to keep their holdings of securities and prevent money from draining out of the banking system. The Fed has held the target for its benchmark lending rate near zero since December 2008 and purchased more than $1 trillion worth of debt to keep rates low and bolster housing. The average rate for a 30-year fixed mortgage dropped to 4.44 percent in the second week of August, the lowest recorded by McLean (Va.)-based Freddie Mac (FRE), the second-largest mortgage buyer.

You'd think home buyers would be snapping up those cheap mortgages. Instead, a July survey by the Conference Board found 1.9 percent of the respondents planned to buy a home in the next six months, near December's 27-year low of 1.7 percent. "There is an epidemic of thrift," says Nariman Behravesh, chief economist at IHS in Lexington, Mass. "Households and businesses are super-cautious right now."

Meanwhile the Lasswells keep looking. "I don't see things getting better," Marion Lasswell says. "I expect prices to be flat for a long time."

The bottom line: The housing market usually leads the U.S. out of recession. Now housing's woes may force the economy back into a downturn.

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