by Mickey Levy
It is not just the rapid decline in home prices but the uncertainty about how much further they will fall that stands out as one of the largest negative factors hanging over the economy and financial markets. The current pace of adjustments suggests that uncertainty will begin to abate late this year and early 2009.
Falling home prices increase affordability and are necessary to reduce bloated inventories of houses for sale, but expectations that prices will fall further keeps potential buyers on the sidelines. And this same uncertainty creates havoc in financial markets by driving up credit losses and making it nearly impossible with any degree of reliability to value a sizeable portion of the over $10 trillion of mortgage securities held by banks, investment banks, Fannie Mae and Freddie Mac and a wide array of global investors. This has plagued mortgage markets and pushed up mortgage rates even as the Federal Reserve has eased 325 basis points. A key channel through which the Fed’s monetary easing is supposed to stimulate the economy has been gummed up.
It is still early, but some evidence suggests that we are inching toward the end of the housing contraction. Obviously, further adjustments are needed, and the mess in mortgage delinquencies and foreclosures will linger far after housing activity stabilizes. But my hunch is that by early 2009, aided by further declines in prices, the inventory of unsold new homes will have fallen sufficiently such that residential construction stops falling and markets will gain more clarity about how much further home prices will fall. This will provide a key inflection for financial markets and the economy.
The falling home prices are clearly affecting real estate supply and demand fundamentals, and facilitating the narrowing of earlier imbalances that mounted during years of excesses and bloated price expectations. Builders have slashed residential construction, home sales have begun to stabilize, and the inventory of unsold new homes has receded materially from its peak. No question, inventories remain well above an acceptable range, particularly for unsold existing homes.
Residential construction has been in a virtual free-fall. New housing starts have fallen more than 50 per cent from their early 2006 peak and the value of new construction has fallen nearly $300bn, from 6.3 per cent of GDP to 3.5 per cent presently. This has been the single largest drag to the economy, and the construction industry has been has been a major source of job losses — as well as lost earnings in the unrecorded cash economy.
Home sales plummeted from their summer 2005 peak, but the pace of existing home sales have stabilized since last December and new home sales in the last three months. Presumably purchasers are attracted by the significantly lower prices.
Importantly, housing construction has been cut below the pace of new home sales, and the inventory of unsold new homes has fallen. Measured as months of inventories at the current pace of sales, new home inventories have just begun to recede from an extraordinarily high level. However, the absolute level of inventories of unsold new homes has fallen from a peak of 572,000 in summer 2006 to 426,000 in June 2008 — more than a halfway retracing of their rise from their 320,000 average earlier this decade.
Lower prices have helped stabilize existing home sales since last December, but as existing houses sell, more come on the markets, and their inventories remain near all-time highs. Reducing these imbalances will take a while to unwind, but they have a lesser impact on construction than the inventory imbalance of new homes.
According to the Case-Shiller Home Price Index, which includes homes financed by non-conforming mortgages such as subprime and Alt-A mortgages, home prices have fallen 17 per cent from their peak, based on a survey of major metropolitan areas. But prices have declined very unevenly across regions. Not surprisingly, home prices have been falling the most in select regions in California, Florida and Nevada, where earlier expectations that prices would rise forever and lax lending standards fuelled speculation, soaring home prices and sharply rising mortgage delinquencies and foreclosures. Prices have dropped over 30 per cent from their peaks in Miami, Las Vegas and Phoenix and over 25 per cent in San Francisco, Los Angeles and San Diego. In contrast, price declines in other regions have been much more modest, and recently, in select markets the pace of decline has moderated.
When will we see “the light at the end of the tunnel” on these adjustments? Let’s consider the magnitude of existing imbalances and extrapolate recent trends. Over time, house prices and their rental equivalent value should generally converge. From the mid-1990s through 2005, home prices soared above a measure of rental equivalence. With the dramatic declines in the Case-Shiller index, prices remain approximately 14 per cent above a measure of rental equivalence. At their recent pace of decline, by year-end, national home prices will have fallen a total of nearly 30 per cent and be close to rental equivalence. This expected decline would involve larger declines in the problem regions.
Similarly, even without a pick up in new home sales, by year-end, the inventory of unsold new homes will have receded toward their long-run average. Construction has already begun to decline at a moderating pace, and with inventories approaching manageable levels, new construction will stop falling round year-end. The story is different for existing homes: although further price declines are expected to boost purchases, trimming undesired inventories will take longer.
As these trends unfold, the widespread uncertainty about future home prices will begin to dissipate. Although prices likely will fall further into 2009, trough levels will be closer in sight and expectations will converge toward more modest further declines. This lifting of widespread uncertainty and fears of further dramatic declines will have pervasive implications for financial markets and beleaguered financial institutions.
With more certainty about the value of mortgage backed securities, write-offs of non-performing mortgage-backed assets will be better grounded in agreement about where house prices are going, liquidity will be restored to the mortgage market. The mortgage syndication market will return to normalcy. Mortgage rates spreads over US treasury yield will narrow. This will boost house purchases. More importantly, it will unclog a key channel of monetary easing, and facilitate an acceleration in overall economic activity.
The severity of the recent declines in activity and home prices reflect their earlier unsustainable exuberance, but like prior slumps, this one won’t last forever. The adjustments are proceeding toward a “new normal” in housing activity and prices, without bloated expectations.
Mickey Levy is chief economist at Bank of America