How worried should we be about the prospect of a housing bust?
There is no question the housing market is slowing. Sales of existing homes fell for a fifth straight month in January, and sales of new homes unexpectedly fell 5 percent, despite unusually warm winter weather that should have spurred some house-hunting activity.
Seasonally adjusted figures compiled by National City chief economist Richard DeKaser show that home prices, which were rising at a steady double-digit pace in mid-2005, have shown an abrupt slowdown over the past few months.
"There is complete harmony among the indicators as far as what's happening here," he said. DeKaser calls it the beginning of what he expects to be a two-year decline in housing sales and construction, although he does not expect "broad-based" price declines because labor markets are still growing.
Other economists are not so optimistic. Mark Zandi, chief economist of Economy.com, predicts that prices will be flat nationally over the next two to three years and said values could fall by 10 percent or more in perhaps a dozen major markets, including Miami, San Diego and Phoenix.
Such double-digit price declines might be nothing to worry about and even could be something to welcome, according to a contrarian view.
After all, for most people any gains in housing values have been purely on paper, since unless you sell your house in San Francisco and move to Kansas, there is no way to lock in your gains. And a decline in housing prices would make the market more affordable to many workers looking to buy their first home or to move up, according to an article published this week in the New York Times.
"It's time that most of us learned to stop worrying and love the bursting bubble," said the article by David Leonhardt, an economics correspondent at the newspaper.
Ethan Harris, chief U.S. economist at Lehman Bros., agrees, although he said the coming retrenchment will not be without pain, especially in locally overheated markets.
"It's not healthy for a local economy to have the median-income people priced out of the housing market," he said. "You have a haves-and-have-nots situation. I think a period of mild retrenchment followed by flat prices for several years will restore equilibrium."
Paul Kasriel is having none of it. Kasriel, economic research director at Northern Trust in Chicago, wonders in a research note whether Leonhardt is a renter.
Kasriel points out a variety of ways in which a housing bust could damage the broader economy:
1. Jobs. More than 40 percent of new new private sector jobs added in the first several years of the current expansion were related to housing, although that percentage has fallen sharply as the broader job market has accelerated, according to Northern Trust research. Still, a sharp downturn in sales could mean layoffs for construction workers, real estate agents, mortgage brokers and even many employees at Wall Street firms that help provide the capital for new mortgages.
2. Consumer spending. The run-up in housing has boosted consumer spending in two ways – through a psychological "wealth effect" and by allowing owners to turn their homes into giant cash machines, withdrawing equity at a record annual rate of more than $600 billion last year, compared with less than $200 billion a year in the late 1990s. If home prices flatten or turn down, there will be no more equity to withdraw, and consumers who have much of their wealth tied up in a single asset will no longer feel inclined to spend so freely.
3. Problem loans. More than 40 percent of the dollar volume of new loans has been made with adjustable mortgage rates in recent years, compared with less than 20 percent in the early 1990s. As interest rates rise, many owners who stretched to buy a house will find themselves facing higher and possibly unaffordable payments. If housing prices turn down, some owners could find themselves "upside down" on their loans, owing more than the house is worth. A a true housing bust – comparable to the collapse that deflated tech-stock values in 2000 – holds the capacity to "cripple the banking system," Kasriel said. That would make it difficult for the Federal Reserve to revive flagging growth since banks would be hard pressed to loan money even if rates were falling.
Kasriel puts no odds on such a doomsday scenario, but there is no doubt that the potential ripple effects from a housing downturn have captured the attention of the Fed and its new Chairman Ben Bernanke.
In a speech Friday, outgoing Fed vice chairman Roger Ferguson highlighted housing as the most prominent risk to the central bank's outlook for continued solid economic growth. Fed estimates suggest that consumers spend about 3.5 cents of every increased dollar of net worth, and other "plausible" estimates range up to 6 cents.
In addition, he said, "a sizable deceleration in house prices could have an outsized effect on consumer confidence and thereby reduce household spending by more than is implied by conventional estimates of the wealth effect."
A newly issued Fed report on consumer finances, published every three years, found that 39 percent of household assets were concentrated in residential real estate in 2004, up from 32 percent in 2001. As a result "the U.S. household sector’s vulnerability to the turn in housing activity now under way has increased," said Goldman Sachs senior economist Ed McKelvey in an analysis.
Initially any downturn in housing prices will affect people differently based on where they are located — both regionally and demographically.
A recent study of British household data from 1988-2000 found that the wealth effect on consumer spending was concentrated in older homeowning households.
"That makes sense because it is the older homeowners who are going to be able to move down and extract equity from their house," said John Campbell, a Harvard economics professor who was lead author of the study. Rising home prices appear to have little impact on the spending habits of younger renters, he said.
Still, if a housing bust has the type of severe ripple effects that Kasriel thinks are possible, even those younger renters could feel the impact in the form of a broad economic slowdown that leads to a downturn in employment growth.
But Harris of Lehman Bros., who Friday predicted the Fed will end up raising short-term rates four more times this year rather than two based on robust growth, said he has been encouraged by the experience of Australia and Britain, where housing markets were even more overheated than here at home.
Although consumer spending retreated as the markets cooled in those countries, there was no general collapse in home prices, nor did the slowdown spill over and cause a wider recession in those to countries.