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The hidden risk of a housing slowdown

As analysts seek to understand the economic impact of hurricanes Katrina and Rita, Fed Chairman Alan Greenspan is keeping his eye on an even more powerful force of nature: the red-hot housing market.
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Many analysts and investors are busy trying to understand the economic impact of hurricanes Katrina and Rita, and rightfully so. But Fed Chairman Alan Greenspan made clear this week that he and other central bankers are keeping their eye on an even more powerful force of nature: the red-hot housing market.

Katrina’s impact began to grow clear Friday as the government reported an unexpectedly sharp decline in personal spending and income in August, even though the monster storm only came ashore in the final days of the month. By all measures consumer sentiment has plunged in the aftermath of the storm, possibly signaling a tough holiday retail season ahead as consumers grapple with fuel costs that are far higher than they were a year ago.

Meanwhile the Fed chairman, whose term is ending in January, is stepping up the pace of remarks warning about the potential for a housing slowdown to act as a drag on economic growth. This week Greenspan revealed the depth of his interest in the economic impact of housing by unveiling a dense study on home equity drawdowns, only the second research paper he has put his name on in his 18 years as Fed chief.

The sharply rising value of housing in recent years has created a “wealth effect” that has contributed significantly to consumer spending growth — not unlike that created in the late 1990s by the boom in stock prices. In fact the housing wealth effect is even more powerful, with homeowners spending an average of 5 cents for every dollar in increased home value they enjoy, compared with 3 cents for every dollar in the increased value of stocks and bonds, said Richard DeKaser, chief economist for National City, a Cleveland-based bank.

One reason is that it has become easier than ever to turn home equity into cash, either through cash-out refinancing or by drawing out cash as part of a “step-up” into a new and more expensive home.

“There is no question that the ability to tap equity has supported consumption,” said Doug Duncan, chief economist of the Mortgage Bankers Association. Rising equity values kept the 2001 recession from being deeper and longer than it was, he said.  “It is a very, very powerful engine for the economy,” he said.

So analysts were not surprised that Greenspan decided to take a close look at the impact of such home equity drawdowns on consumer spending, which is responsible for more than two-thirds of all U.S. economic activity.

“He is reinforcing something that a lot of economists agree with, which is that the economy is being motored by the housing sector,” said Ethan Harris, chief U.S. economist for Lehman Bros.

The conclusion of the 83-page research paper co-authored by Greenspan and Fed senior  economist James Kennedy, as Greenspan explained it in a speech to a bankers conference, is that “a significant amount of consumption” has been fueled by homeowners taking equity out of their residences.

If that is true, he added, an increase in mortgage rates or decline in housing affordability presumably would result in a decline in consumer spending growth.

Greenspan’s remarks were interpreted in various and sometimes conflicting ways.

Wire reporters from both Reuters and The Associated Press focused on Greenspan’s conclusion that “the vast majority of homeowners have a sizable equity cushion” and thus are in a fairly good position to weather a shock if prices drop.

But Wall Street Journal reporter Greg Ip, considered to have sources that give him particularly strong insight into Greenspan’s thinking, took a far more cautionary tone about the potential negative impact of rising mortgage rates on consumer spending.

“He’s got a mixed message,” said Harris, referring to Greenspan. “He is saying there is no major national bubble, but on the other hand we’re going to lose some growth if the market cools.”

And certainly many analysts expect the market to cool, especially now that mortgage rates are edging up, with 30-year fixed rates having risen from about 5.5 percent in early July to 5.9 percent currently.

Goldman Sachs senior economist Jan Hatzius expects the cooling to begin in earnest in the second half of 2006, after an initial bump from hurricane-related rebuilding. Even if there is no housing collapse, a mere moderation of growth could have an outsized impact on the economy because of the loss of home-equity spending, he said in a research report.

"The potential drag on real GDP growth from the real estate sector is large," Hatzius said. He warns of a "triple whammy" in 2007 in which a housing slowdown, unless offset by other factors, would cause sharply slower growth, a deepening budget deficit and a weakening of the dollar.

So far there are few signs that the housing market is cooling. Sales of existing homes surged to the second-highest pace on record last month and prices rose at their fastest pace in a quarter-century, according to a report this week.

New-home sales fell sharply and unexpectedly, but the median sales price rose. The new-home series, based on far fewer transactions, tends to be far more volatile and subject to revision, so analysts were not quite certain how to interpret it.

DeKaser, for one, sees signs that the housing market may have peaked.

“All the data are not uniform, but if you look over the past six to eight months, one could plausibly make the case that we are seeing a moderation play out,” he said. “Frankly I think we’re starting to turn the corner.”

In any case, analysts agree that after years of paying little attention publicly to the run-up in housing prices, the Fed is showing clear signs of concern. Greenspan this year acknowledged for the first time that there are “signs of froth” in some local markets, and in August he warned that “history has not dealt kindly” with the aftermath of asset price bubbles.

“I think there has been a sea change in the Fed’s perspective on this issue over the course of this year,” said DeKaser. “I think as a result of a combination of the recent acceleration in price increases and the emergence of more serious research on this subject the Fed has gotten more concerned and is expressing that concern.”