A necessary adjustment

From the Wall Street Journal:

Pace of Decline
In Home Prices
Sets a Record
By JAMES R. HAGERTY and KELLY EVANS
December 27, 2007

A closely watched gauge of U.S. home prices shows they are falling sharply across most of the nation, as a deepening slump in the housing market threatens to damp consumer spending.

Home prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, according to the S&P/Case-Shiller home-price indexes, released yesterday by credit-rating firm Standard & Poor’s. That exceeded the previous record year-to-year decline of 6.3% in April 1991, when the economy was emerging from a recession.
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The silver lining behind the latest home-price data is that they signal the market is making what most economists see as a necessary adjustment, dragging home prices back into closer alignment with Americans’ ability to pay. The market is working its way “back to reality,” says David Seiders, chief economist of the National Association of Home Builders. He thinks house prices will bottom out by early 2009.

Some other economists say that might not happen before 2010. “The housing shock is only about halfway over, and housing prices will continue to fall well into 2009,” says Lehman Brothers economist Michelle Meyer.

During the housing boom in the first half of this decade, fast-rising home prices made it easy for homeowners to take out home-equity loans or refinance their primary mortgages to extract some cash. That helped sustain consumer spending, which accounts for about 70% of U.S. economic activity.

Economists now worry that falling home prices will prompt consumers to pull back on spending enough to slow growth or even tip the economy into recession. “Eventually what’s happening in the housing market is going to catch up with us,” says Patrick Newport, an economist at research-firm Global Insight Inc.
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The S&P/Case-Shiller index showed that some of the fastest declines in home prices are in metropolitan areas that were among the hottest during the housing boom. Prices were down 12.4% from a year earlier in Miami, 11.1% in San Diego, 10.7% in Las Vegas and 10.6% in Phoenix.

Home prices are still up from a year ago in some cities, such as Seattle and Charlotte, N.C. And people who bought their homes several years ago still are sitting on sizable gains in most of the country.

The boom more than doubled prices in many populous areas near the coasts. The run-up was fueled in part by unusually low interest rates, which slashed the cost of monthly mortgage payments. In addition, in the wake of the technology-stock bubble, many Americans viewed real estate as a safer investment than stocks, and so poured increasing sums into second homes and rental properties. Home sales began to slow in mid-2005. Prices leveled off and then started declining in 2006. Over the past year, mortgage defaults have soared, leading to rapid growth in foreclosures.
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But the recovery of the housing market is likely to be a gradual process. That’s partly because the boom left prices so far out of whack with incomes. As measured by the S&P/Case-Shiller national index, home prices jumped 74% in the six years through 2006. During the same period, U.S. median household income rose 15%. (Neither figure is adjusted for inflation.) That made housing unaffordable for many Americans.

For a few years, lax lending standards — some loans required no down payments and offered low introductory interest rates — meant borrowers could buy more expensive houses than they could really afford. But lenders have been burned by a surge in defaults that started in 2006, and such mortgages generally are no longer available. That means house prices will have to fall to a level potential buyers can afford.

Mark Zandi, chief economist of Moody’s Economy.com, a research firm in West Chester, Pa., predicts that on average U.S. house prices will decline about 12% by the second quarter of 2009 from their peak in the second quarter of 2006. He expects household income to rise by about the same amount over that period.
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The mortgage market also needs to adjust further. Most of the funding for home loans comes from investors who buy securities backed by bundles of mortgages. Since August, many of those investors have shunned the market amid fears of rising defaults. As a result, lenders generally are focusing on loans that can be sold to government-sponsored investors Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration. So-called jumbo loans — those above $417,000, too big to be sold to Fannie or Freddie — have grown much more expensive, deterring buyers in high-cost areas.

The current scarcity of funds available for mortgage lending creates a chicken-and-egg situation, says Prof. Leamer. Investors who provide funding for home loans don’t want to commit more money until they believe the housing market is getting better. But it’s hard for the housing market to rebound as long as mortgage credit is tight. Lower prices eventually will break this impasse, by luring buyers back into the market and reassuring investors that the market is finding a bottom, he says.