Economic Adjustment - Not Doomsday!

Spinning the Wheels

by Lawrence Yun, Chief Economist, NAR Research

Though unlikely given abundant pent-up demand, we are faced with the possibility that the housing market could spur a vicious cycle. The current market is fragile due to excessive pessimism among potential home buyers. A lack of buyers pushes up inventory. High inventory depresses home prices. Falling home prices raise foreclosures. Higher foreclosures lead to further pessimism among potential home buyers. The cycle starts again.

This situation, driven by a lack of buyer confidence, not only impacts homeowners and the housing industry but could easily spread to the broader economy. Any further weakening in the housing market and its related housing wealth impact will likely throw GDP growth into negative territory -- by a full two percentage points. That could push the economy into a virtually “no-growth zone” and very close to an economic recession. Why are buyers hesitant?

Obviously each household makes its own decision as to whether or not it’s time to purchase a home. But there are several major factors that may be holding buyers back.

Anticipated lower home prices are holding back many people from buying a home now. Foreclosures will continue to rise in 2008. Rising foreclosures also push prices downward. In addition, the psychological effect of rising foreclosures affect people’s outlook on housing.

Anticipated lower interest rates are also restraining potential buyers. It is widely believed that the Federal Reserve will be cutting interest rates in the next two meetings of the Federal Open Market Committee. While there is no direct relationship between a Fed rate cut and mortgage rate changes, many consumers perceive that mortgage rates will fall with the later cuts. I should note here that NAR advocates a one-time large rate cut rather than a series of small rate cuts in order to end the delay in home buying.

Subprime lending has virtually disappeared since August, 2007. It had comprised about 20% of mortgage originations. While some subprime lending will return, it will do so with improved underwriting standards, a stricter and sounder regulatory environment, and with proper pricing of risk. But the timing of its return remains very uncertain. A recent pick-up in FHA loan endorsement is very encouraging in bringing some would-be subprime borrowers into loans with much safer interest rates and in helping some homeowners refinance out of the riskier subprime loans.

The jumbo mortgage market is not functioning. The current conforming mortgages average about 6%. Based on historical trends, rates on jumbo loans would be about 6.2% or 6.3%. Rather, the rates are closer to 7% due to the investor fear of anything U.S. mortgage that does not have a (perceived) backing of the U.S. government. Any rational home buyer will balk at such a higher interest rate.

How to stop this vicious cycle? Any boost to buyer confidence will have a significant impact in reviving the housing market and in lifting the economy. As I mentioned briefly last month in this column, one policy measure that can lift buyer confidence is raising the GSE (Fannie Mae, Freddie Mac) loan limits. A simple lifting of the loan limit from its current $417,000 to $625,000 would enable more households to enter the housing market using a conventional mortgage. The direct higher sales would likely induce other hesitant buyers into the marketplace. More home sales will lower inventory and thus strengthen home prices. Any strengthening in home prices could possibly have the biggest impact in lowering foreclosures.

What does that mean in “real life?” We estimate raising the GSE loan limit to $625,000 will result in:

+348,000 additional home sales
+$44 billion in increased economic activity
+$274 to $411 per month savings in interest payments for consumers who get new “GSE jumbo” loans versus current private jumbo loans
+potentially 500,000 refinancings of jumbo loans at lower interest rates
+a reduction in the national months supply of homes on the market by one month
+strengthen home prices by two to three percentage points
+a reduction in the number of foreclosures by 140,000 to 210,000

All this will help improve our economy. Each home sale contributes to GDP. In 2001, a typical first-time home buyer spent $3,500 on furniture, carpet, painting, faucets, and other items after purchasing a home. Trade-up buyers spent $5,000. Obviously those amounts would be greater today – conservatively, I’d say the average would be $4,500 There is also income generated by real estate services (moving companies, mortgage lending, inspection, appraisers, etc.), estimated to be about 9% of the home sale price. A $417,000 home sale generates $37,500 in direct economic activity.There is also the multiplier effect. The home inspector who earned a fee on that home sale goes out to dinner at a restaurant. The owner of that restaurant buys a plasma screen TV. The TV salesperson takes his/her sales commission and takes a vacation. The vacation resort hires additional workers. Those workers will buy a home

...It’s another cycle – but not a vicious one.