The belief that the real estate recession is almost over has become widespread, especially because federal authorities want the electorate to think their remedies are succeeding. But I am much less optimistic than views coming out of Washington and the media. The reasons primarily involve real estate.
The housing industry has been hit by a double whammy. The first blow was excessively risky and often fraudulent home mortgages. These included subprime mortgages requiring no down payments, no verified income estimates by borrowers, and low teaser rates that jumped up sharply. These foolish documents all assumed more home price increases, thereby permitting refinancing at better terms.
The nation's home builders followed their usual reckless practice of building as many new units as possible, even though that caused them to exceed current demand. So home markets became overbuilt in 2004 and 2005 — as they have in all previous economic booms.
Hence home prices began falling, which undermined the basic assumption behind most subprime and many prime loans. This led to massive subprime and other mortgage defaults. Many were buried in complex collateralized debt obligations (CDOs) that had been sold to unknowing investors worldwide.
Many banks that issued CDOs were caught with billions of securities as yet unsold when the bottom dropped out of the CDO market. That left those banks with tons of toxic assets no one was willing to buy. Eventually this led to a worldwide credit freeze in both housing markets and commercial property markets.
The Federal Reserve, the Federal Deposit Insurance Corp., and the U.S. Treasury reacted by pouring trillions of dollars into banks, Wall Street firms, the auto industry, and some housing securities. Even so, housing prices fell sharply and defaults kept multiplying, generating massive home foreclosures.
Shrinking household wealth
In September 2008, asset values of all types collapsed, ranging from office buildings to 401(k) plans, stock values, pension fund holdings, single-family and apartment prices, and even commercial property prices.
This gigantic decline in American wealth caused consumers at all income levels to cut back on their spending. For the first time in years, consumers as a group began saving money. The result was a huge drop in demand for all types of goods and services.
New light vehicle sales fell from an annual average of 16.8 million units from 1989 through 2006 to an estimated 11.5 million in 2009, down 31%. New home starts — excluding mobile homes — dropped from an annual average of 1.7 million from 1989 through 2006 to an estimated 520,000 in 2009, a plunge of nearly 70%, the lowest level since World War II. Office and apartment vacancies rose notably.
The peacetime record fall in housing starts of 75% from 2005 to 2009 reflects the impact of the second whammy to hit the housing markets: rising unemployment caused by falling consumer spending. That led to a further drop in spending because of shrinking incomes among people who have lost their jobs or believe they might soon do so.
This whammy is like the usual decline in housing activities in most previous recessions since World War II. In those recessions, there was usually no major fall in home prices from defaults in inferior mortgage instruments; the big problem was unemployment.
The impact of this second whammy has certainly not played out yet. Unemployment is still rising. U.S. home foreclosure filings shot up from 1.03 million in 2006 to 3.1 million in 2008, and are likely to reach 3.5 million in 2009. Only about 25% of annual foreclosure filings result in lender takeovers in the same year.
Hence the data imply that takeovers will rise from an estimated 789,000 in 2008 to about 875,000 in 2009. Although sales prices of some existing homes have recently risen slightly due to many low-priced foreclosure sales across the nation as a whole, sales of existing homes dropped from 6.5 million in 2006 to 4.9 million in 2008 and are projected to hit 4.6 million in 2009, a fall of 29%, according to the National Association of Realtors.
Both rising foreclosures and falling sales mean the overall inventory of houses on the market is not declining. Therefore, the recession in housing markets won't be over for quite a while.
Deleveraging creates pain
As I pointed out in previous columns, debt repayment problems in commercial property markets will become much greater in late 2009 and throughout 2010. Too many property owners borrowed at high loan-to-value ratios from 2000 through 2007.
Since property values plunged in 2008 and banks have drastically reduced loan-to-value ratios, those property owners will have to come up with lots of new equity to roll over their debts. Where will they get such capital if banks still refuse to lend?
Many won't be able to repay their loans, so huge amounts of commercial properties will change ownership involuntarily. Thus, the recession in commercial property markets has not even hit its low point.
Finally, there is a difference between hitting bottom and actually coming out of a recession. In housing, about 1.3 million new U.S. households are formed in a typical year. That means the housing market won't be back to normal until new starts rise from their present level of 520,000 per year to near 1.3 million — a whopping gain of 150%.
As long as sales in housing markets are dominated by foreclosures, home prices will not rise much from the bottom, which they have not yet reached. In past regional recessions, it took three to five years for home prices to rise from their low point to the peak in previous booms. Since we are not yet at either a housing or commercial price low point, it will be a long time before we get back to normal in these markets.
In addition, gross domestic product (GDP) in 2000 dollars peaked at $11.72 trillion in the second quarter of 2008, then fell to $11.24 trillion one year later — a fall of about $480 billion, or 4.1%. The last time real GDP posted that big a decline (11% in 1946), it took five years to bring it back above its previous high.
Even when it is clear that we have stopped falling, we may still take a long time to get out of the hole we have dug. So don't relax yet. It's not over.
Tony Downs is a senior fellow at the Brookings Institution in Washington, D.C. Contact him at [email protected]