Ducking the Housing Credit Mess

Many pessimists believe the current credit freeze in home markets will spread to commercial property, setting the stage for a full recession in 2008. Consequently, it's important for commercial property markets to estimate how big a fall in home market values and activity will occur.

We need to distinguish between what is happening in the for-sale markets for newly built housing vs. existing housing. U.S. homebuilders achieved over 2 million starts in both 2004 and 2005. In all past periods since World War II when the industry started over two million units in one to three years running, builders were selling into the future, setting the stage for declines in starts. Historically, the result was that new starts fell an average of 37% over the next three to four years.

I believe new housing starts will remain depressed in 2008 and perhaps 2009. Homebuilders will cut prices on existing inventories and put downward pressure on the prices of existing homes.

A different housing animal

But the existing home market is much larger than the new home market. The number of existing homes sold peaked at 7 million in 2005, and remained above 6.4 million in 2006. There are about 76 million owner-occupied homes in the U.S. today; annual sales are now running slightly under 10% of the existing inventory. Since 2005, after home prices had risen dramatically for at least five years, many owners opted to cash in on big equity profits. That enlarged the inventory of existing homes for sale.

Most of those sellers do not have to move, so they will withdraw their homes from the market if prices fall so much that they feel they are not getting what their homes are really worth. That's why median prices of existing homes sold have declined only 4.2% from October 2006 to October 2007, according to the National Association of Realtors.

Some pessimists believe existing homeowners have overleveraged their homes to the point that small price declines will wipe out their equity, causing massive defaults. But the Federal Reserve Board's balance sheet data show that total borrowing against homes, including home equity loans, amounted to 50% of the market value of those homes in the third quarter of 2007 vs. 47% in 2006 and 44% in 2000. Thus, only households who bought homes from 2003 to 2006 are likely to have minimal equity.

Inside the numbers

The peak year for home mortgage lending was 2003, when total originations were $4 trillion, of which $2.9 trillion were refinancings. All subprime mortgages issued from 2002 through 2006 totaled about $2.3 trillion, compared to $10.4 trillion in total mortgage and home equity debt held by all U.S. homeowners in the third quarter of 2007. More than 80% of subprime loans have not defaulted, though defaults are likely to rise in 2008 as payments reset higher.

Finally, home prices soared 91.6% from 2000 to 2006, reports the Case-Shiller home price index. This huge increase in home equity along with lower interest rates allowed owners to refinance, extract funds, and still retain an average of 50% equity as of late 2007.

It would take a very large nationwide decline in home prices to wipe out their equity positions, thereby creating widespread distress. While home prices may fall sharply in a few metro areas where speculation and subprime lending were high, as in Phoenix and Miami, they are not likely to decline enough nationwide to force massive abandonment of homeownership, even though credit card and auto loan delinquencies are also rising.

Solid economic underpinnings

The key factor influencing a recession is employment. Jobs in housing construction and finance have already fallen and may drop even more in 2008. But other economic sectors, especially national defense, energy, exporting, health care, technology, and agriculture, are not being affected by the credit crunch. True, retail spending and jobs may be reduced by less borrowing against home equity. But up to now, even Christmas spending equaling only a 2.5% gain in retail sales has not been a disaster.

The U.S. unemployment rate is just 5%. Since jobs are the basic underpinning of commercial real estate markets, I think there's a very good chance that those markets won't suffer.

The media has exaggerated the overall impact of problems devastating Wall Street because of the greed and stupidity of those firms. Surely the U.S. economy will slow down in 2008, but I don't believe it will suffer an actual decline in GDP, which is what defines a recession.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].

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