Economy Watch: Housing Market Still Falling

As I've discussed before, the residential real estate boom has been responsible, directly and through indirect effects (related industry services and growth, consumer confidence and wealth effects) for almost half of the U. S. post-2000 stock market correction growth. In that context, two new news items suggest the correction in the housing market is not yet done: a continuing, disturbing bit of news for the economy.

First, an item about new home sales from the relatively more stable Washington DC area housing market. Notice that, in the example cited, it's not just the middle or lower bands of the housing market, which had been the most affected in the DC metro area this year, but a defaulted purchase in the upper range of the market:

House Sales In Region Increasingly Called Off
More New-Home Buyers Are Canceling Contracts

By Tomoeh Murakami Tse
Washington Post Staff Writer
Wednesday, October 18, 2006; A01

NVR Inc., the region's largest home builder, said yesterday that four out of 10 of its new-home sales in the Washington area were canceled last quarter, making it the latest builder to report that more buyers are backing out of deals.

Around the Washington market, cancellation rates have tripled in the past year, to 17 percent, according to researchers at Hanley Wood Market Intelligence. In August alone, that meant about 250 cancellations. In its most recent earnings report, builder Toll Brothers Inc. said cancellations in the quarter that ended in July had more than doubled, to 18 percent nationally, while numerous builders said in interviews that their cancellations locally had increased.

Developers and builders say buyers are abandoning five-figure deposits on their future homes because they cannot sell their existing homes or did not sell them for nearly as much as they had counted on.

In an effort to reverse the trend, builders are helping buyers sell their old houses, delaying closing dates or offering favorable loan terms -- or even cash, beyond the free decks and plasma televisions they have been using to try to lure customers since the housing market began cooling a year ago.

For instance, both Pulte Homes Inc. and Toll Brothers here are offering "home staging" services -- that is, help for buyers who want to polish their existing homes to sell them. Pulte will give its customers up to $2,000 toward such services. Toll Brothers is also covering up to six months in mortgage payments for the new homes if buyers take out the loan through the company. The idea is to give buyers room to sell their old homes, a company representative said.

It is difficult to put a price tag on how much in incentives builders are giving to buyers with existing contracts because they tend to be worked out on a case-by-case basis. But both cancellations and builders' efforts to stop them have generally been more prevalent in markets where prices increased rapidly during the housing boom, including Washington.

With little success in selling their home and a settlement date rapidly approaching on a new $900,000 house in Clinton, Irica and James Cheeks last month decided to walk away from that dream house and their $60,000 deposit.

Second, there's this speech from San Francisco Reserve Board President Janet Yellen. For those of you who need a translation, "behind the curve" means the statistics we have don't yet reflect how bad it is out there:

Of course, housing is a particularly interest-sensitive sector, and, as we know, it already has shown clear signs of cooling. Frankly, the pace of it has been a little surprising. Nationally, housing permits are down noticeably—by more than 20 percent—from a year ago. In addition, inventories of unsold houses are up significantly, sales of new and existing homes are off their peaks, and surveys of homebuyers and builders are showing much more pessimistic attitudes.

The national data on residential investment reflect all of these developments and enter directly into the calculation of real GDP growth. After adjusting for inflation, (real) residential investment dropped at an 11 percent annual rate in the second quarter following two small declines in the prior two quarters.

The California data, not surprisingly, show even more softening in the housing market. For the first half of this year, quarterly average home sales in California are down nearly four times as much as they are nationwide, and new housing activity also has slowed more dramatically in the state and in the Bay Area. The local exception is the San Jose-Santa Clara area, where the decline in new single-family housing permits this year has been more moderate, presumably because of the relative strength of the Silicon Valley's tech firms.

According to some of our contacts elsewhere in this Federal Reserve District, data like these are actually "behind the curve," and they're willing to bet that things will get worse before they get better. For example, a major home builder has told me that the share of unsold homes has topped 80 percent in some of the new subdivisions around Phoenix and Las Vegas, which he labeled the new "ghost towns" of the West. Though the situation isn't that bad everywhere, a significant buildup of home inventory implies that permits and starts may continue to fall and the market may not recover for several years. While builders remain hesitant to cut prices so far, and instead offer sales incentives, price cuts at some point in the future seem almost inevitable.

Indeed, we have already seen that the pace of house-price appreciation has clearly moderated, and there are signs that it may continue. For example, one indicator we have been following is the Case-Shiller house price index, which is based on house price data in ten large urban markets—three of which are in California, by the way. Beginning in May of this year, futures contracts on this price index began trading, and they show house prices falling at about a 6 percent annual rate by the end of this year. Though this is still a very new and pretty thin market, the results are interesting and suggestive.

Significant movements in house prices can be an issue for economic activity. Just as the run-up in house prices provided some support for consumer spending, slower increases, and especially outright decreases, could weaken that support. For example, back when house prices were rising so fast, people saw that more and more equity was being built up in their houses, and they might well have felt that they could afford to spend pretty freely. In economic terms, this is called the "wealth effect." In addition, with instruments like home equity loans, refinancing, and so on, households have found it much easier to pull money out of their rising house values to support their spending. Now, with the pace of house-price appreciation slowing, of course, their equity is not rising so fast anymore, which may weaken the growth in consumer spending. In California, the impact of a vanishing wealth effect might be quite significant because over the past year the state has seen a more rapid deceleration in housing prices than the nation. In fact, two northern California metropolitan areas, San Mateo and Sacramento even reported declines in house prices over the past year.

There are those who believe business investment will make up for these downnward trends in the economy. I have yet to comprehend the argument, hear from my clients or ever witness in practice a cycle when businesses significantly increase capacity in a down market. Who's going to buy the new stuff?