Multiple Factors Fueling Housing Decline, Recession Possible

Friday, June 22, 2007 - By Donald W. Riegle and Bartly Dzivi

The personal pain of losing one's home through foreclosure should not be understated, but as Warren Buffet remarked recently, the subprime mortgage problem is not likely by itself to trigger a recession.

Unfortunately, there are four other housing-related dominoes about to fall that will act to depress the economy over the next two years, and raise a very significant risk of recession.

The first domino is the rapid decline in mortgage equity withdrawal, the process that allows consumers to obtain cash through home equity lines and loans, mortgage refinancing, and home sales.

A recent study co-authored by Alan Greenspan indicates that consumers obtained approximately $1 trillion in cash through these techniques in 2005, which in turn boosted consumer spending by $325 billion that year.

Goldman Sachs has determined that the temporary boost to spending from the booming housing economy has already dropped from 7 percent of GDP in 2005 to 4 percent of GDP in 2006, and they project it will drop significantly again in 2007. Early indications for 2007 through the end of March show that home equity lines of credit had actually decreased over the prior six months - the first such drop since 1999.

The second domino may well topple with the scheduled interest rate increases in adjustable rate mortgages.

The Mortgage Bankers' Association estimates that up to $1.5 trillion of adjustable rate mortgages are scheduled to reset upward in 2007. And more of the same is in store for 2008. Because personal savings rates are already negative, higher monthly mortgage payments will necessarily decrease funds available to consumers for other spending.

The third domino - the wealth effect - refers to consumers spending a greater percentage of their income because they believe they have a higher net worth. Since a home is usually a person's largest asset, its current value has a big impact on most consumers' perceived wealth, and their spending habits.

The S&P/Case-Shiller home price index indicates national home prices have fallen about 1 percent since February 2006. The National Association of Realtors has predicted, for the first time since it has kept the statistic that the median price for all U.S. homes will decline by 1 percent in 2007.

The forth and final domino is just beginning to sway as the number of residential construction, real estate and mortgage finance jobs - which have increased greatly during the past six years - now are beginning to rapidly decline.

Early in the decade the housing boom swelled the membership of the National Association of Realtors by 500,000 from 2002 to now, and helped add more than 800,000 construction jobs from March 2004 to April 2006.

An analyst at Moody's calculates that 200,000 housing related jobs have already been lost since the peak of the housing market. An analyst at Citigroup estimates that 600,000 residential construction jobs, and an additional 300,000 manufacturing jobs tied to housing, will disappear in 2007.

The culmination of these falling housing dominos is the stagnation we are just beginning to see in consumer spending. The Commerce Department's report of weaker than expected consumer spending in March, the weakest since the fall of 2005 in the aftermath of Hurricane Katrina, appears to be the beginning of the consumer led slowdown.

This is a warning sign that troubled times lie ahead for businesses that sell to consumers - especially in regions where once robust appreciation in home prices has now reversed.

For example, automotive analysts found that 30 percent of automobiles sold in California in 2006 were financed with home equity loans. Now we see that retail auto sales declined 17 percent in California in just the first ten weeks of 2007.

While corporate profits have soared in recent years, workers' wages have not. From 2000 to 2005, real median family income actually declined in the U.S. Yet, consumers kept spending, temporarily boosted by cash from the housing boom.

So one must look at the overall recessionary risk to the economy from the gathering storm in the housing sector - a storm now being whipped into a potentially destructive whirlwind by higher interest rates, tighter credit standards, falling home prices, and corresponding contractions in consumer spending.

The weak employment report shows non-farm payrolls rose a mere 88,000 in April. The slowing economy is signaling a growing recession risk which could further accelerate the deflationary spiral now underway in the housing sector.

If as expected the employment, home sales price and consumer sales data for May confirm that the significant slowdown is continuing, the Federal Reserve should lower the Federal Funds rate by one-half of 1 percent at its June meeting. Then it should continue to monitor the data and take further easing action, if appropriate, during the rest of the year. This would provide some measure of direct relief to borrowers with adjustable rate loans, and provide needed stimulus to the rest of the economy.

The Federal Reserve and regulators that are properly addressing predatory lending practices also need to give housing lenders express guidance to prevent an overreaction that would worsen the decline of housing values.