The Worrying Housing Bust

If home prices drop too much, the damage to consumer confidence and spending won't be easily offset. The danger: a 2007 recession.

Oct. 16, 2006 issue - We are at the endgame for housing. Until recently, our national motto has been "in real estate we trust." Just last week, the Census Bureau reported that median home prices after inflation rose 32 percent from 2000 to 2005. In some places, the gains were huge: 127 percent in San Diego, 110 percent in Los Angeles and 79 percent in New York. But real estate—which has acted as a national piggy bank, with homeowners borrowing and spending against rising house prices—no longer looks so trustworthy. On this, more than falling oil prices or a record Dow, hangs the economy's immediate fate.

The boom sowed its own destruction. Coupled with modestly higher interest rates, rising home values have priced more potential buyers out of the market. In 2003, a family with an income of $40,320 could buy the median-priced existing home of $180,200, estimates the National Association of Realtors. By August 2006, an income of $56,544 was required to buy the median-price home, now costing $225,700. (The assumptions: purchasers make a 20 percent down payment and devote 25 percent of their income to mortgage payments at the prevailing interest rate.)

With fewer buyers, home construction, sales and prices have weakened. In August, housing starts were 20 percent lower than a year earlier. Last year, sales of new and existing homes totaled almost 8.4 million; next year the NAR expects 7.4 million. Construction workers, real estate agents and mortgage bankers will lose jobs. Consumer spending (computers, cars, vacations) will also suffer, as the borrowing and buying against rising real-estate values subsides. Indeed, the end of the cheap credit that fed the boom means that many borrowers will face higher monthly payments.

Adjustable rate mortgages (ARMs) represent a quarter of the nearly $10 trillion in single-family mortgages, says economist Michael Fratantoni of the Mortgage Bankers Association. ARMs typically change rates annually and are 2 to 2.5 percentage points above, say, a one-year Treasury note. But "hybrid" ARMs made in 2003 and 2004 provided low fixed rates for three to five years; many of these rates are now rising. Consider a borrower with a 4 percent ARM of $200,000 lent in 2003. The monthly payment had been $955, says Fratantoni. Now, the ARM would reset at 7.5 percent; the payment increases to $1,362. Switch to a 30-year fixed-rate loan, and the rate would be 6.25 percent with a $1,164 monthly payment.

To service their loans, some consumers will curb their shopping. Susan Sterne of Economic Analysis Associates says that debt payments will absorb a record 15.6 percent of personal disposable income in 2007. Sterne expects growth in consumer spending and the overall economy to weaken, though she's not predicting a recession. But at least one major investment bank, HSBC, warns of a "recession risk."

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