A healthy housing market is important to the well-being of the US economy. Unfortunately, the market doesn't appear to be turning around just yet, with housing starts dropping to an average annual rate of 1.02 million over the past three months from 2.07 million in 2005. The S&P/Case-Shiller index of 20 major metropolitan areas shows that home prices have fallen 15.8% from a year ago and are 18.4% below their July 2006 peak. By historical standards, the drop in housing starts and sales is still about average; in the average post-war recession, housing starts have plunged 49% from peak to trough. However, the decline in the median home price is the largest since the 1930s and far greater than in any other post-war downturn.
So, is the market bottoming out? It seems to be nearing a bottom, at least in terms of sales and starts, but we thought we were seeing that last year as well. Seasonal factors are volatile, making month-to-month movements difficult to interpret. Current data suggest that starts are levelling out near 1 million, with home sales (new and existing) near 5 million. The inventory of unsold new homes has come down to 426,000 from 543,000 last June. We don't think we have hit bottom yet, but we expect to do so in the second half of the year. Even so, this year will be the worst for housing starts since World War II.
So far, housing sales and starts have done a bit better than we feared, while prices have dropped more than we expected. In a perverse way, this could be good news, suggesting that homeowners and builders are accepting the lower prices more quickly than we had feared. However, it could also just be a reflection of the very low down-payments with which buyers acquired many of these houses, now pushing more homeowners into foreclosure or forced sales.
No sale
Home sales have been dropping from their 2005 peak. In July, existing home sales were at 5.00 million, down 13% from July 2007 and 29% below the record 7.08 million sales in 2005. New home sales have been hit even harder, plunging to a 17-year low of 513,000 (annual rate) in March, before edging up to 515,000 in July.
The reason for the decline is that homes became too expensive. To the average buyer, the price of a home is effectively the size of the monthly mortgage payment. As mortgage rates rose with the Federal Reserve rate hikes from 2004 to 2006, the effective cost of a house increased. The change pushed the National Association of Realtors' affordability index, which is based on the monthly income required to qualify to buy the median existing home with a conventional mortgage, down to 102.7 in the second quarter of 2006 from 136.5 in the first quarter of 2003. (The higher the number, the more affordable the average home is.)
With home prices now falling and interest rates lower, affordability improved to 132.4 in the first quarter of 2008, which brings it nearly back to its 2003 peak. However, the inventory of unsold homes on the market (an 11.1-month supply of existing homes) and loss of confidence among potential buyers are keeping sales down. Potential purchasers are afraid they are buying a depreciating asset, so to get ready to buy they need assurance that prices have finished falling.
We expect the Federal Reserve to begin raising rates next spring. However, just as there has been little impact on long-term bond yields (and thus fixed-rate mortgages) since the Fed began to lower rates in mid-2007, the rate hikes will also have little impact. Adjustable-rate mortgages will become more expensive, but borrowing has shifted to fixed-rate mortgages in any event.
House prices continue to drop
The current drop in the median home price is unique. The price dropped 2.9% in 2007, marking the first annual decline in the history of the series (since 1966). We expect a total decline of 19% by early 2010.
The decline is bringing home prices back in line with incomes. The ratio of the average home price to average after-tax household income hit a record 3.4 in the third quarter of 2005, but the lower house prices and higher incomes brought it back to its historical average of 2.7 (1960-2007) as of the first quarter of 2008. We had originally expected the ratio to remain near its historical average because mortgage rates are below their historical average, but we now think that prices will overreact on the downside, resulting in the ratio sliding to 2.2 by late 2010 - the lowest since 1975.
