WITH NEW HOME SALES DOWN 10.5 percent in February, and with home prices declining for the fourth month in a row, it's high time for a sober look at the consequences of a major housing correction. The Federal Reserve, Wall Street economists, and other observers of the U.S. economy are closely watching the housing market because it has been a key driver of economic growth over the past several years.
I should add that inventory of new and existing homes have been rising for the past year. The current number of existing homes available for sale has risen 32.5% from year ago levels and would provide enough houses for 5.3 months of sales at current levels. The available inventory of new homes for sale would provide enough houses for 6.3 months of sales at current levels. Both of these levels are extremely high and point of a possible glut of homes available for sale in both new and existing home markets. An inventory glut often precedes price declines.
Roughly a quarter of the jobs created since the 2001 recession have been in construction, real estate, and mortgage finance. Even more important, consumers have withdrawn $2.5 trillion in equity from their homes during this time, spending as much as half of it and thus making a huge contribution to the growth the U.S. economy has enjoyed in recent years (consumer spending accounts for two-thirds of GDP).
The US economy has created 3,906,000 jobs since the recession officially ended in November 2001. 728,000 of those jobs (18.63%) are construction jobs. An additional 1 million are professional service jobs and 421,000 are financial jobs. Assuming about 25% of both job categories are real estate related, it's easy to see where the 25% figure comes. The bottom line is real estate is very important for the current expansions' job performance.
Real estate debt is also a prime driver of the current expansion. According to the Federal Reserves Flow of Funds report, the amount of quarterly mortgage borrowing has increased from $422 billion in the fourth quarter of 2001 to a little over $1 trillion in the third quarter of 2005. Over the same period, total mortgage debt outstanding has increased from $5.2 trillion to $8.2 trillion. It's also very important to remember that during this expansion, consumer spending has increased about 18% after adjusting for inflation, but non-supervisory wages have increased about 1.8% after inflation for the same period. In other words, most people haven't seen a meaningful wage increase in about 5 years, but they are spending like they have. Also remember the savings rate was already low below this expansion - about 2% of income. Therefore, consumers haven't been dipping into savings because there wasn't much there to begin with.
Yet the concerns about unsustainable growth in consumer debt and home prices are not easily dismissed. A weakening housing market could transform what has been a virtuous cycle into a vicious one, substantially reducing economic growth during the next couple of years (and going into the 2008 election). If economic analysts on the right ignore this risk, they may be blindsided by a weaker economy. They will also be unprepared to answer those on the left who will blame tax cuts for what could be a painful unwinding of a credit bubble that, in fact, was fueled by a loose monetary policy from 2002 to 2004.
It's nice when somebody from the other side of the aisle gives credence to your primary argument. I just had to say it.
THE CRUX OF THE DEBATE IS HOUSE PRICES. If the inflated prices are justified by economic fundamentals and sustainable, then the 82 percent increase in mortgage debt since 2000 will probably turn out to be innocuous and the risks to the economy minimal. If, on the other hand, prices are out of whack, painful adjustments lie ahead.
Unfortunately, the weight of the evidence strongly suggests a bubble. The price of the median home is up an inflation-adjusted 50 percent during the last five years, an unprecedented national increase. It is true, as Alan Greenspan and others have observed, that real estate is regional, and much of the country has not experienced significant price gains. However, prices are overextended in enough areas that a real estate correction would have national fallout. The mortgage insurance company PMI estimates that regions accounting for more than 40 percent of the nation's housing stock are overvalued by more than 15 percent. Other estimates of overvaluation are much higher.
Economists at international banking giant HSBC have identified 18 states and the District of Columbia as "bubble zones." House prices in these zones look remarkably similar to the rise in the S&P 500 during the 1990s stock market bubble (see chart below). They have dangerously diverged from historic valuation trends, and thus are very likely to drop during the next few years.
Just as cheerleaders of the high-tech bubble of the late 1990s developed ever more creative explanations for why traditional metrics of valuing stocks no longer applied, the same has been true during the housing bubble. Housing bulls point to immigration, building restrictions, Baby Boomer demand for second homes, and other seemingly plausible justifications for skyrocketing home prices. But examining the value of housing using time-tested and common-sense metrics such as price-to-income and price-to-rent ratios suggest the gains in the bubble areas can't be explained by economic fundamentals.
Consider the price-to-income ratio (above, right), an obvious measure of affordability. This ratio has reached an unprecedented level in the bubble markets. While this ratio hovered around its average of 4-to-1 for the past 30 years, it has zoomed to nearly 8-to-1. The current figure is 3.6 standard deviations from its average level, which, if the data have a normal bell-shaped distribution, means the odds of the price-to-income ratio reaching this level would be less than 1 in 300. In other words, it is off the charts.
The bottom line is the housing market is overvalued by all traditional valuations. Numerous news stories have noticed the low in the "affordability index" - the ability of standard income earners to purchase a home.
What is refreshing is someone on the right is actually using facts and figures that actually accurately depict the current situation and acknowledge the concerns expressed by other economists about the high level of consumer debt and the overall impact of the housing market on the current economy. Even more impressive is this article appears in the National Review.