Yes, Housing Will Get Worse. But How Bad?
Two ways the mortgage mess might play out
How much worse can things get in the housing market? With mortgage lenders folding, home builders bleeding red ink, and foreclosures filling the "public notice" section, the answer might seem as ominous as the "price reduced" placards that increasingly top the for-sale signs now littering America's lawns.
After all, as the recent ugly credit crunch shows, capital is once again living up to its well-deserved reputation for cowardice. It's bold when there seems to be little chance of getting beaten up—such as the aggressive lending to even the least-qualified borrowers at a time when the value of their collateral (their homes) kept going up and up. But lenders seem to turn and run as soon as things get rough, holding back capital not only from riskier borrowers but even from those with sterling credit.
It's not hard to envision the resulting house of pain: Mortgage credit, the mother's milk of the housing market, suddenly dries up. Unable to secure proper financing, home buyers all but disappear from the market. Sellers drop their prices even further but still don't get offers. Unable to refinance, increasing numbers fall behind on their mortgage payments and eventually lose their homes, swelling the inventories of unsold homes and driving prices down even more. That, in turn, sucks equity from even the most prudent homeowners, further denting not only their confidence but also that of every investor who ever considered that buying a house, a mortgage-backed bond, or even a money market account was a safe bet. The resulting panic—like depositors' recent run on Countrywide Financial—could freeze lending not only to the housing market but to the entire business community, prompting a nasty recession.
Yet for all the panic the credit crunch has caused, most housing experts aren't convinced that the current misery in the financial markets will lead to the sort of vicious economic cycle that resulted in the last big housing downturn in the early 1990s. Back then, prices in some areas fell by 20 percent and more in real terms before bottoming out. Economists point to continued strong employment, global economic growth, and a financial system far more sturdy than when the federal government had to bail out hundreds of savings and loans.
Risk. Of course, few of them predicted the current mess in the credit markets, either—arguing instead that the broad dispersion of mortgage-backed securities and the advent of risk-hedging derivatives would spread the bets so widely that, although some might get hurt, few would lose their shirts. "That's the great irony of the situation," says Mark Zandi, chief economist at Moody's Economy.com. "The big advantage of all this financial innovation has been the diffusion of risk. But by doing that, we've made it more difficult to know who bears that risk."
And with that fear of the unknown driving what in calmer times would be rational financial decisions, it remains to be seen whether the housing market is about to go from bad to worse or is finally hitting bottom.
To help you hedge your own bets, here are two possible scenarios for how things could play out:
The Good (or at least not so bad). While the past few weeks have teetered on financial Armageddon, the big picture of the housing market isn't quite as bleak as the ongoing credit crunch might make it seem. The reason, first and foremost, is that its ultimate underpinnings—the good jobs that keep homeowners paying their mortgages and potential buyers showing up at open houses—remain both plentiful and better paying.
Indeed, the average American now earns about 7 percent more than he or she did when the housing market peaked in 2005. What's more, the economy has added some 4 million new jobs since then, helping boost national wealth to a record $56.2 trillion.
And with home prices in many areas already sliding back to where they were then, "it's actually more affordable to buy a house today than it was in 2005," says Lawrence Yun, senior economist at the National Association of Realtors.
To be sure, a conventional mortgage now costs more. But with house prices still falling and mortgage rates likely to stabilize or even fall back a bit as the Federal Reserve finally begins to lower interest rates, Yun expects affordability—the key to housing's long-term recovery—to keep improving. "The plain fact is that there's more financial wherewithal now," Yun says. "It's just that people don't have the confidence."
The coming months should make the latter abundantly clear, as already-reluctant buyers are made even more so by a dwindling, downright panicked collection of mortgage lenders. They have not only increased the premiums they charge for making risky loans but also raised the bar for qualifying for nearly all mortgages. The combination will undoubtedly shrink both the number of qualified buyers and the prices they're willing to pay.
Yet Yun thinks the impact won't last much longer than the current credit crunch—about three months or so—as lenders finally come to their senses and realize that the vast majority of homeowners can cover their monthly nut and that new borrowers can do the same.
"It won't take long before people get tired of earning just 2.5 percent on treasury notes," says David Wyss, chief economist at Standard & Poor's. "They'll realize that these mortgage loans are still good, safe investments. And as they do, more money will become available and rates will come down."
With sellers still desperate to unload their properties, the beginning of 2008 "could be a great time to buy," Wyss says.
The Bad (and maybe ugly). Few would dispute that the housing market is likely to get worse before it gets better. Even before the credit crunch hit, falling prices and inventories bulging at an 8.8-month supply had yet to show much sign of stabilizing. In California, for example, July was the slowest sales month since 1995—and would have been even worse if the figures didn't include thousands of foreclosure sales. And after the trickle of summertime buyers who signed contracts and locked in mortgage rates before the market suddenly froze up, housing economists widely expect the pipeline to run dry when sales figures for August and September are released later in the fall.
Low-ball. Although many sellers will simply take their homes off the market until spring, those who have to sell may be forced to take the first low-ball offer that comes along, if one comes at all. That can mean only one thing: "a substantial downtick in home prices and an increase in [mortgage] delinquencies and foreclosures," says Moody's Zandi. He now expects prices in many areas to soon be down by double-digit percentages from last year's peak.
That downtick could finally begin to affect formerly insulated pockets, such as the close-in neighborhoods of Washington, D.C., and even New York City, where skyrocketing prices have forced buyers to take out jumbo loans—the very ones that many lenders stopped making in recent weeks.
Of course, the price swoon may lure bargain hunters back into the market. But such signs of continued weakness tend to feed on themselves. "The more prices go down, the more people expect them to go down," says Zandi, "and the more reason they have to wait."
Meanwhile, with credit still tight, those willing to stick their necks out will find it harder to qualify for a loan. Like Yun, Zandi expects the brunt of the credit crunch to ease in the coming months. Yet some parts of the mortgage market simply won't bounce back, especially the now tainted subprime sector. It has accounted for a growing share of the low-end housing market in recent years, supplanting more traditional Federal Housing Administration loans.
Congress, which had cut FHA funding in recent years, is now reversing course and may even allow the FHA to take over some subprime mortgages to keep folks in their houses. "The FHA will definitely gain more currency in the market," says NAR's Yun. "But it will still take a long time" for the changes to trickle down to borrowers.
By then, things could really have gotten ugly, as the effects of the contracting housing industry inevitably trickle into the larger economy—in the form of pink slips. After all, "you can't afford to buy a house—or stay in one—if you don't have a good job," notes mortgage columnist Lou Barnes, who points to the dour situation in economically depressed Michigan. "You can't give a house away in Detroit right now."
As for the rest of the country, delinquencies—already up by 36 percent compared with a year ago—will continue to rise as a slew of rate resets on adjustable-rate mortgages peak over the next 18 months. Those resets will increase monthly payments just as declining house prices push more and more borrowers underwater on their loans. Even if those who try to sell are lucky enough to find a buyer, the resulting "short sale" means they'll have to come up with cash at the closing, a fate that for many is worse than just walking away.
"There's going to be a lot of jingle mail this winter," Barnes says of owners who will simply pop their house keys in the mail in lieu of a mortgage check. That would make for a very unmerry Christmas, indeed.
This story appears in the September 3, 2007 print edition of U.S. News & World Report.