Commentary

Take my house, please!

The housing market has been cooling off as of late. The sale of single-family homes declined 5 percent from June to July, and are off 11.4 percent from a year ago. Although the national median home price rose 1.5 percent over the past twelve months, there are signs that the frothiest coastal markets are slowing down.

In the Northeast and the West, median home prices have declined by 2.1 and .3 percent, respectively, over the same period. Although the declines are small, they could be marking an end to the years of double-digit price gains in the real estate market.

Another sign of stress can be seen in the buildup of existing homes for sale. As of July, 3.86 million existing units, a record number, were sitting on the market, representing 7.3 months of supply. This is up from 6.1 months in June, and is the largest inventory pile-up since spring 1993. The new home market experienced a record high inventory level in April, and is currently just below that all-time high.

It seems that a combination of record high prices and rising interest rates is forcing some buyers to reconsider leveraging themselves to the hilt in order to provide a roof over their heads.

To many, this seems like a plateau, from which the market will regain its breath in order to resume the climb higher. In my view, this is the canary in the coal mine, or the attic, if you prefer.

Housing is no longer affordable to most Americans, unless they take advantage of the more exotic and risky loan instruments on offer from lenders. Adjustable rate mortgages with artificially low ˜teaser-rates”, interest-only mortgages, and option-ARMs that let the borrower pay less than the full amount of interest due, have allowed people to move into homes they couldn’t otherwise afford. These questionable loan products are now under scrutiny from the FDIC and the Comptroller of the Currency.

Over the past 50 years, home prices have risen at about the same rate as inflation and overall wage growth. But with the drastic reduction in interest rates following the mild recession in late 2001(due in part to the collapse in Technology Bubble), and the abandonment of sound lending practices by US mortgage providers, the real estate market was given a dangerous dose of high octane fuel.

Just as the stock market recorded gains in the 1990s that far outpaced economic growth and broke with historical price trends, the real estate market picked up the bubble-baton, recording double-digit gains from 2001-2005.

As with any asset bubble, the real estate market thrives on cheap and easy credit. The dramatic rise in prices, owing to friendly financing, is also attracting a disproportionate amount of investment capital. This is already causing over-building, and is creating excess supply in many of the hottest markets. Liquidation, and eventually a date in bankruptcy court will inevitably follow for the most reckless of speculators.

This part of the cycle will unfold as mortgage payments rise due to higher interest rates and an end to easy credit terms. As this process gathers steam, market sentiment will shift, prices will fall, and the home will transform itself from a fountain of wealth into a drain on disposable income.

Let us not forget, we are a nation of consumers. The spending of the masses accounts for just over two-thirds of economic activity. The problem facing the US economy is the inevitable reduction in the amount of stimulus from the real estate market as prices revert back to the mean. Many homeowners have been tapping into their home’s equity in order to fund consumption. With flat, and eventually declining equity pools to siphon from, overall spending will decline.

A slowdown in housing activity will put a dent in employment as well. The residential housing, finance, and retail sectors have been providers of solid job growth over the past few years, and they will definitely feel the impact of a cooling real estate market.

No one ever wants the party to end. Remember the “Dow 100,000” book that came out in the late 1990s as the stock market soared to ridiculous heights? The real estate market is another bubble that was created like all the rest: through a perfect storm of easy money and greed. The big difference with this one is the size of the negative impact it will have on the economy once it implodes. Inflated home prices artificially fueled consumption and job growth, and helped to mask the problems the US faces in an increasingly competitive global economy.

© 2006 Splendid Marbles.