In the November 2007 Review & Outlook, we examined the early days of the downturn in residential real estate. In the more than two and one-half years since then, there has been a large and often times painful adjustment in prices. The question now is where are we in the process of unwinding that bubble?
We previously pointed out that, given time, markets self correct through changes in supply and demand, which intersect in price changes. The best measuring stick for home prices is the seasonally adjusted S&P/Case-Shiller 20 city home price composite index. As of its latest data for May, prices nationally are now down 29% from the peak in May 2006. Still, that’s a 4.6% rebound from its low point a year ago in May. The price adjustment over the last several years along with record low mortgage rates has meant that housing affordability has reversed from the worst level ever in 2006 to bouncing around near the best level ever for the last twelve months. While that’s encouraging, it still seems likely that another leg down could be in the offing. There are several reasons to doubt the sustainability of the price bounce over the last 12 months. First, the housing market has been artificially buoyed recently by a homebuyer tax credit, which has now expired. The credit required a signed contract by the end of April and contract closing by September, so the extent to which it temporarily improved prices should become evident over the next several months. Second, several different federal and state programs have lengthened the time it takes for foreclosed properties to reach the market. This has temporarily reduced the number of houses for sale, but this “shadow inventory” keeps growing and will likely eventually pressure prices as these properties reach the market.
The housing downturn will ultimately end when supply and demand return to balance. Currently, demand is being inhibited by the weak jobs market, tighter loan qualification standards, and low consumer confidence. The key long run driver of demand is the formation of new households. This tends to be a relatively constant source of buyers as young people move from their parent’s house or rental properties into their own houses as their need for space grows. However, personal finances also factor into how quickly this transition occurs. The unusual severity of this economic downturn has cut the annual household formation number to around 700,000, which is less than half of what it was just five years ago. A gradually improving economy and the coming of age of the Baby Boom Echo should help these numbers to recover over the next several years, however a rebound in demand is likely to be held hostage until there’s a rebound in jobs.
On the supply side, the stock of houses changes due to the net impact of new construction and abandonments. Abandonment tends to be a modest and fairly steady amount. New construction of single family homes is quite volatile and has now collapsed to a 50 year low of 450,000 per year from 1.8 million at the peak in 2006. This is a very positive development for bringing the housing market back into balance, but involuntary supply from the sales of foreclosed properties is keeping the market oversupplied despite this lack of new construction. The stock of houses is not the complete story however, as the volume of houses for sale at any point in time is the immediate supply influence on prices; for other products this would be called the level of inventories. At the end of June, there were 4 million existing homes for sale, which represents nearly a 9 month supply at the current sales pace. Although this is 13% less homes on the market than a year ago, it’s considerably higher than the 4-6 month supply considered healthy. Generally, anything more than a 7 month supply puts pressure on housing prices. Even more troubling is the “shadow inventory” of houses, seriously delinquent or defaulted loans set to come on the market as soon as foreclosure proceedings are completed. According to the Mortgage Bankers Association, a record 4.6% of U.S. mortgages were in foreclosure in the first three months of 2010. If one adds home loan delinquencies to foreclosures, the combined number is over 14%, or one of every seven U.S. mortgages. Not all of the delinquent houses will end up in foreclosure, but the potential supply lurking is enormous. Just the houses in foreclosure (2.1 million) or delinquent 90 days or more (2.4 million) total 4.5 million, which is more than the existing homes for sale. With delinquencies and foreclosures both continuing to climb to new record highs (see the graph below), it’s hard to see how home prices can avoid coming under more pressure as this new supply makes its way into the market.
If housing prices remain under pressure, it has broader negative implications for the economy, and consumer confidence in particular, since a house is usually the consumer’s biggest asset. Furthermore, falling housing prices would add to deflationary pressures across the economy, while increasing loan losses for banks. The bottom line is that a substantial adjustment has already occurred in housing, but it’s premature to ring the “all clear” bell.