Housing Holds Key to Economy's Direction

Just when housing looked like it was at a bottom, the situation is threatening to take a turn for the worse. Small job gains, weak economic growth and a looming crisis over shoddy foreclosure proceedings at banks are raising concerns that housing will suffer a sharp decline and pull the economy back into recession.

Odds are it won’t happen, but the situation is very delicate. Another downturn -- the much feared double dip -- likely would result if house prices were to fall 10% or more between now and spring. That’s a steeper slide than the 3% average decline we expect, however. On average, prices fell about 30% from their peak in 2006 and have recently been showing a modest gain. Now an increase in foreclosed property hitting the market threatens to erase the gain.

The fact is, about one in four households with a mortgage has seen the value of its home drop below what is owed. In some states, as many as one in two mortgage holders is underwater. If prices slide an additional 5%, that would send 2 million more homeowners gasping for air. Already, 5 million households are in or will soon enter foreclosure.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

The door is open to a steeper decline in prices because of the weak economic recovery. GDP increased only 1.7% in the second quarter, and around 2% is expected in the third quarter. The sluggish pace means too few jobs are being created to stimulate demand for homes and to prevent additional foreclosures. As Jay Brinkmann, chief economist with the Mortgage Bankers Association, puts it, “It takes a paycheck to make a mortgage payment.” While earlier rounds of foreclosures reflected the plethora of loans made to unqualified borrowers, the high unemployment rate is now driving up foreclosure numbers.

So the supply of homes for sale grows, prices slide, and a vicious circle forms. A third of total home sales are houses in or about to enter foreclosure, and when a bank puts one of them up for sale, the price is about 25% lower than the going rate. The declining prices act as a drag on consumer spending, muting economic growth. That, in turn, leads to scant job creation, further reducing home sales and increasing foreclosures.

As if that weren’t enough to cope with, now there’s the threat of a national freeze on foreclosures, as state attorneys general allege that banks committed fraud in preparing paperwork needed to move delinquent payers off their books through foreclosure. A limited freeze for a couple of months might actually buoy home prices in the short term by removing some discounted selling. But if the mess lasts into 2011, buyers will put off bidding on property, expecting that prices will dive when foreclosures eventually pick up. The result will be to delay the process of bringing supply and demand back into balance.

Just how far out of whack are supply and demand now? By at least a million homes, and possibly as many as 4 million. As the economy starts to perk up in 2011 and 1.5 million new jobs are created, home sales and housing starts will improve. But working off the overhang will take years.

In 2011, starts will likely total about 700,000, an improvement over this year’s 600,000 but less than half the annual average from 1985 to 2005. As a result, residential construction and related industries won’t contribute to GDP growth for a couple of years. Sales also will grow very slowly, with existing-home sales totaling about 5.2 million next year, up just 200,000 from this year. Sales of new homes will increase by roughly 40,000, to 400,000 in 2011.

There is no shortage of ideas to help -- but none that offer much chance of success. Adjusting mortgage balances would help, but it won’t fly. Congress would have to put the cost on taxpayers, banks and mortgage debt investors, which include pension funds. Compromise and cooperation would be necessary to hammer out a plan. And there’s no chance of that in today’s heated political climate.

The only sure cure is time. The question is, how painful will it be to get from here to there.