By KARL E. CASE and ROBERT J. SHILLER
August 30, 2006; Page A10
Looking back at past housing booms, the first sign of the end is when a goodly share of buyers stop making offers and eventually stop looking, seeming to just disappear. In the spring of 1987, during another U.S. housing-market boom that was starting to lose speed, Nora Moran, president of the Greater Boston real estate board, said “someone blew a whistle that only dogs and buyers heard.”
Across America today, it is as if the whistle has again been blown. New home sales in July are 22% below July 2005. The decrease is 43% for the Northeast over that same period, and the inventory of unsold new homes is up 22%. Existing home sales are down to 6.33 million in July from over seven million at the end of 2005. Older boomers are cashing out of valuable suburban homes and heading for condos in the city, or out of high-priced regions altogether.
Why is this happening so suddenly? It can’t be interest rates alone. The 30-year mortgage rate is up less than one percentage point since this time last year, and is no higher than it was a few years ago when this boom was roaring along.
The market spoiler was in place some two years ago. At that time, we felt that the spectacular price increases could not be justified. The psychology of that time could not continue indefinitely, and indeed it has not.
In the summer of 2004, the annual rate of increase for home prices in major U.S. cities reached its peak. According to the Standard & Poor’s/Case-Shiller Composite Home Price Index, based on 10 major metro areas, housing inflation reached 20.4% in the 12 months ending in July 2004. Now, the latest numbers announced yesterday show only an 8.2% increase in the 12 months ending June 2006, and most of that increase was in 2005. Six of the 10 cities actually fell between May and June. By simple extrapolation, if housing price changes continue to decline as they have, inflation will turn into deflation, and 12-month price changes might be squarely in negative territory by some time in 2007.
Talk is part of what changes the mood and actions of buyers, and the air is now full of talk of a bust. The covers of the New Yorker, the Economist, The Wall Street Journal and virtually every news magazine and newspaper in America has heralded the bursting of the “housing bubble.”
Part of what has focused the spotlight on the housing market has been the sheer size of the boom. Ten years ago, U.S. household holdings of real estate were valued at just under $8 trillion, about 40% as large as household financial wealth. At the end of 2005, real-estate holdings were $21.6 trillion, 56% as large as financial wealth. Just in the last five years, the total market value of residential real estate alone has increased by nearly $10 trillion.
New construction, initiated in response to high home prices, has reached unprecedented levels, and new houses are still hitting the market just as demand is dropping. Between 2000 and 2005, housing starts were over two million per year, existing home sales were over six million per year, and home-improvement spending hit $162 billion in 2005. All of this generated income for millions of brokers, builders, bankers, appliance dealers and construction workers, and kept the economy growing at a strong clip. But the housing construction boom can’t go on forever.
This incredible boom has been fueled in part by favorable demographics, low interest rates, a very liquid mortgage market with low down payments and borrower-friendly underwriting (option arms, interest-only, stated-income, etc.), a baby boomer generation with a special taste for housing, a substantial volume of foreign demand, and the poor overall performance of the stock market.
But beyond all these factors there is the simple psychology of expectations that is part of any speculative boom. These expectations can turn suddenly when alert home buyers get the sense that something might be amiss. Among respondents to our questionnaire survey of home buyers in April and May of this year, the median expected 12-month home price increase in Los Angeles was only 5%, compared to 10% in early 2005. In Boston, the median expectation was down to 2% from 5% last year.
Long-term expectations for home price appreciation have fallen much less. Americans haven’t changed their basic views on housing as a great long-term investment. Not yet, at least. That won’t happen unless there is a protracted housing price decline.
While our surveys indicate that relatively few expect prices to actually fall, buyers do not want to pay prices that are significantly higher than a year ago. Buyers are waiting and low-balling. Sellers want to get a price increase of the kind they’ve observed in the recent past. The result is that fewer agreements are reached, and sales fall. If the housing market were like the bond market and all houses for sale were auctioned every day, prices would indeed fall precipitously. But they are not. The aggregate indexes based on repeat sales have decelerated markedly but are not yet falling.
The U.S. now has a futures market based on home prices. The market that opened in May at the Chicago Mercantile Exchange is now showing backwardation in all 10 metropolitan areas trading. The backwardation can be expressed as implying a rate of decline of 5% a year for the S&P/Case-Shiller Composite Index by May 2007. Since the margin requirement is only about 2.5%, an investor who is sure that prices cannot actually fall by next May has, on that assumption, a sure return of at least 200% from buying a futures contract, and even more if prices rise at all. But there can’t really be so much “money on the table.” It must be that people really no longer see it as a sure thing that prices won’t start falling across the metro areas.
As always, the future is uncertain. Many of the underpinnings of the boom are still strong, and the soft-landing scenario so widely promoted by economists and industry leaders is a possibility if the U.S. can avoid a generalized inflation, if long rates don’t rise a lot, and if the rest of the economy stays strong. But that possibility is not enough to give great comfort to all those who worry today about the housing market.
Unfortunately, there is significant risk of a very bad period, with slow sales, slim commissions, falling prices, rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected. Deterioration in that intangible housing market psychology is the most uncertain factor in the outlook today. Listen hard and watch out.
Mr. Case is professor of economics at Wellesley. Mr. Shiller is professor of economics at Yale and chief economist at MacroMarkets LLC.
