The "Catch 22" Housing Slump Is Not Over

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 2, 2010

IN THIS ISSUE:

1. 4Q GDP Was Stronger Than Expected

2. The Worst of the Housing Slump is Not Over

3. New Home Sales Continue to Fall Overall

4. Sales of Existing Homes Continue to Plunge

5. Home Foreclosures Continue to Mount

6. When Will Housing Prices Recover?

Introduction

Last week I discussed why many economists and market analysts are downgrading their forecasts for economic growth in 2010. While it seems that the worst of the Great Recession is behind us, there is no consensus regarding when, or if, consumer spending is going to rebound to pre-recession levels.

In the economic world, there is widespread agreement that consumer spending accounts for 65-70% of Gross Domestic Product. As I will point out below, however, consumer spending that normally increases by 2-4% each year actually fell in the last half of 2008 and the first half of 2009.

One of the main reasons that consumer spending has softened is the continuing housing slump. It’s a classic “catch 22” in that the more home prices fall, the less people have to spend, and millions of housing related jobs have been lost as well. While some analysts believe we have seen the worst of the housing debacle, most agree that it will take years for home prices to recover to where they were at the peak in late 2007.

In the pages that follow, we will look at some detailed housing numbers to see where we are in the down cycle. But before we go there, let’s quickly review last Friday’s “advance” GDP report for the 4Q of last year.

4Q GDP Was Stronger Than Expected

The Commerce Department reported on Friday that 4Q GDP rose 5.7% (annual rate), which was above most pre-report estimates. Not surprisingly, the growth in the economy in the 4Q was fueled primarily by inventory rebuilding. This was the first of three reports on 4Q GDP, so it will be revised later this month and again in March. It remains to be seen if the advance GDP report will be revised significantly lower as was the case with the 3Q advance report.

The Commerce Department noted in the report that 4Q growth was primarily the result of positive contributions from private inventory investment, exports, personal consumption expenditures (PCE), and a drop in imports – in that order.

Consumer spending increased 2.0% in the 4Q compared with 2.8% in the 3Q. Government spending in the 4Q increased only 0.1% compared with 8.0% in the 3Q. These numbers confirm that the increase in the 4Q was largely the result of inventory rebuilding which was long overdue. The significant increase in real private inventories added 3.4% to the 4Q change in real GDP compared to only 0.7% in the 3Q.

The price index for gross domestic purchases, which measures prices paid by US residents, increased 2.1% in the 4Q compared with an increase of 1.3% in the 3Q. Excluding food and energy prices, the price index for gross domestic purchases increased 1.2% in the 4Q compared with an increase of 0.3% in the 3Q.

The question that still remains is when, or if, US consumers will return to pre-recession spending levels. Below are the quarterly consumer spending changes since the recession began:

2008	2009
1Q -0.7%	1Q -6.4%
2Q +1.5%	2Q -0.7%
3Q -2.7%	3Q +2.2%
4Q -5.4%	4Q +2.0%

These numbers confirm that the worst of the recession occurred in the last half of 2008 and the first half of 2009. They also confirm that even though consumer spending has risen over the last two quarters, it has not recovered to pre-recession levels.

Following last Friday’s GDP report, The Wall Street Journal responded as follows:

“Even if this [5.7%] growth rate were to be sustained for 3 years we would still not create enough jobs to climb out of the hole caused by this recession. Worse, this growth will not be sustained. This quarter’s growth was driven largely by a restocking of business inventories that will not be repeated in coming quarters.”

“Also note that much of the inventory improvement was limited to non-durable goods and the auto industry, the latter of which is building inventories with questionable short term sales prospects. This inventory-driven GDP number also calls into question the sustainability of this type of growth–there’s no reason to anticipate that inventories will continue to build aggressively with consumer spending remaining somewhat stagnant.”

It is impossible to know if consumer spending will rebound this year, but I think it is safe to say that it will not return to pre-recession levels for some time to come, primarily because home prices continue to fall across much of the country. Given that, let’s take a close look at what is happening in the housing markets.

The Worst of the Housing Slump is Not Over

There is little disagreement in economic circles that the housing slump led us into the worst recession since the Great Depression. Never mind that the Clinton administration and the Bush administration exacerbated the housing bubble by encouraging Fannie Mae, Freddie Mac and the big banks to make home loans to millions of Americans that could not afford them. But that is a discussion for another time.

The point is, the housing slump is still not over. New home sales fell 7.6% in December from November to a seasonally adjusted annual rate of 342,000 units. This was well below the consensus estimate of a 366,000 annual rate and even 8.6% below the year ago rate of 374,000. The December decline followed a 9.3% plunge in November.

New home sales for all of 2009 dropped sharply by 22.9% to 374,000 units, down from 485,000 units in 2008. In good economic times, new home sales typically average one million units or more per year. Yet the latest new home sales for December are only slightly above the record low set back in January 2009 when we hit a 329,000 rate.

You can see the magnitude of the housing plunge in the chart below from http://www.calculatedriskblog.com/.

New Home Sales and Recessions

Some analysts cited the unusually cold weather in December as one reason for the unexpectedly low December sales number. Others said the December drop-off was worse because the government tax credit for new home buyers stopped at the end of November.

Congress extended the home buyer tax credit and expanded it to more potential buyers, which home builders hope will spur more sales this year. But the weak numbers at the end of last year reinforce some economists’ fears that the housing market will stumble yet again when the home-buyer tax credit expires later this year and/or if interest rates rise.

New Home Sales Continue to Fall Overall

Regionally, the data was all over the place. The Northeast was by far the strongest region, with December sales rising 42.9% over November and up 33.3% year over year. The problem is that the Northeast accounted for only 11.7% of total sales in December and is often less than 10% of total sales.

By comparison, the Midwest got slammed with a 41.1% monthly decline in sales in December and down 27.1% from a year ago. The moves in the other two regions were more muted, with sales in the West rising by 5.2% for the month but down 12.0% year over year, and in the South sales were down 7.3% for the month and down 7.8% year over year. The South accounts for over 50% of total new home sales around the country.

The good news is the absolute level of inventories continues to decline, falling to 231,000 units from 235,000 in November, and down 34.0% from the 350,000 level a year ago. Absolute inventory levels have declined for 12 straight months now. However, with the slower sales rate, the months of supply (inventory of unsold homes) rose back up to 8.1 months in December. That is up from 7.6 months in November and an interim low of 7.1 months is October, but it is significantly better than the 12.4 month peak in January 2009, or the year-ago level of 11.2 months.

For the market to stage a healthy recovery, the unsold inventory of new homes needs to fall at least to the six months inventory level. During the housing bubble the inventory shrank to only a four months supply.

The other bright spot in the latest housing report was that there was a big month-to-month pick-up in both the median and the average sales price, with the median increasing by 5.2% in December to $221,300 while the average was up 7.6% to $290,600. However, a year ago the median sales price was $229,600, so it is down 3.6% year over year.

New Home Sales Crucial to the Economy

Most economists agree that the level of new home sales is more important to the overall economy than is the level of existing home sales. New home construction stimulates lots of economic activity, from the various building materials that are used to the workers who build the homes. Existing home sales simply transfer existing assets from one set of hands to another.

Think about it in relation to auto sales. Every month people closely watch to see how many new cars the major automakers are selling, but rarely do we hear about the level of used cars being sold. The point is, the decline in new home sales is very bad news.

Look back at the chart above to see the relationship between new home sales and the various blue-shaded periods indicating recessions. New home sales tend to decline going into recessions and tend to reverse higher near the end of recessions. Obviously, that hasn’t happened yet, which is another indicator that this recession is not completely over.

The major consolation is that the new home sales numbers for December might be revised upwards next month, but of course there is no certainty about that, and they might even be revised lower. If the current numbers stand, this is one of the more negative economic reports we have gotten in a while now.

Keep in mind that the low level of new home sales is happening during a time when there is massive government support for the housing market in the form of the home buyer tax credit, and very low mortgage rates engineered by the Fed through its extraordinarily low interest rate regime and the buying up of apprx. $1.25 trillion of mortgage-backed securities. Who knows where home sales would be without this artificial stimulus.

What Needs to Happen

For new home sales to really get back on track, we need for the employment situation to improve. The construction industry has been one of the hardest hit in terms of job losses in this downturn, with at least 1.8 million jobs lost since the peak in January 2007, an overall decline of 23.6%. That is a big chunk of the total jobs lost in this downturn, especially if you factor in the manufacturing jobs that are tied to the making of construction materials, and the multiplier effects of those jobs. It is going to be very hard to get the employment situation resolved if new home construction does not pick up.

Home construction historically has been a source of relatively good paying jobs, often for people with relatively little formal education, but with other skill sets. Ideally, these laid-off workers would try to get new jobs where they can use those skills. Some have suggested that the government should create even more incentives for people to buy new homes, while others believe such added incentives – on top of the generous home buyer tax credit – could lead to another housing bubble.

With large inventories (at least relative to sales) of both new and existing homes, it does not make a lot of sense to be building lots of new homes on several levels. What we really need is for household formation to pick up. The best way to stimulate household formation, and thus real demand for housing, is through more and better paying jobs. But generating those jobs without a significant increase in residential investment is going to be difficult.

New Homes: Months of Supply

Sales of Existing Homes Continue to Plunge

Sales of previously owned homes took their biggest tumble in at least 40 years last month as the impact of a buying spree spurred by a tax credit for first-time buyers waned. Existing home sales plunged 16.7% in December despite the extension of the home buyer tax credit to April 30. That was a bigger drop than analysts had expected and the lowest sales rate since August. It was also the biggest monthly decrease on records that date back to 1968, according to the National Association of Realtors.

Those who rushed to meet the original November deadline to take advantage of the $8,000 tax credit for first-time home buyers caused a surge in sales earlier in 2009, but left the market wobbly by the end of the year. First-time buyers, who made up more than 50% of sales earlier last year, represented just 43% of the market in December. The shift also resulted in fewer sales of lower-cost homes, which first-time buyers typically seek.

As this is written, there is some optimism that existing home sales will increase this spring, but that remains to be seen. As noted above, Congress extended the home buyer tax credit until April 30 and expanded it to more potential buyers, raising hopes among some analysts that sales will pick up in the next few months. But the surprisingly large drop in December raises questions about the strength of any housing recovery once the revamped tax-credit program expires.

The weak sales come as a Federal Reserve program that has kept interest rates near historic lows is set to expire on March 31. If mortgage rates rise this year, along with the end of the tax credits, that could also make a home purchase too expensive for many buyers. The bottom line is that as long as unemployment remains at 10% or above, many potential home buyers are simply not in the mood and/or are not financially able to purchase a home.

Home Foreclosures Continue to Mount

The weakened housing market may get considerably worse before it gets better according to housing-industry professionals who expect foreclosures and home-price declines to continue pressuring the sector through at least the first half of 2010. The biggest problem will likely be a flood of inventory hitting the market from rising foreclosures, says Bob Curran, a managing director at Fitch Ratings.

With a mountain of specialized adjustable-rate mortgages (option ARMs and certain Alt-A mortgages, etc.) slated to reset over the next 12 to 18 months and unemployment projected to go as high as 10.5% this year, the number of homeowners defaulting on their mortgages is expected to surge. At least $64 billion in option ARMs will reset in 2010 and another $68 billion in 2011, according to First American CoreLogic, a real estate and mortgage-data company.

At the same time, the government’s loan-modification program has been disappointing. The default rate on loans modified after the 3Q of 2008 was 61%, according to a report issued in December by the Office of the Comptroller of the Currency and the Office of Thrift Supervision. All of this is expected to trigger another wave of potential home foreclosures in 2010 and could cause home prices to fall another 5% to 10% or more before the market stabilizes.

A record three million homes received foreclosure notices in 2009, according to the National Association of Realtors. Most real estate analysts believe that home foreclosures will be even higher in 2010. Foreclosure notices include default notices, auction-sale letters and bank-repossession notices.

One reason for the expected jump in foreclosures is that in 2009 many lenders were under pressure from the Obama administration to postpone repossessions until loan modifications could be made. However, many banks didn't have the staff to assess all their defaulted loans at the time, and many of those loans are likely to go into foreclosure in 2010.

When Will Housing Prices Recover?

Home prices have fallen 30% on average since reaching their peak in 2007, and many economists think they will take another tumble this year as more foreclosures pile on the market. Moody’s Economy.com has forecast an additional 10% decline in home prices this year, while Barclays expects prices to fall 8% by early 2011; Wells Fargo is more optimistic as it expects home values to drop just 3% more this year.

For all of 2009, the median existing-home price fell to $173,500, down 12.4% from $198,100 in 2008. As noted above, sales for all homes plunged almost 23% in 2009. While more losses are expected this year, most analysts believe that the housing market will hit a bottom sometime in 2010, most likely in the second half of the year.

Assuming that happens, the pace of recovery will vary significantly throughout the country, with homes in the most battered markets taking the longest to regain value. Meanwhile, millions of homeowners who are “underwater” – meaning they owe more on their mortgages than their homes are worth – face years of negative equity that puts them at a higher risk of foreclosure.

First American CoreLogic estimates that apprx. 25% of homeowners owe more than their home is worth. In that case, it could take up to a decade for many homeowners to regain equity in their homes, while some people in the hardest-hit regions of the country may not see a recovery during their lifetimes.

While it has historically taken five to 10 years for home prices to regain losses after a major downturn, it is likely to take much longer this time, particularly in parts of the country that have seen the steepest declines.

“In California, Florida, in the ground-zero zones, it could take 15 years to fully recover,” predicted Lawrence Yun, chief economist for the National Association of Realtors. In regions marked by rampant speculative home purchases, such as Naples, FL, Las Vegas and parts of southern California, it could take even longer, noted Mark Zandi, chief economist for Moody’s Economy.com.

“Historical comparisons are likely moot, given the unprecedented nature of this housing downturn,” said Thomas Lawler, a housing consultant and economist. Most housing-market collapses have been regional, not national like this one, he said, and many have not included the steep price declines experienced this time around.

“If the question is how long will it take for prices to recover to the peak, it will be longer than before simply because prices fell by more, and in some parts of the country, the answer may be never, Lawler said.

Conclusions – It’s “Catch 22”

As referenced throughout this article, the worst of the housing slump is not yet over in many parts of the country. In fact, if home foreclosures hit another new record this year, as is predicted, many areas could see home prices fall another 5-10% or even more this year.

We can analyze and dissect the data all we want, but the fact is that consumer spending has not rebounded to pre-recession levels, and it is not likely to do so anytime soon. While we got a nice bounce in the economy in the 4Q due to inventory rebuilding, the next few quarters are likely to see much more mundane economic growth.

In many ways, we are in a classic “Catch 22”: we need home prices to rebound to increase consumer spending, but we need consumer spending to rebound to boost the housing market. And neither may happen just ahead.

Finally, I must admit that when I began doing the research for this letter, I did not expect the news to be so overwhelmingly negative. We’ve been fortunate here in Austin as home prices have held up fairly well over the last couple of years, and some areas have actually seen home values rise modestly. Austin is a very popular place to live, and thousands relocate here every month. Unfortunately, this is not true in most parts of the country.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Still Hunting for a Bottom in Housing Prices
http://www.time.com/time/printout/0,8816,1952132,00.html

New home sales fell unexpectedly in December
http://www.reuters.com/article/idUSTRE60O3ES20100128

5.7% GDP growth is not nearly as good as it looks
http://www.realclearmarkets.com/articles/2010/02/01/behind_the_57__growth_numbers_97617.html