Waiting for change for the US housing market

House prices continue to plummet, despite multi-billion government bail-out packages for the financial market.

In the year to end-Q3 2008 there was a 16.6% y-o-y drop in US property prices (-20.8% in real terms), according to the S&P;/Case-Shiller® national house price index. The ten major cities composite index (SPCS-10) plunged by a larger 18.6%. The broader 20-city home price index (SPCS-20) dropped 17.4%.

A more muted picture of the downturn comes from the purchase-only house price index of the Office of Federal Housing Enterprise Oversight (OFHEO), which reports average price of single-family homes falling only 4% during the year to end-Q3 2008, or 8.8% inflation-adjusted.

The median price of existing homes was US$183,300 in October 2008, down 11.3% on a year earlier (the largest drop since 1968), according to the National Association of Realtors (NAR).

The subprime mortgage problems began as far back as 2006.

Since then, the crisis has spread to the financial market. As mortgage delinquencies and foreclosures rose, banks and other financial institutions wrote off substantial losses. The crisis of confidence spread to the entire economy, leading to a credit freeze, rising unemployment and low consumer confidence.

The crisis has spared very few financial institutions. American Insurance Group, the world’s largest insurer, has been partly nationalised. Mortgage giants Fannie Mae and Freddie Mac were nationalised. Several financial institutions were either allowed to collapse or sold to competitors through government-sponsored deals. Leading banks were given financial support through the Troubled Asset Relief Program (TARP). The government has also implemented economic stimulus packages, whose effects remain to be seen.

The end of the economic and financial meltdown is nowhere in sight. House prices are expected to fall until end-2010 or mid-2011.

Consensus as to the causes of the recent crisis is still lacking. Our best guess is that the crisis was caused by:

• A long period of low interest rates, stoked partly by trade imbalances encouraging massive Chinese purchases of US Treasuries, and Japanese carry-trade purchases;
• A reluctance of the authorities to explicitly target house prices;
• A regulatory vacuum, at a time of rapid financial market development. Some part of the blame probably falls both on the government and the Federal Reserve, both ideologically committed to free market principles;
• Special-interest lobbying to expand the mandate of Fannie Mae and Freddie Mac to increase support for first-time homebuyers.

House price bubbles in many areas were stocked by reckless lending by banks and other mortgage companies. The eventual result was a financial meltdown, causing an economic crisis unparalleled since the Great Depression.

Change we can believe in

Unfreezing the credit market and restoring economic confidence are high on the list of the priorities of new president-elect Barack Obama.

Although Barack Obama, elected on Nov 4, will not take office until Jan. 20, 2009, he is already filling the leadership vacuum left by a lame duck president.

In addition, Obama has announced a two-year economic aid plan which includes massive spending, new tax cuts and the creation of around 2.5 million jobs (estimated to cost US$1.1 trillion). He has said that if the current administration will not do it, he will pursue the plan as soon as he takes office.

"The consensus is this that we have to do whatever it takes to get this economy moving again, that we have to -- we're going to have to spend money now to stimulate the economy," said President-elect Obama.

Recession blues

The US fell into recession in December 2007, officially announced by the National Bureau of Economic Research (NBER) on December 1, 2008.

NBER defines recession as a significant decline in economic activity which lasts for more than a few months. It looks at broad economic measures (GDP, gross domestic income, real personal income, employment, real manufacturing sales, wholesale-retail sales and factory output) to determine if the economy is already in recession.

"The committee determined that the decline in economic activity in 2008 met the standard for a recession," NBER said. "All evidence other than the ambiguous movements of the quarterly product-side measure of domestic production confirmed that conclusion," it adds.

Real GDP contracted 0.5% during the year to end-Q3 2008, according to US Commerce Department. The US economy is expected to contract well into 2009.

"The U.S. recession is set to get worse -- a lot worse -- in the next couple of quarters," writes Nariman Behravesh, chief economist at the IHS Global Insight.

• In 2008, US GDP growth is expected to slow to 1.6%.
• In 2009, the US economy is projected to grow by a negligible 0.06%.

Unemployment rose to 6.5% in October 2008, the highest level since March 1994, from 4.6% in 2007. Unemployment in the US is expected to rise to 7.6% by Q3 2009.

Real gross domestic purchases by U.S. residents dropped 1.3% in Q3 2008, according to Bureau of Economic Analysis (BEA).

In the face of collapsing demand, consumer prices fell 1% in October 2008, the steepest decline since 1947, according to the US Labor Department. In 2007, inflation was 2.9%. Inflation is expected to be around 4.2% in 2008 and will stabilize to 1.8% in 2009.

The higher they rose, the deeper they fell

Coastal and/or sunny cities have experienced the biggest property prices drops.

Of the 20 cities in the index, Dallas (-2.7%) and Charlotte (-3.5%) saw the lowest house price declines.

The Pacific Division, especially California, registered the highest house price declines, according to the purchase-only HPI from OFHEO. Average single family house prices plunged 20.5% in September 2008 from a year earlier.

The West South Central Division has been least affected by the crisis, with house prices rising 0.51% over the same period.

Areas that experienced the biggest house price gains during the past decade also registered the biggest declines when the bubble finally burst. House price growth from 1996 to 2006 was highest in Los Angeles (264%), San Diego (232%), Miami (219%) and San Francisco (209%), using the S&P;/Case-Shiller® monthly house price indices.

Sales and supply are plummeting

Sales of new one-family houses dropped 33.1% in the year to September 2008 to 464,000 units (seasonally adjusted), according to the U.S. Census Bureau and the Department of Housing and Urban Development.

The Northeast Region registered the highest decline of -65.1% from a year earlier. The West Region (-37.9) and Midwest Region (37.5%) followed, while the South Region (-23.8%) had the lowest drop in home sales.

Total privately-owned housing units completed fell to 1,043,000 in October 2008; 25.6% down from a year earlier, according to the U.S. Central Bureau. Single-family housing completions were 760,000, 7.7% below the September 2008 figures.

Permits to build new homes, an indicator of future activity, fell to a 48-yr low at 708,000 in October 2008; 40.1% down from a year ago. Privately-owned housing starts dropped 38% to 791,000 (seasonally-adjusted).

Interest rates and the crisis

From a high of 16% in the early 1980s, mortgage rates have been below 10% for the entire 1990s. The Fed funds rate, the key rate used as basis for most mortgages, was at historic lows from 2002 to 2004 – notably, at 1% from June 2003 to May 2004. The average interest rate for 30-year fixed rate mortgages (FRM) was 5.8% while the average rate for 1-year adjustable rate mortgages (ARM) was 4.05% from 2003 to 2005.

As a direct result, from 1996 to 2006 house prices rose more than 200% in major cities like Los Angeles, San Diego, Miami and San Francisco, using the SPCS-20 Index.

However in early 2006, the Fed, headed by newly-appointed Chairman Ben Bernarke, raised interest rates to contain the inflationary pressures caused by higher energy and commodity prices.

• The 30-year FRM rate rose to 6.8% in July 2006 (from 5.7% in July 2005)
• The 1 year ARMs rate rose to 5.8% (from 4.4% in July 2005).

Households with ARMs were immediately affected. More than 30% of loans were ARMs in 2004-2005. Many households, especially subprime borrowers, defaulted on their amortization, and foreclosures rose.

In Q2 2008, there are around 739,714 properties with foreclosure filings in the US, up 121.4% from a year earlier. Nevada (146.8%), California (197.8%) and Arizona (272.3%) had the highest foreclosure rates, based on RealtyTrac’s reports. In 2007, around 1.3 million residential properties were subject to foreclosure, up 79% from 2006.

In response, the Fed frantically lowered interest rates. The key interest rate was reduced three times in 2007, from 5.25% in August (its level since June 2006) to 4.25% in December. In January 2008, the rate was slashed twice to 3% in response to the stock market turmoil. In March 2008, the Fed cut key rates by another 75 basis points, bringing them down to 2.25%. On April 13, the fed funds rate was 2%. In October, the Fed cut the key rate in 2 steps to 1%.

Despite the interest rate cuts, mortgage rates barely changed due, to the credit freeze imposed by lending institutions. Interest rates for 30-year FRMs even rose slightly to 6.2% in Oct 2008 from 6.1% in Dec 2007. One year ARMs moved from 5.5% in Dec 2006 to 5.21% in Oct 2008.

Mortgage markets and the crisis

In the early 2000s the US mortgage market expanded rapidly, as mortgages were made available to individuals with low credit ratings (referred to as sub-prime mortgages), . Some were offered with little or no collateral.

Ninja loans (‘No Income, No Job, (and) No Asset’) became common during the bubble’s height. Poor lending practices allowed these loans to be approved without proper verification that the applicant was reasonably likely to adhere to the loan payment terms.

The mortgage market grew sharply from 65% of GDP in 1998 to 106% of GDP in 2007.

In Q1 2007, the estimated value of subprime mortgages was around US$1.3 trillion. 2.5% of all mortgages were in foreclosure by Q1 2008; 50% of which were subprime mortgages.

About half of the total outstanding mortgages in the US were owned or guaranteed by the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), US government-sponsored enterprises (GSEs) that function as the biggest intermediaries in the US secondary mortgage market.

In the first half of 2008, it became evident that these GSEs would be unable to handle the growing delinquency rates. In September 2008, the government placed the two GSEs into conservatorship, and will infuse up to US$200 billion in additional capital to Freddie Mac and Fannie Mae.

Sluggish rental market

The US rental market has grown only sluggishly during the past decade. Median asking rents rose by only 48% from 1997 to 2007, based on the figures from the US Census Bureau.

In Q3 2008, median asking rent rose by 8.45% to US$719 from a year earlier. Vacancies for rental houses rose slightly in Q3 2008 to 9.9% (from 9.8% in Q3 2007).

Help is on the way

The US government’ actions to infuse to stimulate the ailing financial and housing markets include:

• Economic Stimulus Act of 2008 (enacted February 13). This provides tax rebates (worth US$152 billion) and business tax incentives (worth US$44.8 billion). It also makes the mortgage market more accessible to homeowners who need to refinance to stay afloat.
• Housing and Economic Recovery Act of 2008 (enacted July 24). Designed to restore consumer confidence in Fannie Mae and Freddie Mac through nationalization of the two institutions. The Federal Housing Administration (FHA) was authorized to guarantee up to US$300 billion in new 30-yr FRMs for subprime borrowers.
• Emergency Economic Stabilisation Act of 2008 (enacted October 3). Better known as the bailout of the US financial system. The law authorizes the Secretary of Treasury through the Troubled Asset Relief Program (TARP) to purchase and insure MBS and other distressed assets up to US$700 billion. In November 12, 2008, US$290 billion of the initial US$350 billion allotment funds have already been used for bank equity infusions.
• The Fed announced another stimulus package worth US$800 billion in November 25, 2008. About US$600 billion will be used to buy MBS while the remaining US$200 billion will be spent to unfreeze consumer credit lending in the US.

A bleak medium-term

The US housing market has not yet reached bottom. “We continue to believe that it is unlikely that we are anywhere near a bottom in nationwide home prices,” says Joshua Shapiro, chief domestic economist at the research firm MFR.

Nearly half of all home sales were foreclosed properties by October.

"Many potential home buyers appear to have withdrawn from the market due to the stock market collapse and deteriorating economic conditions," says Lawrence Yun, National Association of Realtors (NAR) chief economist.

House prices will only stabilize when the inventory of unsold houses, now at 10-months supply, is brought back to normal levels.

In addition, we need an economic recovery, and the unfreezing of credit, before things return to normal.