A Troubled 'Ownership Society'

As lenders cease making small, second loans, the homeownership rate is starting to decline, and the outlook for the housing market could worsen

by Peter Coy

After three decades of stability, the national rate of homeownership suddenly began rising around 1995. The rush to buy homes fueled an enormous surge in housing construction and home prices. Experts differed on the cause of the increase in homeownership, from 64.2% of households in early 1995 to 69.1% in early 2005. Was it the aging of the population? Or was it an expression of what President George W. Bush calls the "ownership society"?

Neither. Surprising new research published by the Federal Reserve Bank of Atlanta concludes that the bulk of the increase was caused by innovations in the mortgage market, in particular the explosion of "piggyback" or "combo" loans that made it possible for people to make small or zero down payments. Young families with little savings flocked to those loans to buy first homes.

More Bad News for Homebuilders

Trouble is, lenders aren't making many of those loans anymore because default rates on the smaller, second loans have been extremely high. That means that one of the main props of the housing market has been kicked away. If the homeownership rate drifts back to where it was in 1995, the outlook for housing construction and home prices could turn out even worse than the pessimistic projections.

That, in turn, could further depress shares of homebuilders, which have tumbled this year amid the housing market's persistent weakness. Next week, Centex (CTX) and Pulte Homes (PHM) are scheduled to report their quarterly income.

Declining Levels

One Wall Street economist who has studied the Atlanta Fed working paper, Jan Hatzius of Goldman Sachs (GS), wrote on Oct. 18 that "the implications could be dramatic." Wrote Hatzius: "Our current forecast calls for a decline in new home sales to a trough level of 650,000 by the first quarter of 2008, which we believe is one of the lowest estimates on Wall Street. However, the simple arithmetic [implied by the Atlanta Fed paper] suggests that this estimate could still prove much too optimistic."

The Atlanta Fed paper, "Accounting for Changes in the Homeownership Rate," was published in September. Its authors are Matthew Chambers, an economist at Towson University in Maryland; Carlos Garriga, an economist at the Federal Reserve Bank of St. Louis; and Don Schlagenhauf, an economist at Florida State University and a visiting scholar at the Atlanta Fed.

Many analysts have fingered easy lending as a contributor to the housing boom, but the Atlanta Fed paper may be the first to quantify its effect in a rigorous way. Using math-heavy econometric analysis, the authors conclude that the availability of new kinds of mortgages, mainly ones with low down payments, accounted for 56% to 70% of the decade-long increase in the U.S. homeownership rate, while demographic changes accounted for only 16% to 31% of the effect.

Supply and Demand

A combo loan such as those mentioned in the Atlanta Fed paper consists of two loans, one for 80% of the value of the house and the other for 10%, 15%, or even the entire 20% remaining. The reason for taking two loans instead of one big one is that 80% is ordinarily the maximum loan-to-value ratio for loans that are eligible for purchase by Fannie Mae (FNM) and Freddie Mac (FRE). When the borrower makes little or no down payment, he or she is more likely to walk away from the loan if the house loses value and return to being a renter.

But could the homeownership rate actually decline? Yes. In fact, it already has begun to. According to the Census Bureau, it was 68.2% in the second quarter of 2007, down from 69.2% in the fourth quarter of 2004 and 69.1% in the first quarter of 2005. Goldman's Hatzius says that "given the current number of U.S. households of 110 million, the change in the homeownership rate over the past two years has already subtracted almost 500,000 from the underlying demand for new homes."

Coy is BusinessWeek's Economics Editor .