How Lower Home Prices Hurt Everything

The continuing decline in housing prices is sure to exacerbate stock market weakness and tighten consumer spending

by James Mehring and Maya Roney

Words like "stabilization" and "contained" have all but evaporated from the housing economist's lexicon in the past few months. If anyone was still clinging to the hope that the housing market had stabilized, he probably let go after seeing the latest data. In the second quarter, U.S. single-family home prices suffered their biggest decline in at least 20 years, according to an Aug. 28 report from Standard & Poor's. And the number of new and existing single-family homes for sale reached almost 4.4 million, the most ever. The glut of unsold homes almost guarantees that prices will continue to drop in the months ahead.

The latest numbers weren't exactly a surprise—economists have been predicting a worsening housing market for months. Then again, a Category 5 hurricane may not be a surprise, either, but it still hurts when it hits. The housing market's troubles are currently the source of a passel of seemingly unrelated problems, from stock market weakness to uncertain consumer spending. The housing market's continued decline is making all of those problems worse.

Consumer Spending on Hold

Automakers and dealers, for example, are directly affected by the housing downturn. A year ago, consumers were still taking out home equity loans and using the tax-deductible cash to buy new cars. That's drying up, says Mike Jackson, chief executive officer of AutoNation (AN), the nation's largest car dealer chain. To make matters worse, consumers with adjustable-rate mortgages are paying more every month in interest, causing many to put off buying big-ticket items such as cars and appliances. Says Jackson: "It's a nitroglycerine combination."

Businesses like AutoNation can't easily plan for the worst because they don't know when housing will finally bottom out. That's partly because falling housing prices can create a self-reinforcing downward spiral: Lenders pull back when they fear prices will fall, so would-be borrowers can't buy homes, and prices fall even more. Even well-financed buyers back away when they see prices falling. "There is really no line of sight as to when this will be over," says Brian Bethune, director of financial economics for the U.S. Macroeconomics Group at Global Insight, a consulting firm. Bethune thinks housing prices could fall an additional 5% or more. Mark Zandi, chief economist at Moody's (MCO) Economy.com recently raised his estimate for the decline in home prices by the end of 2008 to 10% (peak to trough), from 5%.

While the figures on unsold homes came from the Census Bureau and the National Association of Realtors, the quarterly price figures were from Standard & Poor's (which, like BusinessWeek, is a division of The McGraw-Hill Companies (MHP)). It reported that the S&P/Case-Shiller 10-City Home Price index fell 3.2% in the second quarter of 2007 from a year earlier. While regional slumps are relatively common, nationwide annual declines in home prices are rare.

Affordable Mortgages? Forget It

When home prices fall, defaults and foreclosures rise. "Home prices have historically been the biggest factor in determining the levels of default," says Jay Brinkmann, vice-president for research and economics at the Mortgage Bankers Assn. One reason is that homeowners hit by life events such as divorce, a major illness, or the loss of a job are less able to get out from under a mortgage to cover the expense if the value of the home is falling. Also, borrowers who had intended to refinance into more affordable mortgages can't do so when they have little or no equity. According to RealtyTrac, foreclosures in July rose 9% from June and 93% from July, 2006.

Falling prices also cause buyers to back off. The most direct hit to the economy is through the downturn in housing construction, which was a major source of job growth during the boom. Economists at JPMorgan Chase (JPM) now see additional contractions in residential construction taking a full percentage point off of growth for the next three quarters. The indirect hit to the economy is through consumer spending on everything from cars to dishwashers to holiday presents. An outright recession remains unlikely, but it can't be dismissed. A lot depends on when the housing market finally stabilizes, which no one can say for sure.

With David Welch in Detroit
Mehring is economics writer for BusinessWeek. Roney is Real Estate writer for BusinessWeek.com.