By Mark Whitehouse
From The Wall Street Journal Online

Home prices in some parts of the country are falling. Builders are scaling back. Bubble or not, the biggest housing boom in recent U.S. history is coming to an end.

Now here is the big question: How bad will the aftermath be? At this point, most economists expect a "soft landing," a gradual decline that won't derail the nation's economic expansion, now in its fifth year.

But there is a good chance they are being too optimistic. The boom has depended heavily on the upbeat psychology of consumers, builders and lenders. As moods swing, the landing could be very hard indeed.

Discuss Is the housing market headed for a severe downturn?

"We could be underestimating the dark side," says Mark Zandi, chief U.S. economist at Moody's Economy.com and among the first to seek to quantify the housing boom's broader effects. "Euphoria could turn into abject pessimism very quickly."

With each passing data point, signs of the housing slowdown grow stronger. In June, total single-family-home sales fell 8.7% from a year earlier, to an annualized rate of 6.9 million -- the sharpest year-to-year drop since April 1995.

The government's report on second-quarter real gross domestic product, the inflation-adjusted value of the nation's output, showed that fixed investment in housing by companies and individuals declined at an annual rate of 6.3% in the quarter. That was a sharp change from a year earlier, when it was increasing at an annual rate of 20%. As of Friday, futures markets were predicting about a 5% drop in house prices by May 2007.

Still, judging by most economists' forecasts, the fallout from a slowing housing market doesn't look all that unpleasant. Typically, they expect the decline in housing -- and housing-related activity -- to shave about a percentage point off inflation-adjusted GDP growth in 2007, compared with the estimated one percentage point the sector contributed to growth in 2005. If business investment and exports accelerate as expected, that would bring inflation-adjusted GDP growth to about 2.8% in 2007, down from a forecast 3.5% this year.

Economists, however, have few clues on which to base their predictions. Today's housing boom differs radically from its predecessors. For one, it has been bigger and longer-lived. House prices are still more than twice the level of 1991, when the boom began. Even after the recent decline, June's rate of home sales is 40% above the 20-year average.

Much of the recent increase has been driven by an unprecedented flood of cash into U.S. capital markets. Global demand for U.S. mortgage bonds, competition among big national lenders and the advent of exotic loans have made it easier than ever to borrow money to buy a house -- and to turn rising home values into cash.

Because the market has risen so far, economists worry it has the potential to fall much harder than their main forecasts would suggest. As Janet Yellen, president of the Federal Reserve Bank of San Francisco, put it in a speech last week: "We can't ignore the risks of more unpleasant scenarios developing."

One big question is how much the housing slowdown will affect consumers, whose spending accounts for more than two-thirds of the economy. If house prices plateau or fall, homeowners will feel poorer, and thus less willing to go out and buy more cars, boats and refrigerators. Typically, this "negative wealth effect" would be only about three to five cents of spending for each dollar of wealth lost.

But modern mortgage finance has magnified the effect of home values on spending, says Jan Hatzius, chief U.S. economist at Goldman Sachs in New York. He estimates that when people take cash out of their homes through home-equity loans and refinancings -- which they were doing at an annualized rate of $558 billion in the first quarter -- they tend to spend about 50 cents of every dollar. If house prices merely stabilize, people's diminished ability to use their houses like automated-teller machines would subtract about 0.75 percentage point from annualized GDP growth in 2007, Mr. Hatzius says.

Another question is how fast home sales, and consequently home building, can fall. Even after the second-quarter decline, investment in residential construction accounted for about 6.1% of the economy -- close to a 50-year high. If, as some economists expect, housing investment merely returns to the long-term average of about 4.6% over the next two years, the decline also would shave 0.75 percentage point from annual real GDP growth.

But there is reason to believe home builders will have to pull back more sharply. That is because the leveling off of house prices changes the equation of homeownership. When mortgage rates were less than 6% and house prices were rising at about double that rate, people could reasonably expect to make more on their house's appreciation than they would pay in interest on their mortgages. Now, though, inflation-adjusted mortgage rates -- the interest rate on a typical 30-year mortgage minus the percentage rise in home prices -- are on track to turn positive for the first time since 2001.

When housing took a similar turn in the 1970s, new-home sales quickly fell to their long-term norm. This time around, that would entail about a 50% decline in sales, says Ian Shepherdson, chief U.S. economist at consulting firm High Frequency Economics. He estimates that the resulting decline in residential construction would subtract about 1.5 percentage points from annual GDP growth in each of the next two years. "It's a 15-year bubble unwinding in two years," Mr. Shepherdson says. "It's going to hurt."

If Messrs. Hatzius and Shepherdson are both right, the effect of the housing slowdown on construction and consumer spending alone would subtract more than two percentage points from economic growth in 2007, bringing it well below 2%.

But that isn't all. Economists can't quantify some risks, including the biggest: the chance that a sharp drop in house prices -- what economists call a "disorderly downturn" -- would leave many homeowners owing more on their mortgages than their homes are worth. If that led to a wave of foreclosures and losses on riskier mortgage-backed securities, banks and investors could get spooked and cut back on all kinds of lending -- a move that could snuff out economic growth.

"For me, the risk of a disorderly downturn is the greater one," Mr. Hatzius says. "That's a scenario that people would worry about a lot, because typically recessions are the result of a general unwillingness to lend."

 

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