312 Real Estate - Luxury Chicago Condos: June 2007

This article from "Business Week" tackles the housing market's worries:

S&P Ratings News April 18, 2007, 7:36PM EST

Housing: Is the Worst Over?
S&P sees some tentative signs that the market is bottoming out, but it will take a while to get rid of excess inventory of unsold homes

by David Wyss From Standard & Poor's RatingsDirect

Like grief, a housing downturn is a multistage process. Stage 1 is denial: If I hold onto the house long enough, I'll get my price. For the U.S. housing market, this stage began in 2005 and ended in mid-2006. Stage 2 is anger: If I can't sell this house, I'll just cancel the sale of the house I was going to buy, and stay where I am. Cancellations of sales agreements now appear to have peaked. Stage 3 is acceptance: I'll get what I can and move on if necessary.

The U.S. housing market appears to be just now entering that third stage, which will probably continue through the rest of 2007. Sales will stabilize, but until the market finishes stage 3 and gets rid of the excess inventory of unsold homes, home prices will continue to drop.

Getting to stage 3 has been painful. In the current housing slump, starts have dropped to an average annual rate of 1.52 million over the past three months, from 2.07 million in 2005. The median existing home price is now down 3.1% from a year ago. By historical standards, however, the falloff in housing starts and sales is still moderate: In the average postwar recession, starts have plunged 50% from peak to trough and to a low of fewer than 1 million units. The decline in the median home price, though, is more uncommon, with the first year-over-year drop since the 1930s likely from 2006 to 2007.

Signs of a Thaw
And homeowners, particularly those with adjustable-rate mortgages, are feeling the financial pressure. Although the economy remains generally strong and unemployment low, higher interest rates are squeezing mortgagees who stretched too far to buy their homes.

Foreclosure rates are rising, though they're still moderate by historical standards.

The good news is some tentative signs indicate that the market is bottoming out, at least in terms of sales and starts. The winter is a bad time to look for signs (other than those that say "For Sale") because weather usually dominates month-to-month movements in sales and, especially, starts. Convincing evidence that the housing market has seen the worst won't appear until we get data on the spring buying season, which started in April.

But the early data suggest that starts are leveling out near 1.5 million and existing-home sales near 6.25 million. The inventory of unsold existing homes has come down to 3.55 million from 3.86 million in July.

Existing-home sales rebounded in January, to a seven-month high of 6.46 million (annual rate), but that remains down 4.3% from January, 2006, and is 8.7% below the record 7.08 million sales reached in the peak year of 2005. New home sales have been hit harder, plunging to a four-year low of 937,000 (annual rate) in January. That's down 20.1% from a year earlier.

Working on Affordability
The reason for the decline is that homes have essentially become more expensive. After all, for the average buyer, a home's price is the size of the monthly mortgage payment. As mortgage rates have risen to their current 6.2% (30-year conventional) from 5.5% three years ago, the effective cost of a house has risen nearly proportionately.

The change has pushed down the National Assn. of Realtors' affordability index (which is based on the monthly income required to qualify to buy the median existing home with a conventional mortgage) to 106.5 in the fourth quarter of 2006 from the record high of 136.5 in the first quarter of 2003.

What could improve affordability? For one thing, Federal Reserve rate cuts, which we expect to begin late this year, would make adjustable-rate mortgages cheaper, helping sales and moderating the impact of rate resets on adjustable-rate borrowers. However, just as the Fed's rate increases since mid-2004 have had little impact on long-term bond yields, and thus fixed-rate mortgages, Fed cuts will also have little impact on long-term rates.

Drag on the Numbers
Rate resets are normally capped in any year and have several more increases to go to catch up with the 4.25 percentage points in rate hikes the Fed has already imposed. Thus, even if the central bank begins to cut rates, resets will continue to push payments up.

Housing is the major factor slowing economic growth in the U.S. If not for the decline in residential construction activity, real GDP growth in the second half of 2006 would have been 3.4%, about even with the average of the preceding four quarters, instead of downshifting to 2.3%. We expect housing to subtract about a percentage point from growth in the first half of 2007. The indirect impact of housing on the economy, however, has so far been small.

Consumers haven't backed away from spending, with the personal saving rate remaining well below zero (negative 1.2% in February). The strong stock market has offset the lower increase in housing wealth. However, trouble could be around the corner if stock prices continue to fall.

Will Borrowing Slow?
One impact has been lower sales of building materials, furniture, and appliances, which are directly related to home purchases. Building material stores reported a 0.4% sales drop in January compared with a year earlier. Furniture sales were up 1.7%. That's below the 4.3% rise in overall retail sales, but at least it wasn't down. Appliance sales are hard to track because stores that sell them also tend to sell electronics, which have been very strong.

One of the biggest questions is whether the higher interest rates and slower rise in home equity values will trim borrowing. Because of home equity loans and cash-out refinancings, Americans have been using their homes as ATM machines. Last year, homeowners took $654 billion (nearly 7% of disposable income) out of their homes. Low interest rates make these loans cheap, especially because they're usually tax deductible.

So far, this activity doesn't seem to be tapering off very much. Refinancings remain high, though some of it probably stems from turning adjustable-rate loans into fixed rates as mortgage holders get the jitters. Moreover, Americans still have a lot of untapped home equity. In fact, the average loan-to-value ratio in the U.S. housing market has barely changed in recent years. It was 46% in the third quarter of 2006, compared with 42% at the end of 2001.

Some Possible Equations
Higher interest rates will probably cut down on borrowing, and thus—eventually—spending, but interest rates, rather than slower home price appreciation, will be the major force. Americans have no shortage of ways to borrow and seem determined to use all of them.
Our baseline U.S. economic forecast includes a two-year drop of 8% in the average existing-home price from the peak reached in early 2006. Along with the growth of income, this decline brings the ratio of home price to income back to 280% by 2010, still above its long-term average of 260%. If the home-price correction comes faster, however, it could help cause a recession. One possibility: Dollar weakness pushes up bond yields and thus mortgage rates, triggering a quicker drop in home prices.

In our alternative economic projection, we assume that bond yields rise sharply, carrying the mortgage rate up to 8% by the end of 2008. Home sales and prices plummet. The average existing home price tumbles 20% from its early 2006 peak, more than twice the decline seen in the baseline. Housing starts drop under 1 million units, a fairly typical recession falloff, by early 2008. The decline triggers a recession, starting in the fourth quarter of 2007.

The stock market drops sharply in response to both weaker earnings and higher bond yields, compounding the impact of lower house prices on wealth. The unemployment rate rises above 6% by yearend, instead of peaking near 5%, as in the baseline. Still, the recession is mild, similar to the 2001 or 1991 downturns.

Worst Case…and Beyond
This scenario is intended as a worst likely case. We believe it has about a 10% probability of occurring. The home-price correction would be severe, in fact unprecedented, at a national level. However, it would be similar to the size of declines seen in Texas in the mid-1980s or in New England in the early 1990s. Even so, the recession it generates is far from severe.

One exacerbating factor could be the subprime market. There's little question that lenders were too enthusiastic in lending money to people who were stretching to buy houses they perhaps shouldn't have bought. When investors become too complacent about risk, and get stung, they often overreact and become too cautious.

Legislative actions aimed at preventing foreclosure would increase losses to lenders and drive up the cost of mortgages. That could compound the effect of overcautiousness by making lenders even less willing to write mortgages. If mortgages are harder to get and more expensive, sales and prices could drop more, and a recovery in the housing market could become very difficult.

Of course, other events, such as oil price shocks or an overall recession, could make economic matters worse in the near future, and any of those possibilities would make our baseline scenario seem benign.

Wyss is chief economist for Standard & Poor's in New York.

Source: www.businessweek.com

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