Uncertainties about the impacts of the ongoing housing “correction” on the economy, including a weaker housing wealth effect on consumer spending and fallout from the evolving subprime mortgage debacle, have energized speculation about economic recession in the latter part of this year. Alan Greenspan, the former Fed chairman, recently put a one-third probability on recession in 2007 at the same time that the current Fed chairman, Ben Bernanke, was expressing confidence in the resilience of the U.S. economy.

We stand closer to Bernanke, putting a 20% probability on recession in 2007, although uncertainties surrounding the outlook for housing finance and the housing supply-demand balance are formidable.
 

It’s now clear that lending standards in this market deteriorated badly during the frenetic housing boom of 2004-2005 and deteriorated even further while the housing market was heading downhill last year.

Subprime lenders recently have been going out of business in rapid succession and revelations of fraudulent behavior have been surfacing. These cases often involve unregulated mortgage brokers, and the Financial Crimes section of the FBI now is on the job.

The meltdown of the subprime mortgage market definitely is a serious matter for the U.S. housing market, promising to add to a heavy inventory overhang (via foreclosures) and to reduce home sales (via tighter lending standards) at a time when lingering affordability problems still are quite serious.

But the bigger threat is spread of the infection upward — into the Alt-A and prime components of the mortgage market. Recently released data on mortgage delinquencies and foreclosures for the final quarter of 2006 show substantial deterioration in the subprime market and some deterioration in the rest of the market — presumably concentrated in the Alt-A component where interest-only ARMs with little or no documentation of borrower income/assets proliferated during the boom.

About the only saving grace in this story is a flight to quality in financial markets that promises to push rates on prime mortgages below earlier projections for 2007 — as long as credit quality spreads to comparable-maturing Treasury securities hold firm. [return to top]
 

As a result, yields on these risk-free instruments have been driven downward to levels not seen for some time. Prime mortgage rates also have come down in the process as spreads to Treasuries have been reasonably stable.

The Fed still is anchoring the short end of the yield structure, holding the federal funds rate target at the 5.25% level established at mid-2006. However, yields on short-term Treasury securities have been compressed recently, widening spreads to the funds rate.

It’s clear that market participants have just about written off any chance of Fed tightening this year, and bets on Fed easing in 2007 are accumulating.

Our forecast still calls for a quarter-point cut in the federal funds rate at mid-year. The Fed certainly could react earlier, and more often, if the shocks from financial markets — including widening of credit-risk spreads — threaten an already subpar pace of economic growth. [return to top]
 

The Mortgage Bankers Association’s weekly series on applications for mortgages to buy homes (available through the week ending March 9) had been showing substantial improvements from the low points last fall, but a disturbing pattern of deterioration has emerged since late January.

It’s true that NAHB’s single-family Housing Market Index (HMI) is up convincingly from the low last September, but the improvement through February was concentrated in sales expectations (rather than current sales) and preliminary tabulations point toward some slippage of the HMI in March. Furthermore, special questions in our March survey show that significant numbers of builders have detected negative impacts on home sales due to tightening mortgage lending standards.

NAHB’s proprietary survey of 30 large home builders shows ongoing deterioration of gross home sales (orders) through February, even though cancellations are falling sharply and net sales (gross less cancelled) have stabilized since late last year (all seasonally adjusted).

That stabilization pattern reflects a dramatic decline in the backlog of orders (signed contracts), a trend that naturally puts downward pressure on cancellations and closings but may not signal fundamental stabilization of demand. [return to top]
 

We’re now projecting 1.5 million housing starts for 2007 (equivalent to the March Blue Chip consensus) followed by a rebound to 1.64 million in 2008 — above the consensus estimate of 1.57 million.

It’s certainly fair to say that the range of uncertainty around our baseline housing forecast has widened considerably in recent weeks, and it probably will take several months to get a firm handle on the net impacts of the unfolding mortgage market saga.

We know that underlying housing demand fundamentals — primarily demographic trends — are solid, but we also know that there are major inventory and affordability hurdles to clear and that the subprime mortgage market mess is working against us on both fronts. The implications for household balance sheets must also be considered. [return to top]
 

Home mortgage debt rose by 8.9% during 2006, down from the extraordinarily rapid rates of 2004 and 2005, but still quite robust. Household equity in homes rose by 4.0% over the course of the year to a record $10.95 trillion at year end, although the annualized gain came to less than 2% for the fourth quarter. Furthermore, the debt-to-value ratio moved up to 46.9% by the end of 2006, continuing the upward trend of recent years.

The weakening of house prices is likely to continue during 2007, causing housing wealth and housing equity to stagnate, and possibly even decline, and the debt-to-value ratio is destined to rise somewhat further.

While not alarming, these developments inevitably detract from the investment aspects of homeownership and reduce the degree of support provided to consumer spending by housing wealth accumulation. [return to top]
 

Get the answer to these and other questions at the Construction Forecast Conference — Spring 2007 on April 26 in Washington, D.C.

Panels of nationally recognized experts will discuss economic trends, government policies, developments in the housing industry and the results from NAHB's recent surveys at the day-long conference.

For more information and to register, click here.

Can't Attend in Person? Webcast of Conference Also Available

The conference is also available via Webcast. For Webcast information, visit www.nahb.org/cfcwebcast. [return to top]
 

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HousingEconomics.com is your single source for market analysis, forecasts, housing statistics and more. In-depth analysis and detailed Excel tables and overviews are available for all the state and metro forecasts. HousingEconomics.com combines unique scientific research with practical applications providing insights that are original and useful.

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• Home Builders Forecast ― state, metro, non-residential, remodeling, etc.
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For more details, visit www.housingeconomics.com. [return to top]