It's bad enough that the stock market's wealth effect is disappearing. What happens to the economy if that other prop, home equity, starts to wobble? There are ominous signs this is about to happen.
If you need proof of the housing boom, just walk out onto your driveway. Pick up the newspaper and read about how this vibrant sector is propping up an otherwise teetering economy. Carpenters are busy. Home equity lending is supporting a lot of consumption. Those For Sale signs your neighbors are putting up could be just big spenders wanting to cash in on the wild appreciation homeowners have enjoyed in the past six years--40% in Atlanta, 54% in New York City, 68% in Boston, 71% in Denver and 100% in San Francisco, says research firm Case Shiller Weiss in Cambridge, Mass.
The general assumption seems to be: Stock prices fluctuate, but house prices just go straight up. Could this assumption be wrong? If it is, a large part of the economy is in danger. A burst of the housing bubble wouldn't just hurt homeowners and people who own shares of Fannie Mae or Toll Brothers. It could end up squeezing all Americans. A real estate slump "could make this little recession we're having turn into something that's quite drawn out and serious," says Yale economist Robert Shiller.
Shiller--famed for his astute calling of the Nasdaq stock bubble in his 2000 book, Irrational Exuberance, but a long-time scholar of the real estate markets--believes consumer confidence could take a bigger hit from a real estate crash than from the stock market correction. It was the boom in housing, he argues, more than the Nasdaq's 175% runup in the 18 months leading up to March 2000, that made consumers feel so flush and spend so freely. Go back as far as 1975 and compare ebbs and flows in retail spending in all 50 U.S. states and 15 foreign countries, and it is clear housing markets directly affect consumer spending, while stock market fluctuations don't, he says.
No one is talking bust--not yet, anyway. In fact, if you ignore what's happening at the high end of the market and look only at midpriced homes, you may be hard pressed to discern any kind of downturn, especially in places like New York, Denver or Minneapolis, where values are still rising. They've been going up for so long that many people can't even recall the last housing recession of 1990-93.
Look closely, though, and you'll see the cracks starting to form. Sales of existing homes nationwide in June were near the record pace set in March. But sales of $1-million-plus homes, which outpaced all other categories last year, sank 15% in the first five months of 2001. Supply is beginning to outstrip demand. The U.S. inventory of unsold homes, which fell steadily during the 1990s and reached a low of 1.4 million homes last year, has spiked upward for the first time in a decade, rising 23% since January, according to the National Realtors Association.
Perhaps more tellingly, in muscular markets like Atlanta, Seattle, Chicago and Washington, the pace of home sales is down 10% or more. And it's taking a whole lot longer to find a buyer. John Hall has been trying to sell his $370,000 downtown Chicago loft since April. He left a good paying job on May 1 to try his hand at independent consulting. He doesn't want the $2,700 monthly mortgage and tax payments to suck his savings dry. He's had some tempting inquiries, but no contract yet.
Shiller worries about an ominous mix of overdevelopment, inflated home prices and rising consumer debt. Add two other factors that historically have presaged a big drop in home prices--the plunge in stocks and massive layoffs, (see chart)--and the case for a crash gets stronger. It won't happen right away. It takes a while for people to let go of optimism--not to mention an emotional attachment to their home--and embrace economic reality. "They're in denial until they take a direct hit," says Barton Smith, an economist at the University of Houston.
The most visible sign of deterioration is in Silicon Valley. Santa Clara County, Calif. has four months of inventory for sale, triple the levels carried in the past three years, according to Creekside Realty in San Jose. The market has been in the dumps since the beginning of the year. Elizabeth and Alan Fletcher first considered putting their home in Palo Alto up for sale in February, when houses like it had been selling for $2 million--quite a jump from the $856,000 they paid in 1998. They hoped to reap a nice downpayment on a new 5,000-square-foot place they were building in the foothills above Los Altos for $3.85 million.
But by the time they listed the house on April Fool's Day, an economic earthquake had hit Silicon Valley. High-tech companies were shedding tens of thousands of jobs, and shares of Oracle, where Alan was a vice president, had dropped from $33 to $15 in just three months. The Fletchers' real estate agent warned them not to list their house for more than $1.4 million. Even at that price, the house sat for more than a month without drawing a single offer. They lowered the price by $100,000, then knocked off another $200,000. A buyer offered $1 million; but then backed out. In late June they finally sold their home for $1.04 million--down almost $1 million in just five months. By then they had lost $250,000 in the stock market and had to borrow $2 million for the new house.
This sort of weakness is expected in Silicon Valley, land of a million scorched dreams. But what about other parts of the country? Just north of Chicago, where prices have risen 24% since 1998, the tony suburb of Lake Forest is suffering a housing correction. Douglas Yeaman, chief executive of Prudential Preferred Properties, has 145 homes for sale priced at more than $1 million--13 months of inventory, up threefold in two years. William Lederer, founder of Art.com, has had his $7 million, 13-bedroom red-brick mansion listed since January. No deal yet.
It's tempting to dismiss such setbacks as merely anecdotal, but the pressure on housing prices has all too many historical precedents. In 1981, after a decade-long oil boom, Houston home builders and buyers got too comfortable. The price of crude oil peaked in March of that year at $35 a barrel. Housing prices paradoxically stayed high for a while as oil prices eased. Texas crude finally collapsed to $9 in 1986. At that point the reality of job losses sank in, and that year home values dropped 10% and kept sinking. By 1988 the real estate gains of the early 1980s had all been given back, and then some.
The securities business was keeping 163,000 people busy on Wall Street when Black Monday erupted on Oct. 19, 1987. It took a while for the jobs to be erased--30,000 of them by 1990--and still more time for the housing market to bottom out. By 1993 prices of apartments and homes in the New York area were 11% below their levels in 1989--a 23% drop in real (inflation-adjusted) terms, (see chart).
In Boston housing prices scratched a new high in 1987, just as the "Massachusetts miracle" was turning into economic martyrdom. Route 128--home to Wang Laboratories, Digital Equipment, Apollo Computer, Lotus and other vanquished tech firms--was a scene of carnage: From 1987 to 1990, 27,000 people lost their jobs. Real estate began a steep descent in 1990, falling 20% in real terms by 1994, setting prices back to where they had been in 1985.
Are home buyers now repeating mistakes made in Houston in 1982, New York in 1988? In Dallas, where housing values soared 73% in the last five years, so many high-end homes (those priced $700,000 and up) are on the market that, at the current pace of buying, it would take 18 months to get them all sold, a level unseen since 1989.
The devastation hits people like Karra and Daniel Guess, she a commercial real estate broker and he an assistant United States attorney. Last year they decided to trade up from their 4,300-square-foot home in a suburb near Fort Worth, Tex. for a 70-year-old, $700,000 renovated cottage in Dallas' University Park. Told that prices in the suburbs were rising quickly, the Guesses listed their home for $680,000, $111,000 more than they had paid for it. Cruising the old neighborhood, Karra counted just three other For Sale signs in six blocks--a seller's market.
Then came layoffs at Nortel, Alcatel, Ericsson--10,000 jobs from offices in the Dallas area. Nine months after listing their home for sale, the Guesses still hadn't drawn an offer, even after lowering their price to $570,000. By Easter there were 12 For Sale signs in the neighborhood. Karra hadn't shown the place in a month. Stretched to the snapping point by mortgage payments on two houses, the Guesses finally unloaded their place in May for $20,000 less than they paid for it.
Even in hot markets like New York, houses and condos are sitting longer without takers. In the first half of 2001, properties in Manhattan were on the market an average of 132 days before they were sold, up from 118 days last year. Real estate sales are down 19% since the beginning of the year. And there are plenty of sellers who refuse to face up to the gathering slowdown. "Sellers still don't want to negotiate and don't feel they have to," says Daniela Kunen, a broker at Douglas Elliman in Manhattan.
All this adds up to the kind of market that a stock market trader would call "overbought." Then there is the supply side of the equation. In the last five years, developers put up 6.1 million homes, easily topping the 5.5 million they built between 1985 and 1989. Until recently, consumers could absorb most of that vast supply. Between 1994 and 1999, the average interest rate on a 30-year fixed-rate mortgage fell from 9.2% to 6.7%, making ever larger homes affordable. Now rates on fixed-rate mortgages have stalled. All that the Federal Reserve has done to cut short-term rates since January hasn't helped.
The downside to easy credit: overleverage. Most households have either no mortgages or very manageable ones. But there are enough people stretching their budgets to have caused a key debt-burden ratio to hit an alltime high. The ratio of mortgage debt service to total disposable income climbed to 6.46% in the fourth quarter of 2000, surpassing a 6.35% record set during the first quarter of 1991 in the depth of the last recession. Collective owners' equity in the U.S., as a percentage of the real estate's value, sank to 55% in the first quarter of this year, the lowest level ever and down from 70% in 1982. "Leverage against an asset that can deflate in value is a recipe for disaster," says economist Charles W. Peabody of Mitchell Securities in Manhattan.
Phillip Bligh made a perilous bet. Enriched by the lofty public offering in early 2000 of Inforte, his Chicago-based Web consultancy, Bligh relied on margin loans and mortgage debt to finance the $4 million purchase of a town house in Chicago's Gold Coast neighborhood. His appraiser told him the price was too high, but Bligh, 34, went ahead. The first part of the bet soured this year when, with Inforte valued at one-tenth its 52-week high, Bligh had to sell 16% of his stake in Inforte in order to raise $4.5 million, much of which was used to repay margin debt.
Internet millionaires aren't the only ones exploiting rising prices. In the first quarter of 2001 half of all households that refinanced incurred debt at least 5% larger than the original loan. That cash is helping to finance things like sport utilities and big-screen TVs. Great for the consumer economy, but a potential calamity if housing values drop or even plateau.
Mortgage delinquencies--homeowners paying their mortgages late--fell slightly during the first quarter of 2001, after rising for three back-to-back quarters to 4.5%, the highest since the third quarter of 1992, reports Peabody of Mitchell Securities. Foreclosures have picked up, affecting nearly one in every 100 home loans by the end of March. Prudential Realty of Atlanta says the number of foreclosed properties it is selling has doubled in the past year, to 25 houses--half of them with values exceeding $250,000.
In Chicago, appraisers told James Strutton two years ago that his Mediterranean-style ranch in the suburb of South Barrington was worth at least $675,000, up from the $540,000 he had paid for it in 1989. Strutton, a management consultant, decided to cash out. He got a new $595,000 mortgage and put some of the borrowings toward a house in Gainesville, Ga.
But when Strutton went to sell the Chicago home, he couldn't get $675,000. Not even $600,000. Buckling under the weight of $4,700 in monthly mortgage payments ($1,200 in Georgia and $3,500 in Illinois), Strutton gave up. National City Mortgage foreclosed in April 2000. In July the house was finally under contract at around $550,000.
Said Fed Chairman Alan Greenspan to the Senate Banking Committee in July, "The housing sector has been a very important contributor to the American economy." It seems that Americans are rather addicted to increases in home prices. What happens when those prices stop increasing?
