Despite continuing declines in home prices during the second half of 2008, home sales continued to plummet. While lower home prices tend to improve conventional measures of affordability, fundamental negative factors predominate. Deteriorating labor markets have reduced disposable personal income, and constrained access to mortgage credit. The considerable pace of home price declines and expectations that home prices will fall further has deterred demand.

One expects construction, which will decline at a 20%+ pace in 4Q 2008 and 1Q 2009, to contract more modestly through much of 2009. The recent sharp decline in mortgage rates and further declines in home prices will improve affordability, providing support to sales activity. Over time, inventories of unsold homes will diminish, and construction and home prices will stabilize.

Since the Fed announced its quantitative easing operation, mortgage rates have fallen about 140 basis points, from 5.4% to 4.0% (for a FNMA 30-year current coupon). To date the impact of the declining mortgage rates has been felt far more in refinancing than new purchases, and rates for jumbo mortgages remain sticky. Home prices continue to fall: the Case-Shiller Home Price Index (for 20 metro areas) has fallen through October 2008 from its July 2006 peak, and the pace has picked up with the intensification of recession in recent months. Price declines have been considerably sharper in problem regions that experienced the greatest excesses in construction and home prices, including California, Florida, Nevada and Arizona. Given the projection of a large decline in home prices in 4Q 2008, one expects roughly another 10-12% declines in home prices in 2009, with the Case-Shiller index approaching its rental-equivalent measure late in the year. The adjustment will involve outsized declines in select regions.

While we look for residential investment—the real value of housing construction—to trough late in 2009 following a brutal four-year contraction, home price declines may continue somewhat longer. The wild card is likely to be potential improvement in credit conditions. As long as mortgage credit remains unavailable and the mortgage market dysfunctional, the possibility is that housing markets will “overshoot” to the downside. Uncertainties—including how much further home prices will fall and what additional relief programs and regulatory changes lie ahead—continue to weigh on mortgage markets and housing.