Will demand pick up?

At present we are not seeing any increase in demand. Existing home sales (EHS) had levelled off at a low level earlier this year (including an estimated 40% foreclosure sales), but took a sharp hit in November. One month clearly does not make a trend but EHS are currently 38% down from their peak. New homes sales have fallen to very low levels despite plenty of inventory. When people are uncertain about their employment status six months forward they are unwilling to make what is typically the largest purchase of their life. We see unemployment continuing to rise strongly over the next year, adding 2.3% to the current 6.7% rate by December 2009. In short, the economy is unlikely to provide any support to house prices for at least a year. Another factor which is likely to prove more and more troublesome for potential buyers is finding the down-payment. Banks now look for a higher down-payment than before while appraisers are likely to be much more cautious in their valuations so that even a 90% mortgage might actually need a 20% or more down-payment and then there are closing costs. This is a challenge to first-time buyers but, as home prices fall and an increasing number of people are underwater on their existing mortgage, it becomes difficult for repeat buyers as well, particularly with their stock market holdings likely down. A crucial factor will be price expectations. How many people will decide that buying now is a wonderful opportunity versus how many will worry prices could fall further? Evidence from past housing busts, in regions of the US and elsewhere, is that buyers take a while to come back. Even when they start to do so, the overhang of inventory discussed above first has to be reduced.

Will lower mortgage rates help?

Until recently, the fall in official interest rates and Treasury bond yields had little impact on mortgage rates. But the December slump in Treasury yields combined with Fed promises to buy mortgage securities is beginning to bring mortgage rates down. The Federal Reserve confirmed in the last week that it plans to purchase $500 bn in agency securities in the next few months. The rate for a 30 year conforming mortgage has now come down to about 5.10% from the 6-6.5% range seen for most of the year, the lowest levels in modern history. The Federal Reserve and government both believe that it is important to keep mortgage rates low – there has been talk of aiming at 4.5% - and the government has reportedly been looking at providing government guarantees in some form, though this may be difficult to implement. The Fed is likely to focus on buying mortgage securities to try to pull the mortgage rate lower. Other things equal, this will surely encourage some buyers to step up. But all the other negatives described above suggest people may still be cautious and wait for house prices to fall further.

New policy efforts may help

The incoming administration is known to view housing as crucial and to be prepared to take more radical efforts to help homeowners and prevent an overshoot of prices. As already noted, keeping mortgage rates low will be part of this strategy. The Fed will be focussed on keeping government bond yields low and reducing the spread between government yields and mortgage rates, which is currently unusually wide. Hence the quantitative measures will focus on this area. The Obama administration is looking at new measures to prevent foreclosures. Loan modification is a crucial area and the new government is likely to push hard on that. One controversial idea is to give judges the power to modify mortgages, which in practice would mean cutting the principal owed as well as lowering interest rates. Obviously such a change would raise the perceived risks for mortgage lending still further, but it might help in the short run. A broader approach would be for the government to encourage the Agencies to refinance most mortgages, even those under water, at low interest rates. Again, this would disturb the housing finance system, potentially permanently, and also expose the agencies to more risk, but might help to prevent home prices overshooting.

The bottom line: the housing bust is not over

Current view is that house prices are set to fall for at least another year and a total decline of 40-50% is inevitable. The risks to that forecast are probably that prices decline even more, as seen in Hong Kong and Japan after their house price bubbles. From the bottom house prices are unlikely to bounce back up again in a hurry. Usually, after a bubble bursts, people remain cautious for some time. Moreover, regular consumer price inflation is likely to be near zero, giving very little support to asset prices. Current market prices of mortgage securities probably already reflects this further house price decline, though it is not entirely clear whether financial institutions have all written down those securities to market prices. It is also not clear whether households have fully realised how low house prices will go. Until last summer, the decline was mostly confined to limited areas of certain states, principally California, Florida, Nevada, Arizona and Michigan. Now it is spreading to every area.

But this does not preclude an economic recovery

The likelihood is that consumer spending will continue to be constrained as households come to terms with the sharp deterioration in their balance sheets. But the evidence from house price crashes in other countries in the past, whether Scandinavia and the UK in the early 1990s or Asia in the 1990s, is that the economy can still recover even if house prices are still falling, though the pace of growth may be constrained. The US economic recovery is likely to be slow, held back by continuing asset price weakness and financial sector stress, but expansionary monetary and fiscal policy as well as the natural cycle in the economy should ensure it gets started before the end of 2009. This is not to say that the next 6 months will be smooth.  A deep recession is expected, with further serious distress and the potential for major new bankruptcies (outside the financial sector which is now largely underwritten by the government). But the economy is likely to turn up before house prices bottom and, indeed, will be a key factor in establishing that bottom.