Wednesday, March 28, 2007

The Recession That Never Occurred

The phenomenon of a housing bubble has been widely used, but not much news has been focused on it until recently due to the huge boom occurring in the early 2000s. The most fundamental way that a housing bubble forms is through a fairly simple process. The process starts with general economic expansion with increased employment which drives demand for homes. Initially the increase in demand causes supply to shrink and vacancies to disappear causing prices to start increasing. The increase in housing prices causes homebuyers to forecast higher prices in the future either leading to purchase of an investment property or a new home since homes in the future will be more expensive. The bubble comes about once supply reaches demand and inventories of new homes increase, prices start to decline and the bubble is fully visible. In addition, people must be aware that the prices are increasing above a fundamental level of regular economic growth. So this is the case in the mid-1980s and the current state of the housing market in 2007.

The first progression of a housing bubble is the expectations of homebuyers in at the time. Whether people believe a bubble is going to appear is often the starting point for a housing bubble. So, a study in 2003 appearing in Brookings Papers on Economic Activity mention that many buyers did not believe they were in a housing bubble because they felt there was little risk in buying a home, which Is a factor in bubble situations (Anonymous 2003). Though the study's conclusion reveals that since many people were buying "strictly for investment purposes" it is a key factor in a housing bubble forming. Furthermore, if people are buying for an investment they are buying for the short run, and in combination with low subprime mortgage rates can only pay for the house for a short period of time while the interest rate is low and if housing prices start to fall and these investors cannot sell nor pay off the raise in their non-fixed interest rates, then there are defaults on loans and many disasters can spiral out of this situation. The good thing about 2003 is that housing prices continued to soar up until 2006 when the bubble was pretty indistinguishable and many homebuyers became wary. In early 2007, several articles were published regarding the current state of the housing sector and whether economists felt the housing sector would lead to national economic problems such as a recession.

The housing bubble is in a state of limbo. Many experts acknowledge the current decline in prices, but some expect it to end soon while others feel it will continue for some time. The market is in a state of correction. The current decline will continue for a little bit longer, but should level out within the next couple of months as the 2nd quarter is usually the hottest time of the year for real estate purchases. The only negative to this information is a recent article by Rex Nutting, a writer for, that states new-home sales fall to a seven year low and February's inventories of unsold homes is at a 16 year high. The negative out of this information is that February is suppose to be a strong month and with the numbers being worse than January it shows no signs of slowing down. Though, many experts suggest that the true indicators cannot be understood until March's numbers come out. One such expert is Stephen Stanley, chief economist for RBS Greenwich Capital, who admits that "It is dangerous to overinterpret the February numbers given the weather, so it is probably best to wait until March and see what a more normal weather month brings" (Nutting 2007). Despite the poor numbers and enormous amounts of unsold new homes, there are still positive economic conditions and relatively low mortgages rates that encourage buying. The only sure deterrent for many homebuyers is the expectation that prices will continue to drop, so they might as well hold off on buying a new home. Furthermore, if the low February numbers were so bad, why was there not a major market downturn or recession like symptoms? In response to the news Jay Suskind, head of trading at Ryan Beck, mentioned "certainly in the last day and a half it has been about housing concerns, but the flipside is that the market closed up nicely yesterday and we're seeing some of that today," in addition stating "The market bends but won't break and has been very resilient …the market is saying that it's confined to housing concerns and there is a sense that perhaps we are close to a bottom in housing" ( 2007). So, Suskind feels that the business world understands the housing concerns, but feels the correction will end shortly. Since there was not a huge drop in the market and the small drop only lasted a day, it is noticeable that many people do not believe a recession is coming about or much more severe housing problems.

In contrast, the housing market is on a decline and cannot be entirely predictable. Many experts suggested February to be better than it was, but that was not the case. So, some experts are expecting two years for a turnaround while others expect a start up later in 2007. David Seiders, chief economist for the National Association of Home Builders, feels that 2007 will be the first nationwide decline in housing values ever. He does not feel it will be a huge stating that "It won't be a big decline, maybe 1%" (Kerch 2007). The bottom line is that it is the first predicted decline in housing values for a single year ever, which is significant. Seiders main concern is the "seriously large inventory situation (of new homes)," but he believes that there will be a gradual recovery over the next two years. Despite, the relative safe standing by Seiders he has continuously decreased his outlook for new home sales over the past month from 2% to 4% to 8% decreases in home sales this year. The negative and continuous changes in outlooks show some uneasiness in his predictions and a longer than expected turnaround. In addition, on the blog "housing Crash Blog" the writer, though may not be too credible, suggests that housing prices could be falling for "5 years or more" (Housing Blog 2007). The argument he makes is that mortgages rates have been increasing due to the "trillions of dollars" in unpaid loans that mortgages institutions will have to absorb. Therefore, this raises the mortgage rates and also does not allow partially risky homebuyers to obtain loans. Thus, home prices will continue to fall since no one will be able to afford them for awhile. This follows the suit that "cheaper money drives up housing prices… reverse the process and you get the logic of bursting bubbles" (Jubak 2005). In his defense, I feel he has a valid point, but five years is a ridiculous amount of time when mortgage rates are still near record low levels, though mortgage companies are tightening up their credit standards. In response to the blog Frank Nothaft, chief economist for Freddie Mac – one of the largest mortgage lenders, mentions "We should hit the trough (of the housing bubble) in the first half of the year. But we're a few years away from robust levels of activity we saw in 2005" (Kerch 2007). Furthermore, the housing market is unpredictable in its current state and most experts have been off in housing numbers for the first two months of 2007, which is quite disappointing. The numbers have been off and some have the economists, but I still see the housing bubble slowing down in mid- late 2007 without general economic hardships.

Despite the predicted decline in housing prices for the year and general uneasiness in the housing sector, our economy is still strong and a recession is quite unlikely. The strength of the economy while the housing sector is dropping is a significant factor in the conversation of a housing bubble. Since, approximately 5% of our GDP comes from housing construction one would think the new-homes sales number would have had a larger affect on the US economy. In 2005 Dean Baker, co-director for the Center for Economic and Policy Research, mentions that housing prices are surging well above the fundamental level which will generate a housing bubble that will cause problems due to the large amount of evenly distrusted wealth across the nation. He makes a point that "the collapse of the housing bubble will throw the economy into a recession, and quite likely a severe recession" (Baker 2005). Baker mentions that home construction has been increasing a near record pace for a few years and that once the market cools off there could be a major drop off of 40% equivalent to 2% of GDP. In addition, he adds that the decrease in demand will add about 2% of GDP and if unemployment follows suit then several millions jobs will be lost as well. Furthermore, the government could not currently boost the economy out of recession due to our large deficit. So, in effect the recession would be quite severe if it were to occur. The reason the recession will not occur is because the housing market has been in decline for a year now and the economy is still in good shape. David Seiders states "One of the good things is that the U.S. economy has been able to handle the dramatic correction in housing…GDP growth, unemployment, the overall inflation situation and interest rates have all been positive despite housing's woes" (Kerch 2007). In addition, the stock market has retained its strength despite housing issues. Since the economy is stable and many experts perceive the housing sector to continue its struggles for some time, it is a safe and very likely occurrence to believe the US economy will not enter a recession. The housing sector is under a major correction process due to the surging boom of 2004, 2005 and early 2006, but the overall economy is still strong and a recession is quite unlikely.

No comments: