Real estate's major impact on today's ever-changing economy

Adhvith Dhuddu, CT regular columnist

Wednesday, January 30; 12:00 AM

The housing market's tumble late last year, which started out as a normal correction in home prices, is now ominously appearing to have opened the Pandora's Box of a liquidity and credit crisis. Discouraging data released over the last few weeks has only dampened the sentiments of the economy and worsened the housing market outlook. Although a stimulus package has been announced recently, many fear it to be too little and too late.

A closer analysis of the real estate market will reveal a profuse amount of disturbing data confirming that this is just the beginning of a slump in home prices. For the first time in decades, sales of new homes dropped by 26 percent last year to stand at 774,000, exceeding the old record of a 23 percent decline in 1980. Likewise, sales of existing homes plunged 13 percent last year (biggest drop since 1982), and construction of new residential buildings dropped by close to 25 percent, again a record drop, the largest since 1980.

The average market price of a home is largely determined by the supply-demand relationship, and during the last six months demand declined. Unfortunately, supply has either increased or stayed constant. The inventory buildup of close to 2 million homes exceeds the medium term need of 1.5 million, and it would take close to a year to eliminate this backlog (given the economy doesn't enter a recession and grows normally at 2 to 3 percent). This will undoubtedly create an imbalance, leading to lower home prices in the future. Sellers have already been cutting their asking price to move homes out of inventory. Prices of new homes will be dented the most, as old and used homes tend to find a market in a depressed down cycle. Other credible proxies, like the stock prices of Home Depot and Lowes, also hint a significant slowdown.

Remember that a majority of borrowers use their house value as collateral for loans, and in the case of rapidly declining home prices, banks and lenders usually prompt faster and bigger payments fearing a rise in defaults. The subprime crisis found its roots for this exact reason. A double whammy of declining home prices and increasing number of defaults sent the banks and lenders into a spin, leading to multi-billion dollar write-downs and revaluations and tighter lending standards.

Housing has a significant 4.5 percent share in the GDP calculation, and unfortunately, because only new home sales are counted, gloomy GDP numbers could surface to push the country into a recession (two negative quarters of GDP growth confirms a recession).

The woes of the economy only pile up, as the weak dollar is attracting foreign buyers to stock up on U.S. homes. Although this has its own pluses and minuses, a surge of foreigners buying U.S. homes is the last thing we need when in the process of cleaning up our own mess. The only silver lining of a weak dollar is the surge in exports, which many optimists feel could overwhelm the housing market slump and prevent a recession.

Only a crisis often forces corrective action. This is clearly happening now, as the stimulus package not only puts money into the hands of consumers but is trying to revamp Freddie Mac and Fannie Mae. The approved package will now allow Freddie and Fannie to approve bigger mortgage packages by increasing the loan limits. This way, more loans are approved and liquidity remains average.

The biggest fear is the potential of this slump slipping over to other sectors of the economy. Just as homes are used as collateral, other assets, such as stocks, mutual fund holdings, etc., are also used as collateral. If asset prices across the board start to decline (stocks already have), the problems could multiply to get out of control. Recently, for the first time in 23 years, the president of the International Monetary Fund appealed to many nations to stimulate their economies to avoid a liquidity crisis.

Last week, the Federal Reserve convened an emergency meeting to cut interest rates by 75 basis points, preventing a crash in the stock markets. Again, this broke all records and was the biggest one-time cut in interest rates in two decades. All these numbers draw parallels to the housing slump and banking crisis of 1980, and we could well be at the start of a long drawn real estate market crisis. We can only hope that a recession or a slowdown doesn't convert to a long, drawn-out depression.

Online link to this article:

http://www.collegiatetimes.com/stories/2008/01/30/real_estate_s_major_impact_on_today_s_ever-changing_economy