Housing Market in Ruins

THERE are two things everyone knows about American economic recoveries. The first is that the housing sector traditionally leads the economy out of recession. The second is that there is no chance of the housing sector leading the present economy anywhere, except deeper into the mire. In the two years after the recession of the early 1980s housing investment rose 56%; it is down 6.3% in the present recovery. America is saddled with a debilitating overhang of excess housing, the thinking goes, and as a result is doomed to years of slow growth and underemployment.

The economic landscape is unquestionably littered with the wreckage of the crash. Home prices languish near post-bubble lows, over 30% below peak. The plunge in prices has left nearly a quarter of all mortgage borrowers owing more than the value of their homes; nearly 10m are seriously delinquent on their loans or in foreclosure. The hardest-hit markets are ghost neighbourhoods, filled with dilapidated properties. Housing markets are far from healthy. Yet current pessimism seems overdone. A turnaround in sales, prices and construction may be closer than many imagine.

The potential for a strong housing recovery lies in the depths of the bust. America’s housing boom was remarkable for its impact on prices and for the flow of new households into the market, which pushed the home-ownership rate above 69%, the highest on record. Construction also boomed, but less wildly. Housing completions were above average during the boom, but not unusually so, particularly in light of the relatively restrained growth in housing supply during the 1990s (see chart 1). The bust, by contrast, dragged new construction to unprecedented depths. At the current rate, fewer homes will be added to the housing stock this year than in any year since records began in 1968.

America therefore has only a minor problem of excess housing supply. Under normal conditions, that small glut would quickly have disappeared in a bust on the present scale. But America is now adding new households at a rate well below normal—not because the population is growing more slowly, but because, for example, young people are opting to stay longer in their parents’ home. According to one analysis, there are now 1.5m more young adults (aged 18 to 34) living at home than would be expected, given long-term trends. Thrift imposed by a sickly economy is probably the principal cause. Better prospects for young adults would encourage the forming of new households, buoying the demand for new homes.

Although total housing supply is not far out of line, the distribution of supply between the rental and owner-occupied markets remains distorted. In September the inventory of newly built houses for sale fell to its lowest level since record-keeping began. But the inventory of existing houses, while falling, remains high. In September the figure dipped below 3.5m, down from over 4.5m in 2008 but still above the 2.5m registered early in the last decade. The total number of vacant homes for sale has steadily declined and is at the lowest level since 2006. But the pace of sales remains extraordinarily low, and foreclosures will continue to prevent a faster decline in inventory.

Rental markets, by contrast, look far stronger. America’s rental vacancy rate stood at 9.8% in the third quarter of 2011, down from a high above 11% in 2009. Vacancy rates in some cities are strikingly low—2.4% in New York City, for instance, and 3.6% in San Francisco—which translates into rising rents. Nationally, rents rose 2.1% in the year to August, in stark contrast to house prices (see chart 2).

Strength in the market for rentals is beginning to seep into the more troubled owner-occupied sector. Rising rents help housing markets heal on both the supply and demand side, by encouraging renters to consider buying and through the movement of supply into the rental market, easing the glut of houses for sale. The Obama administration hopes to take advantage of better rental conditions to unload some of the more than 200,000 foreclosed-on homes held by the two government-sponsored mortgage giants, Fannie Mae and Freddie Mac, and the Federal Housing Administration (which account for roughly half of all such inventory), on to investors who may rent the properties out.

Rental-market strength is also rousing a long-dormant building industry. New housing starts rose 15% from August to September of this year, driven by a 53% surge in new structures containing five units or more. In the three months to September construction employment rose by 29,000 jobs. The sector is still some 2.2m jobs below its pre-recession peak, and new hiring there would help a dismal labour market.

A stranglehold on lending

The convalescence, however, may be complicated. Housing recoveries have seemed imminent before, only to peter out when the economic outlook weakened. Foreclosures are falling, but they continue to place downward pressure on prices. New proposals from the administration aim to help underwater borrowers refinance, but more lavish assistance for troubled borrowers is too politically unpopular and expensive for Washington’s taste.

The macroeconomic environment, too, remains troublesome. Housing markets could lurch sharply downwards if a new shock, perhaps from Europe, disturbed the global economy. A new financial shock could rattle confidence and send buyers fleeing, while the flow of mortgage credit from exposed banks would dry up. Lenders carry the scars of the housing crash. Cautious banks are reluctant to lend. Housing-finance institutions, having kept credit standards too loose during the bubble, now seem to be setting them too tight, preventing rising demand and low rates from translating into new sales.

Yet once the housing sector finds its footing it may quickly gain momentum. A switch from falling to rising prices should encourage banks to make more loans. Higher house values would chip away at negative equity, stanching the flow of defaults and foreclosures.

A new analysis by Goldman Sachs argues that housing can “punch above its weight” in recoveries. Rising house values boost confidence and spending, and home construction is more labour-intensive than other sectors. A housing recovery should also give monetary policy more traction; low interest rates do less to perk up the economy when housing markets are depressed. Indeed, the Federal Reserve is considering nudging recovery along by buying mortgage assets, which should ease the flow of credit to borrowers.

Such hopes for housing would smack of an effort to reanimate a corpse, had the bust not so far outpaced the boom. But a turnaround now seems probable on many measures. If it happens, the recovery should become much more vigorous.

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