The Economic Hit from Housing

There are certainly a few cracks in the economy's walls, but its foundation is still solid. A housing-led recession isn't coming.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

Peter Goldstein, Senior Economics Editor, The Kiplinger Letter

March 19, 2007

This economic expansion will survive the housing slump, but not without some damage. In light of ongoing woes in the residential property market -- caused mainly by overzealous mortgage lending -- we're lowering our economic growth forecast for this year by about a quarter-percentage point to 2.5%, which will be the smallest annual advance since 2003. We expect housing's negative impact to be more pronounced in the first half of the year, holding growth to a meager 2% or so, before it accelerates to nearly 3% in the second.

Clearly, ongoing weakness in residential markets is causing pain for many economic players -- homeowners, builders, construction workers, household services firms and real estate professionals, to name a few. The sector's problems are acute in the subprime mortgage segment that caters to borrowers with either poor credit or low incomes, or both. The percentage of subprime borrowers late on their payments was a lofty 13.3% in the fourth quarter, compared with only 2.6% for holders of higher-quality prime loans.

Within the subprime group, the bulk of the trouble involves homeowners with adjustable rate loans, which total roughly 7% of the $10 trillion mortgage market. These folks are currently being hammered by upward shifts in their mortgage interest rates as the low introductory rates expire. Some 700,000 of such loans are likely to go into foreclosure between now and the end of next year because the homeowners won't have enough cash to cover higher payments. Some mortgage lenders are now catching flak for allegedly ignoring standard screening practices so they could sell loans to people who really couldn't afford them.

The wave of bad mortgage news will bruise confidence among both consumers and businesses, prompting them to spend less than expected, especially in the first half of this year. Stock investors are also likely to remain on edge as the coming earnings season in early March reveals the gory details of the mortgage mess' impact on company finances. We expect a number of banks and other types of companies to take big write-offs to cover hits they've taken in residential lending. Note that General Motors, a firm not typically associated with the housing market, recently announced it has set aside $1 billion to cover subprime exposure from its former finance unit.

But don't expect a full-blown crisis for either housing or the economy. The bulk of the mortgage market is solvent, and the increase in foreclosures is nowhere near enough to overwhelm housing demand. In fact, the demand side is showing real signs of life. Demand for mortgages, adjusted for seasonal variations, has gained about 10% since hitting a post-boom floor last August. This is a big plus for the busy spring home-selling season. Also helping demand is ongoing growth in the number of jobs in the economy. History shows that the worst housing slumps were closely linked to downturns in employment.

Meanwhile, fears of a broad credit crunch are overblown. Most major banks are sufficiently diversified and scrutinized by regulators to make a subprime-led financial squeeze highly improbable. There's also no evidence that mortgage lenders are going to pull away from the bulk of borrowers in the prime market. In other words, subprime ills aren't spilling over into other segments.

We continue to set very slim odds for a recession this year. The bottom line is that consumer spending, the real anchor of economic activity, isn't in jeopardy of contracting. Fortunate or not, the subprime meltdown primarily affects lower-income Americans, whose portion of overall consumer spending is rather small. And despite the steep rise in debt loads in recent years, Americans as a whole continue to amass net wealth.

The housing sector, while not suffering from a crash, is experiencing a tough correction this year. At the national level, median house prices are likely to fall about 4% to 5% after they gained roughly 30% during the boom years, 2002-2005. Total home sales are on track to fall about 8.5%, while housing starts will probably decline about 18%. By year end, however, the market will emerge far healthier, and sales and construction trends will shift to a very gradual upward trend.

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