February 13, 2008 (Housing Market Monitor)

Housing Market Monitor

Falling House Prices Force Tighter Lending Standards 

February 13, 2008

By Dean Baker

"Excluding food and gas, January retail sales were almost flat." 

The rapid decline in house prices in many markets is having a predictable effect on lenders: they are tightening standards. Many major lenders are now requiring 10 percent down payments (not borrowed) in markets with rapidly declining house prices. The rationale is obvious; falling house prices will lead homebuyers with small down payments to have zero or negative equity in their homes. Since having no equity in a home hugely increases the default risk, it makes sense for lenders to impose rules that make this situation less likely.

Of course tighter lending standards will be yet another factor putting downward pressure on prices in troubled markets. Requiring 10 percent down payments will exclude many potential homebuyers from the market, and also reduce the amount that other homebuyers are able to pay for a house. This is the sort of downward spiral that is to be expected in a collapsing bubble.

Just as the bubble’s expansion created a dynamic of easy credit and exaggerated appraisals that were self-reinforcing, the bubble’s collapse creates a self-reinforcing pattern on the negative side. The big risk is that the market will actually overshoot on the negative side, with prices dropping lower than their long-term trend level.

This is exactly what happened with the NASDAQ following in its collapse from its peak of more than 5000 in March of 2000. It eventually bottomed out at less than 1200 in the summer of 2002, a level that was certainly below what would have been justified by any realistic assessment of the profitability of the firms in the index. The consequences of the U.S. housing market overshooting on the negative side are likely to be far more serious than the consequences of the NASDAQ overshooting.

We are seeing more evidence of the impact of falling house prices on consumer spending. This was clearly the major factor behind weak December and January retail sales. Analysts may be misled on the strength of the January sales, since the 0.4 percent reported increase was somewhat higher than was generally expected. In fact, most categories of retail spending actually showed nominal declines from December. Almost the entire increase was due to higher spending at food and beverage stores and gas stations. The higher spending in these sectors in turn was almost certainly driven by higher prices.

Pulling out these two sectors, spending was up by just 0.07 percent for the month. Excluding these sectors, year over year retail sales were up just 1.2 percent in January. This is consistent with the very weak reports from the chain stores released last week. 

On Monday, USA Today reported the results of a survey by Zoomerang showing that two out of three homeowners planning home improvements this year were putting them off, and 11 percent were canceling them altogether. (The 11 percent are presumably part of the two-thirds.) This is another predictable effect of declining home equity. This will appear in both residential investment (renovation and actual building) and consumption (new appliances like stoves and refrigerators). 

Efforts by Congress to boost the housing market by raising the cap on loans that can be purchased by Fannie and Freddie may prove misguided for several reasons. First, if the GSEs buy more high-priced mortgages, it diverts money that could have otherwise been available for lower priced mortgages. A $600k mortgage uses as much capital as three $200k mortgages.

Second, by pushing the GSEs into a new market at troubled times, Congress may be further jeopardizing their financial health. The GSEs will be taking big hits already from losses on mortgages that fit under their current caps. If they expand into an area in which they are less experienced, at a time where many of these mortgages will go bad, it is virtually certain that they will make some serious mistakes and possibly incur large losses. The public and the housing market will be best served if the GSEs move very cautiously in buying up higher priced mortgages. If they have to turn to Congress for a bailout in a year or two, the public will be very angry at Congress for raising the caps.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net). CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.

Click here to subscribe to the HMM