June 7, 2007 (Housing Byte)

By Dean Baker

The ratio equity to home value will fall below 50 percent before the end of next year.  

The quarterly Flow of Funds data from the Federal Reserve Board show that homeowners are still taking on mortgage debt at a healthy pace even as their homes have largely stopped appreciating in value. Homeowners increased their mortgage debt at a 5.4 percent annual rate in the first quarter, adding debt at an annual rate of $510 billion. This is rate of borrowing is down from the 9.3 percent growth rate in 2006, but it is considerably more rapid than the 2.0 percent rate of house appreciation reported for the first quarter.

As a result, the ratio of equity to home value continued to fall. At the end of the first quarter of 2007, the ratio of equity to home value stood at 52.7 percent, another record low. This ratio stood at 54.3 percent at the end of 2005. It had been at 57.9 percent as recently as 2000, and was close to 70 percent until the nineties. This drop in the ratio of equity to value is especially disconcerting given the country's demographics. With much of the baby boom cohort at the edge of retirement, it would be expected that the ratio of equity to value would be near record highs.

There is reason to believe that the ratio of equity to value will continue to decline for the foreseeable future. The inventory of unsold new and existing homes both stand at record highs. The 4,200,000 stock of unsold existing homes is more than a year's supply at the pre-bubble sales rates of the mid-nineties. Furthermore, the surge in foreclosures ensures that a large additional supply will be entering the market well into 2008. This will put substantial downward pressure on prices, which are already falling in many areas. With slowing productivity growth and rising material prices putting upward pressure on inflation, mortgage rates are also moving higher, which is yet another negative for the housing market.

Falling house prices are likely already curtailing many homeowners' ability to borrow, which undoubtedly explains the slower pace of borrowing in the first quarter of 2007. Tighter lending standards in all segments of the mortgage market, but especially the sub-prime market, are also likely having an impact on borrowing. However, this effect will be felt more in later quarters, since this process just began in the first quarter.

Even with a slower rate of borrowing it is virtually certain that the ratio of equity to value will continue to decline, primarily because of weak house prices. With even a modest drop in house prices, the ratio of equity to value is likely fall below 50 percent for the first time ever before the end of 2008 and quite possibly before the end of 2007.

Among the other interesting items in the first quarter Flow of Funds data, state and local government retirement funds continued to accumulate assets at a very modest pace. Net acquisitions of financial assets were just $8.2 billion in the first quarter, which is almost identical to the $33.9 billion rate of acquisition for 2006. By comparison, the federal government plan, which covers many fewer workers, increased its financial assets by $43.6 billion and $201.0 billion in first quarter and 2006, respectively. This suggests that many state and local government pension plans may not be adding sufficient reserves at present. If the economy turns down and government budgets become strained in future years, then they may have lost an important opportunity to shore up these funds.

The continuing drop in the ratio of home equity to value shown in this report implies both serious short-term and long-term problems for the economy. The short-term problem is that the home equity financed consumption boom, which has supported the economy since the recession is likely to be coming to an end. The long-term problem is that tens of millions of baby boomers are approaching retirement with relatively little equity in their homes and almost no assets outside of their homes. Their retirement income will be almost entirely dependent on Social Security.