Dean Baker
Truthout, March 14, 2007

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As reports of problems in the mortgage market build, the number of people who view a collapse of the housing market as a serious possibility is growing rapidly. At the moment, the surge in defaults is taking place primarily in the sub-prime market, which is composed of borrowers who have poor credit histories. However, the problems are likely to affect the broader housing market and the economy as a whole before the end of the year.

The basic story in the sub-prime market is straightforward. Mortgage bankers were anxious to sell mortgages even when they knew that the borrowers could not make the payments, because they derive their income from selling the mortgage, not holding it. Hundreds of thousands of low- and moderate-income homebuyers were lured into buying homes by discounted "teaser" rates on mortgages. These teaser rates would reset to market rates, typically after three years, at which time many borrowers would be unable to make their monthly payments.

As long as house prices keep rising, everything works fine. Homeowners can always borrow against their equity to make their monthly payments, or they can sell their home, pay off the mortgage and pocket whatever gains they may have.

However, in 2006, supply finally outpaced demand, and home prices began falling. This led to a huge surge in defaults in the sub-prime market. As a result, some sub-prime lenders have gone bankrupt, and many others are leaving the business or radically curtailing their lending. The same thing is happening in the Alt-A market, which consists of borrowers with somewhat better credit ratings, but still below prime.

The housing optimists claim that the problems in the mortgage industry will be restricted to these sectors and will not spread to the larger prime market. However, the sub-prime and Alt-A markets together accounted for 40 percent of the market in 2005. If lending in these sectors is sharply curtailed, then a huge portion of potential homebuyers will be excluded from the market. According to an analysis from the Bear Stearns investment bank as many as 1.1 million potential homebuyers may be excluded from the market in 2007 because of tighter credit conditions.

While home sales did cross 8 million in 2005, as recently as 1995 the number of homes sold in a year was under 5 million. There is no way that 1.1 million potential buyers, or even half this number, can be excluded from the housing market without a substantial impact on house prices.

It is also important to remember that this credit tightening is occurring against a backdrop in which house prices are already falling. The median house price nationwide fell by more than three percent over the last year. On the supply side, the inventory of unsold homes is up by more than twenty percent from last year. In addition, a record high percentage of these homes are vacant. The vacancy rate of ownership units is more than forty percent higher than in any prior housing slump.

This describes a scenario of more downward pressure on prices, which will lead to more defaults and foreclosures. This in turn will lead to further tightening of credit and more homes being subject to distress sales through foreclosure.

All the experts who used to insist that this scenario could never happen are now insisting that the scenario does not describe the situation in their favored housing markets. While each local market does have its own dynamic, the run-up in housing prices was nationwide. Not everywhere is going to experience the same decline, but there will be few, if any, areas that escape unscathed. The fact that a particular metropolitan area has a sound economy with a healthy labor market should offer little solace - that doesn't mean that house prices are not overvalued.

The tech bubble in the stock market provides an appropriate analogy. While the largest overvaluations were in the tech sector and especially in the dotcoms, virtually all stocks had become overvalued. As a result, there were very few stocks that did not experience a sharp price decline from 2000-2002. The fact that a company had strong growth and solid profits didn't matter - overvalued stocks still fall when a stock bubble collapses. Similarly, overvalued houses will fall in price when the housing bubble collapses.

The vast majority of metropolitan areas are likely to see a fall in housing prices over the next few years, with the biggest declines likely occurring in the areas that had the largest run-ups (largely the two coasts). Few people will be insulated from the impact, just as very few stockholders were unaffected by the 2000-2002 crash. Don't let the happy-talk real estate peddlers tell you otherwise.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.