Facing the Housing Mess

Alan Greenspan said he was "puzzled" about why the subprime mortgage mess hadn't had a greater impact on the economy.

That was last month.

The latest economic data show that indeed the combined crunch of higher mortgage payments and higher energy prices are sapping the sales of companies ranging from WalMart to Liz Claiborne to General Motors. Overall economic growth for the first quarter was an anemic 1.3%.

Clearly, the mortgage mess impacts all homeowners, even indirectly. If the house down the block is sold at a foreclosure auction, how much is your home worth? The thought is chilling for millions of Americans who count their home as their most important asset -- both financially and psychologically.

How bad can things get? How far can home prices fall? It depends on which economist you ask. Months ago, Robert Z. Aliber, retired University of Chicago economics professor, told me home prices would drop 30%. The forecast was so shocking that I hesitated to print it.

The latest gloomy forecast -- backed up by compelling data -- comes from A. Gary Shilling, frequently bearish but even more frequently correct. To be blunt, Shilling is forecasting a drop of 40% to 50% in home prices in the more overpriced areas such as California, Florida and Las Vegas or downtown condo markets. And the ordinary homeowner, he says, could see a decline of 10% to 15% in the value of a suburban home.

Shilling's forecast is based on the historic value of homes, adjusted for what he calls the "McMansion effect" of today's larger homes being worth more. Using historical data compiled by Robert Shiller, he says that home prices would have to drop 45% to get back to their historic normal levels.

Existing-home prices peaked in October 2005 and are down about 4% on a national basis through March 2007. But Shilling says the worst is yet to come, because he estimates that it takes about 18 months from when home prices first start to slide for homeowners to recognize that this is not a fleeting blip. Now the "interval of denial" is about over, and homeowners will start realizing that if they want to sell, they'll have to cut prices, says Shilling. But actual recorded sales at lower prices will take a few more months to show up in statistics.

Even worse, Shilling says there is no way this problem can be confined to the housing market. He estimated that overbuilding has resulted in at least 2 million "excess" homes -- a factor that will depress not only homebuilding but related industries as well in the coming years. Already, housing starts have fallen 33% from their peak of 2.265 million in January 2006, to 1.518 million in March. Shilling predicts an additional 25% decline in housing starts and says there is no way that capital spending by businesses can pick up the slack. Ugh!

It's a good thing there's a contrary opinion on this subject. Economist Brian Wesbury takes an opposite viewpoint. He points out that the housing industry has fallen victim to the Fed's 17 consecutive rate hikes (before the recent period of stability, which the Fed said Wednesday would continue).

Wesbury contends that "absurdly low interest rates" in 2002 to 2004 pushed housing activity beyond fundamental levels and created incentives for buyers to make purchase decisions that seem irrational now. Today, he says, rates have moved "closer to normal," causing a housing crunch.

But Wesbury says that since rates are not excessively high today, there should be little impact on other sectors of the economy. While acknowledging the pain of the housing slump, Wesbury says that overall low unemployment and strong manufacturing indices demonstrate an accelerating economy, despite continued woes in housing. Says Wesbury: "After the shock of rate hike works its way through the system, the ample liquidity of an easy monetary policy will reassert itself," resulting in renewed growth.

The stock market seems to agree with Wesbury. Shilling predicts "an American recession to commence later this year, and to extend globally in 2008." Time will tell.

In the meantime, under the heading of "mortgage news you can use:" Washington Mutual has just announced a new mortgage product that will provide the flexibility of an adjustable rate mortgage with the ability to lock in a fixed rate at any time with no cost the first time you make a change. In fact, you can relock your fixed rate again if rates drop, or return to an adjustable rate -- all without a new closing as is typical with refinancing. This process is allowed up to two times per year and costs only $250 after the first free change is made.

Unfortunately, this won't help subprime borrowers who are currently struggling. You must have at least 10% equity in your home and a good credit score to get this new mortgage.

Tough times always bring out American ingenuity. And that's The Savage Truth.