Are Housing Troubles Standing in the Way of Growth?

U.S. home prices (as measured by the Case-Shiller index) have declined 33% since they peaked in 2006. Overall, Americans have seen home values drop further and faster than they did during the Great Depression.¹

The housing industry has been credited with helping to boost economic activity after past recessions because residential construction requires the hiring of workers and creates demand for goods and services related to the formation of new households. However, the pace of the current recovery has been slower than expected, and many economists (including Federal Reserve Chairman Ben Bernanke) blame the housing sector for ongoing weakness in the economy.²

In previous economic recoveries, housing accounted for 15% to 20% of overall growth, but in 2009 and 2010 it added only 4% to gross domestic product (GDP).³ One reason why the industry has not played its former role is simply the large imbalance that currently exists between housing supply and demand.

Too Much Supply

Falling home prices, the financial crisis, and high unemployment have resulted in a large number of borrower defaults and foreclosures. It’s estimated that 4.5 million households are either three months behind on their mortgage payments or officially facing foreclosure proceedings. The historical average for mortgage delinquencies is around 1 million households. Economists have warned that prices may not hit bottom until this large “shadow inventory” of distressed homes is cleared out.⁴

In recent months, the pace by which lenders are taking back homes and reselling them has slowed due to court backlogs and other legal issues. A number of federal and state officials have also charged that loan servicers did not always follow foreclosure procedures required by law and are currently demanding reforms and negotiating a potential settlement with the nation’s largest banks. Foreclosures are likely to hit the real estate market at a faster rate once the legal issues are resolved.^5–6

Too Little Demand

Buyers have not returned in large numbers despite historically low interest rates and greater affordability. In the wake of the financial crisis, stricter underwriting standards and larger down-payment requirements have made it more difficult to qualify for mortgages. Employment uncertainty, a lack of consumer confidence, and fear that prices will fall further are also reasons why many potential buyers have stayed out of the housing market.⁷

Demand was also affected by the fact that fewer new households (which includes renters and buyers) were formed during and after the recession. The number of new households dropped from 2 million in 2005 to 578,000 in 2008. Many couples have postponed marriage or divorce, and young people are living with parents or sharing housing with roommates to reduce their living expenses.⁸

Home Building Slowed

Faced with lower prices overall and deeper markdowns on distressed sales, home builders are unable to compete with the available supply of existing homes. Government statistics show that housing starts dropped to an annual pace of 477,000 units in April 2009 from a peak of nearly 2.3 million in January 2006. Even though housing starts rose to 546,000 for the 12 months ending in May 2011, the rate is still far below the 1.2 million homes per year that is generally considered healthy.⁹

Relatively little new home construction is also the main reason why the housing industry has failed to contribute significantly as a component of GDP. When $300,000 is spent on land, labor, and materials to build a new home, it adds $300,000 to GDP, whereas the sale of an existing home adds only about 5% to 6% of the purchase price (in brokers commissions and other sales-related costs).¹⁰

The Key to Progress

Roughly 950,000 new households were created in 2010, and Moody’s Analytics has forecasted an average of 1.2 million annually over the next decade.¹¹ If the employment situation and wage growth continue to improve in the broader economy, more people may have the financial means and the confidence to move out on their own. That could drive up rent prices and make home purchases more desirable, which could eventually help strengthen the housing market.

It’s possible that modest economic growth will continue despite the headwinds created by the housing crisis. However, high-profile economists have cautioned that more robust growth could be out of reach until the housing industry gets back on its feet.

1, 4) CNBC.com, June 14, 2011
2, 7) USA Today, June 23, 2011
3, 9) The Associated Press, June 16, 2011
5) The New York Times, June 19, 2011
6) CNNMoney, June 16, 2011
8, 11) The Wall Street Journal, June 4, 2011
10) CNNMoney, May 31, 2011

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