For Better, For Worse! What Will Happen to the Housing Market When Tax Credits Expire?
USDA economist explains what to look for in a housing recovery and how the market may react when federal tax credits expire this year.
By Dr. Al Schuler
Date Posted: 3/1/2010
With the housing sector being such a critical piece of the U.S. forest products industry, many want to know when it will rebound. The good news is that housing appears to be stabilizing, which means that prices have stopped falling. This is due in large part to a variety of stimulus packages and tax credits that are temporary although they were recently extended to the end of May.
The big question is, “What will happen to the housing market after the tax credits stop?” Most analysts agree that the overall U.S. economy, particularly consumer spending, must get much healthier if a housing recovery is to have legs. Much of consumer spending is tied to optimism regarding the job market. Unfortunately, that is going to take time to fully recover because unemployment is expected to remain high through 2010.
Realistically, once the stimulus money is gone, housing prices must still come down further in some markets before a complete recovery can sustain itself. The housing market is likely to have some bumpy numbers over the next year as the tax credits end and the market finds the real bottom. House prices are being propped up by various programs, and I believe this only delays a meaningful and sustainable housing recovery.
Another huge question mark is what will happen when/if the federal government decides to reduce its level of support for Fannie Mae and Freddie Mac. Both are government-sponsored enterprises (GSEs) that have been heavily involved in the housing market for over a quarter of a century. The Treasury Department has covered $111 billion worth of their losses so far. Many have argued these measures were necessary to prevent a collapse of the U.S. housing market. But, some question whether the U.S. government will be able to keep up this pace indefinitely as the GSEs lose billions each year. Eventually, the market is going to have to move to a more stable solution. In fact, more articles are appearing calling for reform in the residential mortgage markets with special emphasis on mortgage servicing, including counseling1. Regulators have been paralyzed as they search for a better solution and the right time to enact it. But you don’t want to make the wrong change at the wrong time.
Consumer spending remains suspect as unemployment stays at 10%. People are less likely to want to buy a home if they don’t feel confident about their employment. The unemployment situation is clearly improving. If this continues, the economy will rebound and housing will strengthen. The unemployment situation is probably the single greatest indicator to watch as a sign of long-term, sustainable growth in the overall economy.
Okay, there is some good news. I believe we have turned the corner, both with the U.S. economy and housing. Things seem to have reached a plateau or in some cases are improving. Our financial system is still a bit shaky, and will remain riskaverse (a fancy word for continuing credit tightness) until capital ratios improve. This means that companies and consumers will still struggle to get loans in many cases, which may keep some from buying a home or expanding their business.
Looking specifically at housing numbers, total starts were down 4% in December, reaching an annual rate of 574,000. The good news was the 11% increase in total permits and the 8.3% increase in single family permits. The increase in permits is good, but this is a fairly natural occurrence with the spring building season approaching. Starts are still terrible despite mortgage rates now dipping below 6%. But at least the market is headed in the right direction.
D.R. Horton, one of the country’s largest new homebuilders, recently reported that during the three months that ended December 31, 2009, its net sales orders were 45% higher than a year ago. This represents the second consecutive quarter of growth from the comparable prior year quarter.
Horton warned, “Our sales and gross profit could be severely impacted by prolonged weakness in the economy and continued high levels of unemployment as well as by the scheduled expiration of the homebuyer federal tax credit in June 2010, and the announced end of the Fed’s open market purchases of mortgage-backed securities in March 2010.”
This once again points to the uncertainty of what will happen when federal dollars flowing into the housing situation are curtailed.
Basic laws of supply and demand are at work in the market. A large inventory of existing homes continues to grow, which means there are a lot more sellers than buyers even though the number of buyers has increased over recent lows.
Demand depends on price and affordability. Affordability is a function of mortgage rates and household income. Supply (new construction) is partly a function of cost, but the real problem today is supply in the resale market. Foreclosures were up 28% in 2009 versus 2008. This adds to downward price pressure by adding to the housing inventory.
Resale prices are so low that they are making it extremely difficult for new home builders to compete. Until foreclosures stabilize, this action will continue. Another factor affecting new construction is the price to rent ratios. These are still too high in most cases, which means that renting remains attractive to many potential first-time buyers. Even though house prices are coming down, record rental vacancy rates (currently exceeding 11%) are driving rental rates down too.
House prices must come down to a level where enough people can afford the payments. This means the job picture must improve, and, lending must “unthaw”. That is happening very slowly – e.g., FHA, a major government mortgage writer, now requires higher down payments. Other lenders are doing the same – in addition, credit checks are getting tougher.
Foreclosures continue at a high rate, and the “shadow inventory” keeps growing. This includes the inventory of homes not officially listed by the banks, plus people who will sell their homes as soon as prices improve; homes currently in foreclosure that will end up on the market; and future homes that will end up in foreclosure. Nobody really knows how high these numbers could go. However, a recent Wall Street Journal article (James Hagerty, Jan 27 – Housing momentum builds, but perils persist), suggests that there are more than seven million households that are behind on mortgage payments or in foreclosure. These results contribute to the continuing disarray in the U.S. mortgage market.
Fannie and Freddie are “wards of the state” – in conservatorship, and the Federal Housing Administration (FHA) is now having problems. They are the group that underwrites/insures almost 100% of the residential mortgages in the U.S. today. Few others, such as the private banks, are in the mortgage business to the degree they use to be.
Mortgage adjustment programs that were designed to keep people in their homes and prevent a glut of further foreclosures have not worked well to date. The federal government was hoping for 7–9 million rewrites, but to date, there have been fewer than 100,000. And half of those rewrites are in trouble again within 6 months of being completed. In many instances, it is financially better (i.e, they lose less money) for the lender to allow the foreclosure than to try to help people stay in their homes.
Bank failures are the worst since the 181 failures in the 1991–92 recession. This is particularly alarming because this indicates that many banks are having problems, which further exacerbates the credit crunch. Troubled banks don’t like to lend. This is a big problem for small businesses which, by the way, create most of the jobs in the U.S.
My best guess is that housing will take some time to recover - another two years at least. The government programs to shore up prices, such as mortgage rewrites are not working as well as expected. The 30-year mortgage is currently hovering near 5%, yet not enough people are buying. Many don’t have jobs (or good enough jobs – many are “underemployed) and can’t meet down payment requirements. Low rents compete with starter homes, and first-time homebuyers just so happen to be purchasing over half of the homes sold in the past 12 months. These factors indicate that a protracted recovery is the most likely scenario. Things may get worse before they get better depending on how far the market drops once the government tax credit programs expire.
The biggest bright spot in the horizon is long-term demographics. The birthrate and the immigration trends
continue to point to a strong housing market in the United States with a solid base of housing demand. I believe demand will eventually again reach 1.5-1.8 million housing starts on an annual basis. When will we get there? Well, your guess is likely as good as mine. Keep a watch on the inventory levels, the home prices and the unemployment rate in your area to know when things truly are back to normal.
Dr. Al Schuler is a research economist with the U.S. Department of Agriculture in West Virginia. He can be reached by e-mail at email@example.com
1 State Foreclosure Prevention Group. 2010. Analysis of mortgage servicing performance. Data report #4, January 2010. (www.csbs.org/Content/.../Home/SFPWGReport4Jan202010FINAL.pdf)
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