March 20, 2003
The Housing ‘Bubble’ Has Popped

The war in Iraq is officially underway.  As such, and drawing from the consensus, expect the travel industry to be negatively impacted, auto sales to weaken, and consumer discretionary spending to tighten even further.  Moreover, expect a U.S. recession if the war drags on. 

That said, with the action in equities, bonds, oil, gold, and the U.S. dollar all suggesting that the war will not have a lasting impact on the economy, there is hope that everything will go according to plan; that the war will end quickly, without domestic terrorism fears being realized, and that U.S. consumers will celebrate victory by peeling themselves away from their televisions and heading to the mall. And while it is difficult to believe that this scenario will unfold, especially since consumers were saving more/spending less before Iraqi tensions began to build, the basic war trend is ‘economic weakness before/during the war and strength afterwards’. 

One area of the U.S. economy that may buck this war trend is the U.S. housing market.  To be sure, since 9/11 the housing market has been one of the strongest areas of the economy, and there is reason to believe that following Iraq, regardless of the interest rate situation, the housing market will weaken. 

Reports Suggest The Peak is In

‘A number over 50 indicates that more remodelers view remodeling conditions as higher than the previous quarter.’ NAHB

The NAHB’s ‘Remodeling Index’ has declined for much of the last year.  The slump in the index, which is not considered to be one of the most important housing market reports, highlights the fact that the housing market is perceptively ‘strong’ because of declining mortgage rates and market activity, not because owners and renters are enthusiastic about investing capital to pursue remodelings. Given that the $150+ billion residential remodeling market represents two-fifths of total spending on housing (or an estimated 2% of 2001 GDP (NAHB)), perhaps these stats should not be ignored?


Following the ominous decline in the 4Q02 Remodeling Index, New Home Sales and Housing Prices surprised to the downside in January. Released on February 27, these reports are largely considered the first indication that the housing market is cooling.




As it turned out, weakness in the January was not an isolated event. Rather, housing starts for February, released earlier this week, plunged by 11%.  Again, this report is evidence that the housing market is cooling.


The Beginning of a Weakening Trend or Iraq/Weather Impact?

The housing market, like all markets, revolves around the ‘supply and demand’ axiom. And while declining mortgage rates can serve to stimulate demand, it is uncertain how sustainable this correlation is.  Quite frankly, it is not as simple as ‘mortgage rates decline to new records, so the housing market soars’. Rather, there remains the question of ‘supply’. Suffice it to say, the supply of homes for sale has been rapidly rising. 


The question that deserves to be asked: if mortgage application demand is running at a record pace (week ended March 14), why are home prices and building activity in freefall? 

The Answer: As MBAA economist Phil Colling notes, ‘When homeowners perceive that interest rates have bottomed out, they often rush out to refinance. That's reflected in last week's record high refinance index.’

In short, while a brutal winter and Iraq uncertainty have clearly had a negative impact on the housing market, the ‘refinance’ market has been covering up hidden weakness (remodeling index) for some time.  That this weakness is starting to work its way into the major reports is not surprising.

Conclusion

It may or may not be the case that a huge housing ‘bubble’ is about to pop.  Nevertheless, since the housing market has been an area of the strength for more than a year, it will, inevitably, go through a period of weakness (or adjustment).  Moreover, since the statistics suggest that this period of adjustment is now underway, until the interest rate environment becomes more predictable speculations of a popping bubble are likely to persist.  With demand slumping and supply growing, a spike in interest rates could embellish the already weakening trend in housing. 

The last chart to consider is NAHB’s HMI report, which was released earlier this week. Mortgage rates may be hitting new lows, but HMI just logged its sharpest decline in more than a decade. 

The HMI declined sharply following 9/11, but mortgage rates declined to record lows to combat this weakening outlook.  Given that few people see mortgage rates heading significantly lower, what, if anything, can combat the currently weakening outlook in the housing market?

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