Home Values Slashed in Half? The Housing Bubble Is About to Burst

The latest data on housing sales showed that the inventory of unsold homes climbed to 4.4 million in May, yet another record. The current inventory would be more than a full year of housing sales in the mid-nineties, before the housing bubble began to take off. There is also a record inventory of new homes for sale. Economists usually expect that excess supply leads to a drop in prices, and in this case, there is a considerable excess supply of houses.

In fact, house prices by many measures are already falling. The National Association of Realtors reports that the median price of an existing home is down by 2.1 percent from its year-ago level. Prices have fallen by much more in some local markets. For example, an index constructed by Yale economist Robert Shiller shows that house prices are down by 4.9 percent in the Boston area and by 6 percent in San Diego. Adjusting for inflation, Shiller's measure implies that the real price of an average house in San Diego is down by almost 10 percent from its year-ago level. That's real money in a city where middle-income families might have purchased a $700,000 house in 2006.

Even these numbers understate the true decline in house prices. At the peak of the boom, houses were sold without conditions. No successful buyer got a home inspection, and then forced sellers to make repairs before closing. It has also become a standard practice in at least some markets for sellers to make kickbacks to buyers at closing - effectively allowing the buyer to pull out cash by inflating the sale price. These kickbacks, which can be 2 to 3 percent of the sale price, are not picked up in any of housing price indices which rely on the contracted price.

Unfortunately for homeowners, several factors indicate that the situation is likely to get worse in the near future. The vacancy rate for ownership units is 50 percent higher than it had ever been prior to the last two years. A seller holding a vacant unit - one which collects no rent - is likely to be a very motivated seller.

Similarly, foreclosure rates are soaring. Foreclosure rates had been very low in 2004 and 2005. In a period of rapidly rising house prices, very few borrowers had no equity in their homes. If they found they could not meet their monthly mortgage payments, they could borrow against their newly accumulated equity or simply sell their home and cash out excess equity. Homeowners in a market with declining prices have no equity cushion.

While the run-up in foreclosures was originally concentrated in depressed markets like Ohio and Michigan, it has now spread to some of the formerly hot markets like San Diego and Miami. Prices have dropped enough in these areas that many recent buyers are now letting the banks take possession of their homes. Of course, few things will bring down house prices more quickly than a spate of foreclosure auctions.

In addition, interest rates have risen sharply in the last two months and are likely to rise further in the months ahead. The rate on 10-year Treasury Bonds has risen from 4.6 percent earlier in the year to more than 5.1 percent in recent weeks. Many economists have recently come to remember that this is still an unusually low interest rate, and that the 10-year Treasury rate could quite possibly rise to more than 6 percent in the near future. This would lead to a corresponding rise in mortgage interest rates, pushing a standard 30-year mortgage well above 7.0 percent.

Add in the fact that job growth is considerably slower than its pace in 2005 and early 2006, and that real wages are again declining, and there seems little reason for optimism about the housing market.

House prices will not collapse to nothing like the most ridiculous of the Internet stocks, but homes in the most-inflated markets could lose 30 to 50 percent (in real terms) from their bubble peaks. Some people bought homes in these markets expecting to make great returns on their investments. Perhaps these people deserve their fate.

However, many homeowners followed the advice given to them by Realtors, politicians and financial advisors, and were simply pursuing the American Dream of homeownership. When the wreckage from the real estate bubble becomes clearer, these "experts" will have much to answer for.

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