November 2006 SGE Monthly Luncheon
Frank E. Nothaft, Chief Economist, Freddie Mac
By Darryl E. Getter, Housing and Urban Development
Dr. Frank E. Nothaft, Chief Economist at Freddie Mac, provided his perspective on the state of the recent housing decline at the most recent SGE monthly luncheon. His discussion began with a summary of overall macroeconomic conditions and was followed by a review of housing market conditions before he concluded with a discussion of mortgage market activity.
A very robust housing market has strengthened macroeconomic conditions over the past few years. Dr. Nothaft pointed out that about one-fifth of GDP growth was tied to the housing sector and that the recent decline in housing market activity has shaved 1% off recent growth. Nevertheless, the U.S. economy has been growing at, or perhaps slightly above, its full employment long run level. While the inflation rate increased markedly due to the spike in oil and gas prices associated with Hurricane Katrina, the core inflation rate, which does not include the volatile food and energy components, rose to nearly 3 percent, prompting the Federal Reserve to raise short-term rates. And although the Federal Open Market Committee decided not to raise the federal funds rate at its last meeting in October, there is still much concern about the core rate being above a 1%-2% desirable range.
Turning to U.S. housing markets conditions, Dr. Nothaft discussed the National Association of Realtors’ affordability index, an important determinant or gauge of housing market activity. The index accounts for changes in mortgage rates, median house prices, and median family income—an increase suggests that purchasing a home is becoming more affordable. In late 2005, the affordability index declined to its lowest point in 15 years despite the existence of falling and historically low mortgage rates. This decline in affordability can be attributed to rising house prices and, as a result, the subsequent drop in home sales is not surprising. Accompanying trends provide similar evidence: Single-family home construction hit a record high in 2005, but then declined by 18% a year later while inventories of homes on the market and the average number of days on the market both increased.
As a result of the drop in home sales and building activity, real house price appreciation declined over 2006. This trend is noteworthy because real housing price growth has typically declined only during recessionary years. The one exception occurred during the 2001 recession when real house price growth continued because housing market activity was so strong. Despite the current robust macroeconomic conditions however, U.S. home value appreciation has begun to decline after reaching a high level of about 13% in 2005. Again, this decline suggests overall GDP growth would have been higher if house price appreciation—which translates into higher household wealth—had continued moving in the same direction as general macroeconomic activity.
At this point, the explanations for the decline in housing market activity that Dr. Nothaft provided may be viewed as changes in economic fundamentals. Turning to investor and vacation home purchases—which doubled from 10% of conventionally-financed purchases in 1999 to 20% in 2005—also provides evidence of the housing market downturn. While the aging of baby boomers would explain the increase in vacation home purchases and not necessarily be a cause for concern, the increase in investor homes does raise a cautionary red flag. Places such as West Palm Beach (Florida), Las Vegas (Nevada), and Tampa-St. Petersburg (Florida) have second home and investor shares between 34 and 41%, which suggests house prices in those regions may reflect some speculative fervor.
Finally, Dr. Nothaft commented on the efficiency of U.S. mortgage markets and the forces behind market activity. U.S. mortgage markets have increased in sophistication over the last decade, which translates into reduced transactions costs and greater access to financing. For example, 50% of the single-family mortgage debt outstanding at the end of 2003 had been originated that year. Today, many people are refinancing out of those mortgages because they want to tap into the huge amount of equity wealth they may have accumulated. Many with adjustable rate and hybrid mortgages want to refinance before having to make a series of higher mortgage payments. To avoid higher mortgage payments, many borrowers took on non-traditional loans (e.g., interest-only and negatively amortizing loans) in 2004 and 2005, but such types of originations are declining.
After reviewing all the market conditions, Dr. Nothaft concludes that the U.S. has probably seen the worst of the housing market decline in activity. By historical standards, he believes we are more likely to see a return to what would be considered normal activity. In addition, Dr. Nothaft is less worried about a wave of delinquencies and defaults. Typically, job loss or some other unexpected circumstance is the reason borrowers get into loan repayment problems. Because the macroeconomic conditions are favorable towards sustaining a healthy level of employment, only some unexpected negative economic shock can trigger a wave of delinquency and default problems.
The views in this summary are those of the author and do not represent those of the Department of Housing and Urban Development.
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