July 30, 2013
The first of a two-part series examining the importance of housing to the U.S. economy
At first blush a house might be viewed as simply a place to live, but for the U.S. economy, the housing sector is much more than that – it is a dynamic force that can provide a tremendous tailwind to growth in good times or a strong headwind during a recession. While only representing about 5% of the economy, this sector packs a punch much larger than its size, because home ownership is a bedrock principle of American society. Most of us have a majority of our retirement savings wrapped up in our home and a rising price not only influences our belief about a more secure retirement, it also impacts our desire to spend. Whether building, updating, adding to or simply furnishing our homes, housing permeates much of the economy, including through construction jobs, transportation, industrial production, retail sales and financial services.
This sector played a particularly important role in the U.S. economy during the past decade, both before and after the recession of 2008-2009. Prior to the recession, housing prices and housing-related activities accelerated at an unsustainable pace. This was particularly true in housing finance where credit became easier than was historically typical. Partially because of this exaggerated behavior the recession was much deeper and broader than it would otherwise have been. And it was also this depressed state that has been largely responsible for the weak and exceptionally slow recovery.
Today, we are seeing signs that housing is well on its way to recovery, although a healthy improvement in home prices has yet to spill over into the broader economy. In this first of a two-part series, we will explore the critical role of the housing sector in the recession and how the current turnaround is fundamental to returning the economy to its long-term potential growth rate. Part two of the series will explore our economic forecast and what role housing will play in the next few years.
Looking back: Collapsing home values and a weak recovery
The housing bubble was the proverbial car going over a cliff without leaving any skid marks. Home prices began to rise in the 1990s and continued through the early 2000s, with values rising around 15% annually during the peak years of 2004-2005. A deeply held belief in many corners during this period was that home values would always rise. Housing values have historically shown volatility in local and regional pockets, but they had not fallen dramatically on a collective national scale in the post-World War II era. This time, prices fell over 30% from peak-to-trough and contributed to one of the deepest and most painful recessions since the Great Depression.
Figure 1: America’s mountain of mortgage debt
Source: Standard & Poor’s, Federal Reserve Bank of New York, as of March 2013, mortgage debt is on right-hand side, in trillions.
The housing boom and bust is extremely complex, and there are many views on what caused it. One factor in the remarkable run-up in home prices was low interest rates. Other reasons included the introduction of new and exotic mortgage products and institutional investor demand. With time, irrational thinking gripped both Wall Street and Main Street, as many were caught up in the euphoria of fast-rising home values. This thinking helped justify actions such as lending to people with no documented income and assigning triple-A ratings to some pooled assets with heavy exposure to subprime mortgages.
Mortgage innovation and growing pools of capital gave record numbers of Americans a path toward owning a home. The home ownership rate increased to a record 69.1%, along with total residential mortgage debt, which peaked at $9.3 trillion in September 2008—a figure that nearly doubled in just five years (see figure 1). The cost burden, and ultimate loss in net worth was extreme. By 2004, for example, more than 15 million households were spending more than half of their income on housing. Real (inflation-adjusted) household net worth dropped by $14.3 trillion from 2006-2011, with home equity accounting for $8.2 trillion of the total figure. Home equity is at its smallest share of household net worth in the post-World War II era.1
A strange recovery
While the recession ended in mid-2009, the broader economy failed to bounce back to the degree that it has following previous recessions, which is not surprising since collectively, we were $14.3 trillion poorer on paper. Typically after a recession, housing activity provides a swift, caffeinated boost to the economy. Interest rates usually fall, providing incentives to borrow. This process often kicks off a virtuous cycle of rising home sales, residential construction, price appreciation, job creation and retail sales growth. As home prices rise, people feel more confident and wealthier and are more likely to spend money on household items, cars and vacations.
Residential investment grew by greater than 30%, on average, after the three recessions preceding the most recent one, but actually decreased by about 3% in the first two years of recovery this time around, creating a drag on overall growth. This decline occurred even as the Federal Reserve has kept interest rates at all-time lows for several years.
Mortgage defaults and delinquencies rose to extraordinary levels beginning in 2007, while home values plummeted. More than a quarter of all mortgages in the U.S. were “underwater” as of December 2009, meaning the owner owed more on the house than it was worth.
Figure 2: Percentage of “underwater” U.S. mortgages
Signs of a normalizing housing market
There is growing evidence that the housing market has started to rebound, causing the economy and future growth estimates to rise along with it. While real GDP rose at disappointing 1.8% in the first quarter and is forecast to come in even lower in Q2 at 1.2%, there has been a silver lining. Residential investment, which includes new single-family and multi-family houses and manufactured housing, produced its seventh consecutive quarter of positive gains, a robust 14% increase versus the previous quarter. The housing rebound was a primary reason why GDP-growth has held up in the face of a large drag from fiscal spending cuts, which is encouraging news for the economy.
Figure 3: Residential investment is rising
Source: Bureau of Economic Analysis, real private residential fixed investment 1995-2012, quarterly data, billions of chained 2005 dollars.
Housing prices have also bounced off the bottom—and have even come back surprisingly strong in many areas, such as San Francisco and Las Vegas. The S&P/Case-Shiller 20-City Composite Home Price Index, a broad measure of home prices in U.S. cities, rose 12.1% in April, which was the largest year-over-year increase since 2006.2 A limited supply of housing, in addition to extremely-low mortgage rates and a continued improvement in employment figures has helped push demand for housing. The economy, however, is not experiencing the full throttle of housing growth, as most residential sales have occurred in the existing home market recently. Existing sales, while important, don’t show up directly in the GDP statistics. We expect that to change in the coming months, although interest rates will remain an important driver for the overall housing market.
Looking ahead: Housing should provide an economic tailwind
Consumers who feel better about their home’s value tend to spend more on improvement projects and buy big ticket items. This creates many knock-on effects for the broader economy, including job gains, increasing investment and a rising perception of household wealth, security and stability. Although the housing market and the overall economy have yet to fully “normalize,” negative factors are declining and positive ones are rising. We see this in modest but improving monthly job growth statistics where private employment, if it continues to grow at its current pace, will fully recover to pre-recession levels within the next eight months. We also see it in retail sales, where growth should be closer to 6% on a year-over-year basis, but is increasing at a pace of around 4% per year with much of the growth coming from categories related to home improvement. Rather than looking back at where the economy has been, growth in coming quarters will be increasingly driven by the improving values of consumers’ homes.
Please look for the second part of this series in the coming weeks.
1 Joint Center for Housing Studies of Harvard University, June 14, 2012.
2 Bloomberg, June 25, 2013
The information provided herein is as of July 30, 2013.
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