A housing correction -- or a bust?

By Jim Jubak

Housing stocks -- the shares of homebuilders such as Centex (CTX, news, msgs), D.R. Horton (DHI, news, msgs) and Toll Brothers (TOL, news, msgs) -- are off 40% to 50% from their highs. That's certainly enough to qualify as a major stock market bust for this once-booming sector.

But the punishment absorbed by housing stocks doesn't tell us how big a drop in real-world housing prices homeowners might expect or when the real-world housing market might bottom and begin to rebound. The size of the housing-price correction and its duration all still depend on our old friends the Federal Reserve, the banking industry and the economy.

This means we won't know if we're headed for a housing correction or a housing bust until 2007. Until then, we're all guessing, I'm afraid. Which doesn't mean you can't do anything, however. At the end of this column, I'll tell you how to make the best of the current uncertainty.

Checking the data

On the surface, the most recent data on price trends for new and existing homes don't seem especially alarming. For instance, average U.S. home prices grew 1.17% in the second quarter of 2006 from the first quarter, according to the Office of Federal Housing Enterprise Oversight. Home prices were 10% higher in the second quarter of 2006 than a year earlier.

But while housing prices are still rising on average, they are decelerating at a record pace. The 1.17% increase in the second quarter of 2006 represents a huge drop from the 3.65% increase in prices in the first quarter of 2006. The drop from the first to the second quarter of 2006 is the sharpest in the history of this data series, which began in 1975. The 1.17% quarterly gain in prices was also the smallest gain in housing prices since the 1.12% appreciation in the fourth quarter of 1999.

The year-to-year slowdown is just as stark. The 10% year-to-year increase for the second quarter of 2006 from the second quarter of 2005 is an almost 30% slowdown from the 14% year-to-year price appreciation in the second quarter of 2005.

As you might expect, the slowdown in price appreciation traces back to a tumble in home sales. Sales of newly built homes, for example, fell by 4.3% in July from June's rate to a pace of 1.07 million units, a 22% drop from July 2005. The inventory of unsold homes on the market rose to a supply of 6.5 months, up from 4.2 months in July 2005. Sales of existing homes followed a similar pattern, dropping by 4.1% in July. The inventory of unsold existing homes climbed to 7.3 months.

Mortgage rates and market psychology

Higher mortgage rates explain a good bit of the drop in sales. For the week of Aug. 17, a 30-year fixed rate mortgage carried an interest rate of 6.52% on average, nationally. A year earlier, that mortgage cost just 5.77%. That's enough to add $200 in monthly interest costs on a $300,000 mortgage.

The power of higher interest rates is magnified by the effect of higher home prices themselves. As house prices rose, so did the size of the mortgages that home-buyers had to take out to afford the house. That extra leverage didn't matter much as long as interest rates were low, or even better, falling. A lower interest rate was enough to offset the higher price of the house.

But with rates and house prices going up, it was a different story. Taking on an extra $100,000 in mortgage debt at a higher interest rate was enough to put some home-buyers on the sidelines.

The mix of higher interest rates and higher home prices is enough to get the slowdown in sales volumes and home prices started, but a slowdown quickly gains its own momentum.

In the boom, buyers rushed to market before prices rose even higher, and sellers kept inventory off the market in hopes of higher prices. As market psychology shifts, however, and buyers begin to anticipate lower prices in the future, they become more comfortable waiting. Who wants to buy now, when that house might be on the market for 10% less in 30 days?

Potential buyers now become pessimists about future home prices, and their reluctance to buy at today's prices in the hope of lower prices tomorrow becomes the housing market's version of a stock market short-sale.

Despite the pessimism of buyers about future prices, prices may remain stubbornly high. That's because sellers stubbornly cling to a belief in a quick market rebound after a minor drop in price and refuse to reduce their asking price. That seems to be characteristic of the housing market right now.

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