Three economists weigh in on when the housing market will hit bottom and rebound

August 2007 is the month that most REALTORS® and lenders cite--and curse--as the beginning of the credit crunch presently rumbling through the state's housing market. With it came tighter lending standards that will reverberate through the industry and the state's economy for--and here's the billion-dollar question--how long?

To help answer that question, C.A.R.'s Chief Economist and Vice President Leslie Appleton-Young assembled three economists at the recent California REALTOR® EXPO 2007 (www.realtorexpo.org) as part of a panel discussion aptly called, "Up, Down, or Sideways: What's Next for California's Housing Market." The economists were: Frank Nothaft, chief economist for Freddie Mac; Richard Green, Oliver T. Carr Professor of Real Estate Finance at The George Washington University; and Jack Kyser, chief economist with the L.A. Economic Development Corporation.

Staying Alive  >  Richard Green

Recently, I was privileged to speak immediately after Federal Reserve Chairman Ben Bernanke. That was intimidating. This too is an intimidating moment, because I've got to tell you that things aren't that great.

California's economy as a whole is fairly healthy, but the housing market is not. The top states for negative-amortization purchase loans in March 2007, according to data from Loan Performance, are California (number two) and Florida. These loans count on house prices going up faster than inflation.

The good news is that loans that are fundamentally sound will be fundamentally sound. Wall Street's not understanding this, and it's important to California's housing recovery for Wall Street to understand this. That's why it's also important to understand that California has among the highest prepayment rates in the country. California's housing turnover rate is not particularly high, largely because of Proposition 13. In California, as the yield curve flattened out, people who could refinance out of ARMs were refinancing into fixed-rate mortgages, and that helped stabilize the housing market.

As for subprime mortgage delinquencies, there are pockets of California--Stockton, Fresno, San Bernardino County, and Riverside County--where this is a real problem. Overall, as a state, it doesn't rank among the states with the worst rates of subprime delinquencies. I's important to make a distinction here between nontraditional products and subprime products. I'm going to argue that subprime loans per se are not the problem: Exotic mortgages are the problem.

What produced this crisis? Partly, it's the private label market that Wall Street charges for credit. This market creates securities that slice up mortgages to be rated by rating agencies. The rating agencies looked at the tranches between 1997 and 2005, when there were almost no default losses, and concluded they were safe. Problem is, we had no history of observing what these people looked like or their default behavior.

Second, there are a coupleof problems between borrowers and lenders, including the nature of disclosure. Does the typical borrower really understand the HUD-1 form? But on the flip side, which borrowers are going to take on a 2/28 loan? Speculators. If the value of the house goesdown, you walk away.

Finally, originators and investors. Originators have an incentive to originate, thereby creating a lot of moral hazard based on compensation. They don't have an incentive to do quality control on the kind of loan that they're selling to Wall Street. The mystery to me is why Wall Street didn't understand this.

Right now, we're outside the economic models. Anyone who thinks he knows when issues will be resolved is deluding himself. I deluded myself last spring. I am embarrassingly quoted in Newsweek as saying "the subprime crisis would be well contained soon; people would forget about it."

BOTTOM LINE > The key statistic you should watch is the months' supply of homes available for sale. When that number starts shrinking, the bottom is coming. Until that number starts shrinking, you don't know when it's coming. I find it hard to imagine that this will last more than three years. Sam Zell, in 1990, said of the commercial market, "Stay alive till '95." I can't think of a good rhyme, but try to stay in business until 2010. You'll be happy that you did.

Worse Before It Gets Better  >  Frank Nothaft

We've still got a good sixor 12 more months of downturn in the housing market nationwide before we hit the trough. It's going to be a very weak gradual recovery that commences toward the end of 2008, and then picks up steam in 2009. Overall, 2008 will be a pretty weak year,too, with national home sales and construction lower than the 2007 levels. I think we'll avoid a recession, even though the recession risks are greater. Freddie Mac's projections have the economy expanding at about 2.5 percent in 2008.

In terms of the California housing market, there's still lousy news in front of us.

Subprime accounts for only 15 percent of the single-family loans in California, but over the past year has accounted for 70 percent of the single-family loans entering foreclosure. The news on the subprime front is just going to get worse in terms of defaults and higher foreclosure rates in the coming months.

I get worried when I see elevated levels of investor activity in a particular market, because this introduces a speculative component to the valuation of homes at the margin. The share of second homes doubled in terms of mortgage-financed home purchases from 1999 to 2005 and 2006.

Jumbo loans account for more than half of the loans originated in California. Jumbo loans have gotten significantly much more expensive. I think they're going to remain very expensive for many months to come, hampering also sales for higher-priced homes in expensive markets.

Loans with interest-only (IO) negative-am features havebeen in the market for a long time. When we had mortgage rates of 18 percent in the early 1980s, we saw many lenders offering IO negative-am products. It's a product that surfaces and grows in the market when there is an affordability problem. There's nothing wrong with IO loans and negative-am loans, but they're not the right loan for every borrower. There's a fundamental suitability issue.

BOTTOM LINE > At Freddie Mac, we studied and identified the prime trigger events or hardship reasons that led to delinquency on prime conventional loans: unemployment, followed by illness. Sometimes bad things happen to good people. Do they ultimately lead to foreclosure? It depends on whether or not the owner has equity in the home or the home equity wealth is wiped out. That's what leads to foreclosure.

Sideways and Holding Steady > Jack Kyser

Are we going up, going down, or are we going to move sideways? Let's take the economic temperature.

California Industries with Positive Trends

Agriculture: Steady. Exports are up due to the dropping value of the U.S. dollar.

International trade Exports from California are up as a result of the dropping value of the U.S. dollar.

Technology: Technology's outlook is quite good in both the public and private sectors. The Department of Defense budget will run at higher levels for the next few years, bringing a lot of the money coming into Northern California and Southern California.

Tourism: Strong.

Industries with Problems

Housing: Don't invest in any retail operation in the Inland Empire.

Office market: The Riverside-San Bernardino area has a lot of new construction, plus space is being given back by the subprime lenders. You've got some issues out there.

Hot Metro Areas

The "animal spirits" are back in San Francisco and San Jose. Technology is back.

Biomed is performing strongly. You're looking at about a 2.3 percent growth in jobs in San Francisco Metro this year, 2.1 percent next year.San Jose, 2.1 percent this year, 2 percent next year. They're doing pretty good.

Steady Eddies

Los Angeles County has been insulated from some of the lows of the housing market. Expect a 1.1 percent growth in employment for 2007, 0.9 percent in 2008, acknowledging there's going to be a hit from the motion picture industry. Sacramento experienced 1.7 percent growth in 2007, and is expected to show 1.5 percent growth in 2008. Government (jobs sector) is holding them up. Ventura County is chuggingalong at about 1 percent.

Problem Areas

Orange County is expected to report 0.4 percent nonfarm job growth in 2007, 0.5 percent in 2008. Obviously, this is the fallout from the subprime lending situation and residential real estate problems. One interesting thing is all of a sudden there's this big rush to build high-rise condos in Orange County, especially around Costa Mesa. Now the pins are dropping, and speculators are coming into the market and sending false signs that there's a market forhigh-rise condos in Orange County.

Riverside-San Bernardino rumbled along with 3.5 percent nonfarm job growth in 2007; expect about 2 percent in 2008. The gut feeling is it's not going to be pretty in the Riverside-San Bernardino Area next year. TheCoachella Valley and the Moreno Valley are overbuilt, with a lot of subprime loan problems there. The Inland Empire is going to suffer a little bit in housing and retail sectors because retailers were "running into the market." We're already hearing stories about furniture stores going out of business. They were the canary in the mineshaft.

Troubled Area

In 2007, San Diego experienced a 0.6 percent growth in nonfarm employment, but this will pick up a little in 2008. Remember the old accounting term: FIFO? First in, first out. San Diego was first into this real estate problem. San Diego is going to look a little bit better in 2008. In part because military spending is going to run at higher levels.

State Forecast

[Anticipate] slow growth over the next two or three years. You're moving sideways, but you're not in a recessionary situation. There will be a 1.4 percent growth in nonfarm employment in 2007; 0.8 percent growth in 2008; then 1.3 percent in 2009. Advance indicators fromthe Department of Finance in Sacramento show financial services and construction will lose 20,000 jobs statewide.

BOTTOM LINE > The news media will focus on the housing crisis well into 2008. A lot of the stories are going to come out of California.

We will get through this. California's economy will survive. When will the housing market start to recover? Early 2009.

Economists One-on-One

Q: Lenders have been saying that we will see an increase in conforming loan limits. True?

Frank Nothaft: Freddie Mac's loan limits are set by statute using a formula that's based on house prices. It's up to Congress to make a change allowing for higher loan limits in high-cost markets, at least temporarily. We do not anticipate a change in ourloan limit going forward, unless there is congressional action.

Richard Green: I don't think that increasing the loan limit will be all that helpful. For it to do any good, Fannie and Freddie would have to be able to buy more mortgages. Until they get current on their books, I doubt the regulator is going to allow them to grow. Also, the people who need help have impaired credit. Fannie and Freddie are not going to be interested in refinancing those loans because they want to protect their capital.

Q: What will happen in the residential rental market--will rents be higher or lower?

Jack Kyser: The rental market is in good shape. Vacancy rates are not that high and rental rates have been going up. People who were thinking about buyinga home are going to go into the rental market. People who are losing their homes will have to go into the rental market. If you're looking for a fairly safe investment, quality apartments will do fairly well.

Q: When are foreclosures going to peak, and how big of an impact will they have?

Green: We're outside the model here and have never had this kind of phenomenon before. The jobs market in California is OK and the traditional trigger for default is not there. The default rates among fixed-rate products are low; the default rates among adjustable-rate loans are becoming appallingly high. What share of them is going to go bad? Some economists predict 70 percent. I'm not that pessimistic, but think 20 to 30 percent is a real possibility. It's going to be a while before that shakes out.

Q: Let's find a financial solution to help these people keep their homes. What would you suggest?

Green: Andrew Samwick, a professor at Dartmouth College, came up with an idea for helping the people who got into loans they didn't understand--not investors. They get to live in the houses as long as they want, as renters, at a reasonable rental rate based on the local rental market. The person who holds the mortgage is left todeal with the fact that they're going to have something at a substantial discount. That way, people stay in their house. They're not victims of the negative equity position that they're in and the house doesn't go on the market.

Q: Instead of recasting the loans, could the lenders allow them to remain in effect for the next three to five years? That would alleviate a lot of the problems that homeowners encounter with the higher payment.

Green: These loans are not owned by a lender. They were put into trusts and they're tranched and they're owned by different classes of investors. It's not entirely clear actually who owns these things.

Second, certain classes of investors, those who have the senior positions, may say,"if you default on the loan, I will get all my money back." That's why this is so thorny. I think youvd have to rewrite the laws about how the trusts are set up and into which these securities are sliced and diced. In principle, you're exactly right, but executing it is very difficult.

Q: How do you qualify buyers given the subprime [meltdown], when they now need 10 percent or 5 percent down for a half million-dollar home?

Nothaft: Some people may have to wait to buy a home until they have saved up enough for a down payment of 5 percent or 10 percent. Everyone needs to have a little skin in the game. They may have to rent longer.