Forecasters predict further housing market slump

Usually, home prices are an exception to the old rule that what goes up must come down.

But in the aftermath of a historic housing boom, it now looks possible that property values in much of the nation will be weak – and possibly falling – for some time to come.

This is the case, many economists say, even though the overall economy remains on solid footing. They cite several reasons:

•Potential buyers face a new hurdle, with the cost of borrowing up sharply in recent weeks. The average interest rate on a 30-year fixed loan hit 6.74 percent last week, up from 6.21 a month earlier.

•Although the real estate market has cooled considerably from the peak sales year of 2005, inventories suggest that supply and demand haven't yet come into balance. In April, the number of homes on the market was 23 percent higher than the previous April.

•The run-up in home prices was built partly on an unprecedented surge in risky lending: To borrowers with poor credit history or no down payments. Those excesses take time to work off. Foreclosure rates have recently reached record levels and may continue to rise over the next year as adjustable-rate mortgages reset for more borrowers.

The biggest worry is that high interest rates will persist, curbing buying activity.

"What we've been building into our forecast is that sales are close to a bottom," says James O'Sullivan, an economist at UBS Securities in Stamford, Conn. "The risk now is that we're actually going to get another leg of weakness in home sales."

The housing downturn is hammering a few states particularly hard. The toll is greatest where prices surged the most – California, Florida, Nevada – or where industrial jobs are disappearing, such as Michigan and Ohio.

If today's higher interest rates persist, the housing slump could endure in much of the nation.

"The housing downturn is pretty much national," says Patrick Newport, an economist who tracks the housing sector for Global Insight in Lexington, Mass.

Cities in the Southeast (except Florida), Mountain states, and the Pacific Northwest have generally held up well over the past year. But nationwide, the median sale price of a previously owned home was down 0.8 percent in April from a year before, according to data tracked by the National Association of Realtors.

This median price will have to fall further to bring supply and demand into balance, predicts Mr. Newport. His current forecast calls for prices to come down 2.6 percent in the current calendar year and another 3.5 percent in 2008.

It's not unusual for housing slowdowns to unfold over several years, as home builders and sellers gradually adjust to changing conditions in the marketplace.

An eventual recovery in housing hinges on homes becoming more affordable for buyers. If interest rates keep rising, "that would be really bad," Newport says.

Yet he and other forecasters say that a worst-case scenario, with a deep housing slump constraining consumers and driving the whole economy into a recession, remains unlikely. For one thing, the big jump in interest rates reflects investors' belief that the economy is strengthening, so the Federal Reserve Board won't need to cut its benchmark interest rate to stimulate growth.

Many economists don't think interest rates will rise much more for now. Inflation isn't ringing alarm bells, judging by the consumer price index. The core inflation rate – with food and energy prices stripped out – rose by a tame 0.1 percent in May.

"The run-up in [interest] rates will push mortgage rates up, and that will give a little smack to housing. The question is how much," says Brian Horrigan, chief economist at Loomis Sayles, a Boston investment company. He says, "there is not that much more upside risk" for interest rates.

Still, any rise in interest rates is a burden on potential buyers, and on homeowners who may be forced to sell if a rate reset pushes up their monthly payments. Last week, the Mortgage Bankers Association announced that a record 0.58 percent of home loans entered the foreclosure process in the first quarter of 2007, on a seasonally adjusted basis.

Until recently, stagnant housing prices were helping to improve affordability in much of the country. One new analysis, by Global Insight and National City Corp., finds that homes in 54 of 317 metro areas were significantly overvalued as of early 2007. That's down from 62 metro areas in the third quarter of 2006.

Another challenge for potential home buyers: Banks have been tightening their lending standards, pulling back after a period of easy credit.

In a hearing last week, the Federal Reserve came under pressure to draw a tougher line with banks on certain lending practices, such as failing to check whether borrowers will be able to pay off their loans once low "teaser" interest rates reset.

"We must walk a fine line," Fed Governor Randall Kroszner said. "We must determine how we can help to weed out abuses while also preserving incentives for responsible lending."