Professor Paul Palley's
          Economics Seminars

Two critical factors in the process of stabilizing the housing market are affordability and price expectations, and the stabilization of the economy as a whole. There is little reason for buyers to step up when they believe home prices will continue to fall. Instead, it is more logical to wait until confidence emerges that prices have bottomed, or at least nearly bottomed. It is for this reason that resolution of the foreclosure crisis is so important in that continued expectations that many distressed properties will hit the market leads to lower home prices that will force prices below levels that are consistent with fundamentals, hurt existing homeowners, and delay the time in which the market will stabilize. In addition, there is little reason for potential homebuyers to act if they are afraid that they will lose their job. As long as the economy is in recession, the potential buyer will tend to delay large purchases until they are more confident about their income stability.

Affordability is dependent on home prices, incomes, and interest rates. At the top of the housing boom in the second quarter of 2006, the affordability index for new single-family homes as reported by Arizona State University Realty Studies was 60. This means that the household earning the median gross monthly income could afford only 60% of the monthly single-family home payment associated with a home whose price equals the median sales price (this assumes a long-term fixed rate mortgage). The affordability index for new single-family homes exceeded 100 as of second quarter of 2004. Clearly by the middle of 2006 home prices had reached levels consistent with a speculative bubble. Furthermore, this explains the rush to subprime and variable rate loans that were irresponsible on the part of both borrowers and lenders as it is difficult to explain the high levels of home sales for any other reason. The question then is when will the affordability index reach 100 once again? As of the fourth quarter of 2008 the affordability index for new single-family homes was 86.4. Mortgage rates will be low in the first quarter of 2009 than they were during the fourth quarter of 2008, home prices have fallen further, but incomes are lower. It is my belief that the affordability index is in the range of 94 to 96 at this time. This suggest that we are to the point where affordability is much less of an issue than it was in recent years.

This leaves two important factors; price stability and income stability. Price stability will depend on resolution of the foreclosure crisis and the banking crisis. The resumption of functioning mortgage and securitization markets, and the resolution of the interests of those homeowners who are at risk of losing their homes and the interests of lenders who are seeing the value of their loans declining is a necessary condition for solutions to the foreclosure crisis. Income stability will depend on resolving these issues as the housing and banking crisis have greatly contributed to the recession. Income stability will also greatly depend on expectations related to when the recession will end.

Given uncertainty related to the strength of the economy it is understandable that people look to experts for forecasts. The National Association for Business Economics (NABE) is a very good source of economic forecasts. The February 2009 NABE Outlook (see: http://www.nabe.com/) reported continued very tight credit markets, significant job losses, declining home and stock prices, and a very sharp contraction in real GDP during the first half of 2009 and then very low rates of economic growth later in the year. The forecast represents the consensus of macroeconomic forecasts that have been prepared by a panel of 47 professional forecasters.

The current forecast is for real GDP to decline at an annual rate of 5.0% during the first quarter of 2009, decline at an annual rate of 1.7% during the second quarter of 2009, and then slow growth after this point. Overall, it is expected that real GDP will decline 0.9% in 2009, and then show steady economic growth equal to 3.1% in 2010. These poor results reflect a significant retrenchment in consumer spending. The housing market and the poor credit markets are the primary reasons for the current weakness of the economy. Well below trend levels of housing starts and declining home prices in 2009. Only 630,000 housing starts are expected in 2009, and only 900,000 are expected for 2010. However, the housing market is expected to actually reach its bottom by the middle of 2009.

The consumer price index is expected to decline 0.8% in 2008 due to weakness in the economy and large declines in commodities prices, but this deflation should not continue into 2010 as it is expected the inflation rate will equal 1.9% in 2010. Given the absence of inflationary pressures the Federal Reserve can continue its very aggressive monetary policies. The consensus of the economists who were surveyed by NABE is that the Federal Reserve will leave the federal funds rate target this year at nearly 0.0%, but that it will raise it to the still very low rate of 1.5% by the end of 2010. The expectation is that long-term interest rates will also remain relatively low. The yield on the 10-year Treasury note is expected to equal 3.09% in 2009 and increase to 3.78% in 2010. These lower long-term interest rates, party the result of aggressive monetary policies, and will contribute to relatively low mortgage rates.

The strength of the dollar is important to those who are interested in traveling and those who import and export goods and services. The dollar has strengthened since the financial markets crisis deepened during the second half of 2008 as global economic weakness led investors to purchase dollar denominated assets to try to hedge against risk. One Euro bought 1.58 dollars in July 2008, but bought only 1.32 dollars in January 2009. The economists expect the dollar to continue to be relatively strong in 2009 and 2010. One Euro is expected to be able to buy 1.29 dollars in 2009 and 1.31 dollars in 2010. Reflecting the expectation that the economy will start to strengthen later in 2009, the S&P 500 Index is expected to end 2009 at 975 and end 2010 at 1118.

There are other very good resources on the internet for forecasts related to the economy and specific economic indicators. Among the good resources include websites for the Congressional Budget Office (http://www.cbo.gov/), Mortgage Bankers Association (http://www.mbaa.org/), National Association Home Builders (http://www.nahb.org/), Freddie Mac (http://www.freddiemac.com/), and RSQE Forecasts (http://www.umich.edu/~rsqe/).

As the Phoenix-area housing market continues its correction, home prices decline, wealth is lost, and the local economy suffers through a deep recession, it is natural to think about when this cycle will end. Then, it is natural to think about how strong the recovery will be. One reputable forecast I discuss below, and many other economic forecasts, indicate the expectation that economic growth will show signs of resumption in 2010. This positive indication, including expectations of greater levels of population growth in future years is significant for the local housing market. There are risks that I should note before we get to details related to this. First would be if the U.S. government does not quickly respond to signs that additional economic stimulus is needed, including further addressing foreclosure risks beyond what is accomplished by the enacted version of the Homeowner Affordability and Stability Plan. Second would be if other governments in Europe and Asia don’t positively address the problems their economies face. Third would be the risk that governments engage in counter-productive trade protectionism that further weakens the global economy.

The national economic recession started in December 2007, and this recession will be deep and long lasting. The reasons for the recession have been clearly identified as the bursting of the housing bubble, the financial markets crises, excessive reliance on credit, and other factors. Getting out of this recession will be difficult as monetary policy is now largely ineffective because the inflation rate is approaching zero percent and the federal funds rate approximates zero percent as well. This leaves fiscal policy as the most immediate course to take, and debate about this will likely continue even though the stimulus bill has been adopted as law at the time in which I wrote this. The proposed, but not enacted at the time this was written Homeowner Affordability and Stability Plan will provide incentive payments to lenders to modify troubled mortgage loans and subsidize lower interest rates. Coupled with this is a big stick – support for a new law that would allow bankrupt homeowners to seek to get their mortgages modified (a plan that would be a strong incentive for lenders to avoid issuing reckless loans in the future). The plan would also help some, but not all, homeowners who are not delinquent to refinance their mortgages. What is missing from the plan is help for those nearly 14 million borrowers with higher mortgage balances than the value of their homes. At the time in which I wrote this, further measures to address the banking system were not yet adopted, but even some conservatives are suggesting that bank nationalization may be necessary in some cases. The initial reading on these measures is that they will have a positive impact on the economy, but given the scale of the recession and related economic problems, it is likely that additional measures will need to be enacted. A deeper recession that lasts longer will only exacerbate the problems facing the housing market leading to further declines in home prices.

The S&P/Case-Shiller Home Price Indices tell us where we came from and where we are today in very sharp terms. Home price reached their peak in June 2006 at an index value of 227.42 versus 130.54 as of November 2008 (a decline of 42.6%). If one constructed a trend line for Phoenix-area home prices based on data from the S&P/Case-Shiller Home Price Indices over the period of January 1989 to December 2003, and we compared that trend to actual prices we find that as of June 2006 home prices were approximately 44% above trend, and as of November 2008 they were about 5% below trend. We have experience with seeing financial asset prices over-shoot trends on the way up, and under-shoot trends on the way down. Because the housing market was so speculative recently, it should not be surprising to then see home price continue to decline and fall further below long-term trend levels before correcting. The point is that the price data we have indicates that this process of finding a bottom may be underway now or soon will be.

Given the above, it is not expected that the local economy will begin to demonstrate growth until 2010 as the housing market will first need to find its footing. The expectation of economic growth resuming in 2010 indicates a long recession, exceeding any of the recessions the U.S. economy has experienced in the post-World War II period. One very reputable resource for professionals to look to for forecasts is Arizona’s Economy, published by the Eller College of Management. The January 2009 issue indicates the expectation that employment growth in the Phoenix-area will resume in 2011, retail sales will show a small increase in 2010, strong levels of personal income gains will occur in 2011, and residential housing permits will reach levels consistent with normal levels of population growth in 2012 (http://ebr.eller.arizona.edu/azeconomy/). It is the expectation that strong levels of population growth will resume in 2012 along with employment gains, and further resolution of the foreclosure and housing crisis, that will lead to sustainable strength for the housing market. Is it logical to assume that strong levels of population growth will resume again in the Phoenix-area?

One factor contributing to answering this question is related to how attractive Phoenix will be to those interested in moving from their current place of residence. The Pew Research Center completed a study that offers interesting details to consider (http://pewresearch.org/pubs/1096/community-satisfaction-top-cities). Among what we learn from this study is that while more than 80% of those who completed the survey rated their communities as excellent, almost half of those surveyed would rather live in a different kind of community. Furthermore, far more people preferred living in the suburbs than in urban communities. We learn that younger people are more attracted to cities, but those with families and retirees would rather not live in cities. These trends conform to much of the existing development pattern, and housing product which has been produced in Phoenix, and the following point is positive for demand for housing and development in Phoenix. We also learn from the study that seven of the top ten cities American want to live in are in the west. Overall, Phoenix ranked seventh behind Denver, San Diego, Seattle, Orlando, Tampa, and San Francisco.

Biography:

Paul Palley manages Palley Economics Seminars and is a Lead Faculty Member for the University of Phoenix where he teaches graduate and undergraduate economics and statistics courses.

Here is a very timely column written by Thomas Friedman in the New York Times. The link is: http://www.nytimes.com/2009/02/01/opinion/01friedman.html?ref=opinion

This bit of gallows humor is both timely and oddly funny; Davos humor: What is the capital of Iceland? Answer: $25.