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Now that the homebuyer tax credit is no longer able to prop up home sales, risks facing the housing market are heavily weighted to the downside.

Housing at the Brink

Now that the homebuyer tax credit is no longer able to prop up home sales, risks facing the housing market are heavily weighted to the downside.

Recent housing data have been dreadful; home sales have plummeted as potential buyers disappeared from the marketplace. The fate of the nation’s housing sector largely rests on prospects for the economy as well as the government’s response to current anemic conditions.

Economy

The next two quarters will be unpleasant for the U.S. economy. The economic recovery has strayed off course; the job market remains weak and household and business confidence have eroded. The bad news is the government is about out of tools for remedies; the Federal Reserve has done all it could over the past 12 months with interest rates near historic lows; while Congress and the Obama Administration contemplate yet another fiscal stimulus package (or business tax credits).

Notwithstanding these current problems, the economy is poised to recover, albeit several quarters late. Business and household balance sheets have improved markedly, with debt burdens falling over the past several years. Corporate profits are up as well as household savings rates. Job creation is expected to gain momentum during the next several quarters, boosting both business and consumer confidence. On balance, the economic recovery remains on shaky ground; everything must go right for the economy to experience a steady rebound.

Housing

So far, the nation’s housing sector has experienced a brutal summer. Existing home sales plummeted 27.2 percent in July to 3.83 million annualized units compared to an annualized 5.26 million unit pace in June. The hangover effect of the housing tax credit was the primary cause for the sales debacle; a large number of buyers, who would have closed on homes in July, were incentivized to purchase homes earlier to take advantage of the tax credit, explaining July’s historic low sales pace. Adjusting for the tax credit effect, existing home sales are running at an annualized 4.9 million unit pace (the average of the past three months).

Similarly, new home sales for July fell 12.4 percent to an annualized 276,000 unit pace from a month earlier. Weak demand for new homes and competition from distressed properties has weakened the homebuilding industry considerably; builders continue to avoid new residential construction.

The months supply for both existing homes and new homes in July rose considerably to 12.5 and 9.1, respectively. Although these numbers indicate a serious excess supply problem, it is not as bad as it appears. Most of the rise in the months supply is due to the huge drop-off in the pace of home sales and not due to any meaningful increase in the number of properties available for sale. If we used the three month average of home sales to smooth out the tax credit effect, the months supply number would be much lower.

Even with tax credit adjustments, its clear current housing demand is anemic; potential home buyers have literally disappeared from the marketplace. And who’s to blame them? The financial incentives (tax credit) to purchase property are gone; the economy is performing poorly, creating a paltry number of jobs per month; and everyone is expecting another round of distressed home sales, promising to exert downward pressure on home values. No one wants to purchase a home today, knowing its value will be lower tomorrow.

It’s not all bad; there are signs that the post-tax credit blues is coming to a close. Pending home sales rose by over 5 percent in July, while mortgage applications to purchase homes climbed 6.3 percent in July. Both housing measures suggest that the worst may be over but nothing more. There are no signs that a recovery is in the offing.

Government Response

How the government responds to the current housing crisis is critical to the likelihood of recovery. Government efforts to mitigate the number of foreclosures projected to flood the market over the next twelve months must be effective. If government programs like the Home Affordable Mitigation Program, HAMP, fail, distressed property sales will be more pervasive, exerting substantial downward pressure on home values. Falling home values, in turn, inhibit an already anemic demand for home buying. Government efforts to revive the nation’s job market are equally as critical to a housing recovery.

Outlook

At present, the housing sector is in a precarious position; risks are heavily weighted to the downside. Any meaningful rebound in housing demand rests largely on the wobbly shoulders of the economy. So far, economic recovery is tepid; job gains have been scrawny and consumer and business confidence continue to fall. Suffice it to say, the economy is providing only modest support for housing.

The housing industry will likely remain frail for the remaining months of this year and well into next year. A new wave of foreclosures is expected to hit the marketplace any time now. There is a large number of mortgage loans residing in the 60- and 90-day past due categories, and a meaningful percentage of them are headed for foreclosure. Further, a number of public and private loan modifications over the past year have failed, adding to the inventory of distressed properties. Weak housing demand combined with a flood of distressed properties are expected to exert substantial downward pressure on home values.

To this end, home values, as measured by the Case-Shiller home price index, will likely resume its descent and fall by another 5 to 7 percent over the next two to three quarters, particularly if government foreclosure mitigation programs prove ineffective. That’s the good news; the bad news is– if the economy double dips into recession, home values could fall by another 10 to 15 percent (my guesstimate).

Despite the negativity surrounding housing, the likely scenario remains a housing recovery sometime in 2011. Expect home values to fall by almost 5 percent during the next six months, followed by stabilizing home values due to the end of the foreclosure wave. At that time, a gradual rebound in home sales is in the offing; fingers and toes crossed.

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