Moody's Reports Weaker U.S. Economic Recovery to Dim the U.S. Housing Outlook

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According to a new report from Moody's Analytics' Celia Chen, the U.S. housing market may end 2010 on a more positive note as the sales distortions created from housing tax credits eases and as job creation slowly gains steam.

Chen's full report below states that the housing market's backslide into a double-dip correction will hamper the broader economy's already-slow path upward but will not drag the U.S. back into recession.

The nearly five-year correction has diminished housing's contribution to national output and job growth sharply, and the upside of this trend is that the economy is less reliant on housing.

A housing double dip does, however, raise downside risks to our forecast for the economy. Housing still affects consumer balance sheets, wealth, spending and confidence. Specifically, the foreclosure crisis poses a downside risk to the macroeconomic outlook. Should mortgage modification programs fail to help as many borrowers as expected, the price correction would deepen, and the unraveling market would drive the economy back into recession. At the same time, the risk that the economy could enter a nonhousing-related double-dip recession has now risen. If that occurs, then the second dip in housing will be more severe than expected as job losses keep potential buyers on the sidelines and drive foreclosures even higher.

• The housing market's fledgling recovery is faltering.
• Housing's backslide will hamper the broader economy's already-slow path upward.
• The double-dip correction will not drag the U.S. back into recession.
• A housing double dip does raise downside risks to our forecast for the overall economy.
• This year should end on a better note as the distortion from housing tax credits eases and as job creation slowly gains steam.

Behind the backslide

Partly behind the housing market's backslide are distortions due to the homebuyer tax credits offered this year and last. The credits did prompt some buyers who otherwise would not have purchased homes to do so, thus boosting underlying demand and lifting sales, construction and house prices late last year and in the second quarter of this year. However, the tax credits also brought some sales forward, which the market is now paying for in the form of large declines in sales and slowing construction.

Also contributing to the weakening in housing, the broader economic recovery has lost its momentum, keeping job creation lackluster and consumer and business confidence low. The other weight on the housing market, distressed homes, is mounting despite efforts to modify troubled mortgages.

A dimmer outlook

Based on the lingering weakness in the housing data and the expectation that job creation will remain soft this year, we have downgraded our near-term housing outlook. The retrenchment already evident in measures of housing will continue through the third quarter as previously projected, but sales and starts will slow even more.

Our new projections for sales and construction in 2010 just about match last year's poor performance. A slight strengthening in job and income growth by the end of the year will help offset the third quarter's retreat. The weaker outlook vis-à-vis last month's forecast will persist through 2012. On the upside of the housing cycle, however, the pace of sales and construction will be stronger.

Total home sales have been sliding since the April sales contract deadline to qualify for the tax credit, with sales dropping particularly sharply in July. Even after smoothing out the impact of the tax credit, sales are treading very slowly, reflecting the faltering economic recovery's constraint on underlying demand.

Further, leading indicators suggest home sales will sag in the coming months. The Mortgage Bankers Association's index of mortgage purchase applications is stuck as low as it has been since the mid-1990s, while the National Association of Realtors' pending home sales index and the National Association of Homebuilders' index remain near record lows.

Amid such soft demand, homebuilders will remain cautious. Notwithstanding the slight uptick in construction starts in July, the pace of starts has barely lifted from last year's low.

The weight of foreclosures on construction and prices will only worsen before it improves. According to RealtyTrac, nearly 1 million properties were on bank balance sheets as repossessed homes as of July, while new repossession filings have been rising since mid-2009.

Prices, which rebounded more strongly than expected in the second quarter, will head south again. Softer price appreciation is evident in July's national median existing-house price. Prices will begin to fall outright as a growing number of highly discounted distressed homes hit the market at the same time that nondistress sales decline. Prices will descend until distress sales represent a smaller share of total home sales.

As we have forecast for some time, house prices will be the last measure of housing to improve, but the timing of the bottom has been moved from the first quarter of 2011 to the third quarter. The degree to which prices will fall is about the same as we had expected last month. As measured by the Case-Shiller home price index, the national house price will fall 34% from peak to trough, compared with last month's projection of a 33% decline. However, because the second quarter house price increased by an annualized 10% from the first quarter, the decline still to come has increased from 5% to 8%.

The Case-Shiller home price index will fall 8% from the second quarter of 2010 before bottoming out around the third quarter of next year. Distressed properties will keep prices descending. By 2013, enough excess supply--in the form of distressed inventory--will have been removed from the market to allow for strong price appreciation.

The slow disposition of foreclosed homes, combined with a weaker near-term outlook for nondistress sales, fuels our revised expectations that this share will remain elevated well into 2011. Mortgage servicers are working through troubled loans slowly for a number of reasons: First, the flood of 4 million homes that are in late-stage delinquency and foreclosure has clogged the pipeline from servicers to the courts. Second, many borrowers who fall out of the Home Affordable Modification Program trial period are being considered for private modifications rather than going straight to foreclosure, delaying the appearance of these homes as distress sales. While some 45% of these HAMP dropouts will at least temporarily benefit from private modifications, many fail to make it through that process as well or will obtain a private modification, only to redefault somewhere down the line. Even those who do make it through HAMP are still highly leveraged, with an average total debt-to-income burden of nearly 64%, and thus are prone to redefaulting.

According to the Treasury Department, only 16% of HAMP dropouts are in foreclosure or have completed the foreclosure process. However, 30% are in limbo, and many of these borrowers will likely end up with a short sale or foreclosure. These statistics are based on actions completed through June by the eight largest servicers, representing 74% of HAMP servicers.

Improvement ahead

This year should end on a better note as the distortion from the tax credits eases and as job creation slowly gains steam. Fourth quarter home sales and construction will improve, although the pace will fall below last month's forecast.

Two drivers of housing demand will remain very positive well into next year and will help sales gain traction once the job market and confidence improve: Mortgage interest rates will stay exceptionally low, as will house prices. Also, mortgage lenders are slowly opening the credit spigot. The most recent Federal Reserve senior loan officer survey indicates that for the first time since 2006, lenders are finally easing credit -- albeit slightly and only for prime borrowers.

On the supply side, inventories of new homes for sale are near a 40-year low, which will encourage homebuilders once they perceive a sustained strengthening in demand.

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