Fresh economic shocks on the scale of the current credit squeeze will occur if US house prices continue to fall, one of the country’s leading housing experts warned on Wednesday.Now, before you start hyperventilating, keep in mind that this is one of those, "if nothing happens" scenarios. Do you remember when the Fed kept raising interest rates in the 1990s to deal with what Alan Greenspan called "excessive exuberance"? Well, each time the Fed raised interest rates, they managed to inject a little reality into the stock market.
Robert Shiller, a Yale university economist, told a US congressional panel that he feared “the collapse of home prices might turn out to be the most severe since the Great Depression”.
“The decline in house prices stands to create future dislocations, like the credit crisis we have just seen,” he told the Senate’s joint economic committee.
Mr Shiller, who designed the respected Case-Shiller house price index and predicted the bursting of the dotcom bubble in a bestselling book, said that while there had been a focus “on lax and irresponsible lending standards, I believe that this loss in housing value is the major ultimate reason we see a crisis today.”
Alan Greenspan, former Federal Reserve chairman, told the Financial Times this week that double-digit falls in house prices from their peaks would not be surprising. A fall in house prices on that scale would be unprecedented in US history and would have an economic cost several times greater than the meltdown in the subprime mortgage market that triggered the current financial crisis.
The Center for Responsible Lending has predicted that foreclosures on subprime loans will lead to a cumulative loss of $164bn (€118bn, £82bn) in home equity. Investment banks have suggested the costs to financial institutions could be more than $300bn.
I suspect that Tuesday's 1/2 point drop in interest rates--larger than many analysts expected--was the first of several such efforts by the Fed to deal with "unnecessary gloom." The reason is simple: if you want to lift housing prices, dropping interest rates will do it. The good inflation numbers gave the Fed the room to drop interest rates. The gloom of falling housing prices has really negative effects on the rest of the economy, such as construction and appliance sales. Falling housing prices also interfere with people using their house equity to buy really important necessities like vacations to Hawaii, speedboats, breast implants, and Jumbotrons for the living room. My guess is that as long as there's some risk of these worrisome housing price drops, the Fed will keep cutting interest rates.
Hint: this is probably not the time to lock in a 30 year fixed mortgage. I am expecting to see continued cuts in interest rates--maybe another 1/2 point, maybe another full point. And that should get the housing prices to stabilize, maybe even start to rise, and put the breast implant surgeons and Jumbotron salesmen back in business.