House Call: When the Bubble Pops, Consumers Will Scale Back Spending

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What happens when the housing bubble bursts? Best case: prices level out. Worst case: recession. Either way, consumer spending is set to take a big hit.

Consumer spending drove this economic recovery, and a surreal estate market fueled that spending. Total consumer expenditures-including consumption and interest payments on debt-this summer surpassed disposable income, giving the nation a negative personal savings rate for the first time since the Great Depression. Mortgage debt has soared 54% since the '01 recession ended while wages have gone up just 16%.

Signs are growing that the housing boom is a bust. The number of new homes for sale reached a record level in August while the median price has fallen 7% from its February peak, according to the Census Bureau. The supply of unsold existing homes has been rising since March, according to the National Association of Realtors; the 4.7 month supply is highest since 2002. Rates for 30-year mortgages are near a six-month high; mortgage applications are falling.

Even real-estate agents are pulling back. The California Association of Realtors predicts the median price of a house in that state in '06 will rise a "moderate" 10% to a not-so-moderate $575,000 while unit sales will fall 2%. It noted only 14% of state households can afford to buy a home. That's the lowest affordability index since 1989-eve of a six-year California housing slump.

Strong, but less frenetic

Price gains are biggest on the coasts, but every state has participated in the boom to some degree. Average U.S. home prices in the second quarter rose at an annual rate of 13.4%, according to the government. That's the fastest growth since 1979-eve of a debilitating downturn that sent after-inflation (real) housing prices tumbling.

For now, the housing market appears strong, if less frenetic. But there's no shortage of economic or media analysis suggesting the market is living on borrowed time (and money). "Housing bubble" has appeared in 2,434 newspaper and magazine articles this year, more citations than for the stock market "bubble" in 2000. Federal Reserve Board Chairman Alan Greenspan warned last month: "Signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels."

What happens if the boom becomes a bust?

At worst, the economy slumps into recession amid rising energy prices and plunging consumer confidence; real housing prices fall, especially in overheated markets; home building plummets; overextended consumers hunker down, slashing spending.

Best chance: Housing prices stabilize, economic growth slows but the recovery-4 years old next month-stays on track.

Either way, spending suffers. The explanation is the "wealth effect." A study last year by the National Association of Realtors found that over time, consumers spend 5.5¢ of each dollar increase in housing wealth and stock wealth. Spending from housing wealth takes only a year to reach 80% of its long-term effect, the study found, vs. nearly five years for stock wealth. NAR said that's likely because consumers are more confident that housing gains will hold.

U.S. home values have soared to $18 trillion this year from $8 trillion in `95, according to Mr. Greenspan. Said Delores Conway, director of the Casden Real Estate Economics Forecast at the University of Southern California: "That money has created a lot of retail spending."

The Fed's '01 move to cut interest rates helped drive housing and spending, softening the recession. Housing wealth accounted for more than one-fourth of personal consumption gains from `01-`03, NAR estimated. Housing also made recovery a bit less jobless; home building, real-estate finance, brokerage and related jobs account for 21% of employment growth since the recession ended, according to American Demographics' analysis.

What goes up can come down. Michael Bazdarich, senior economist with the UCLA Anderson Forecast, said home-building jobs could take a big hit. Construction produced the most new jobs since 2003 of any industry in California.

A personal ATM

Weaker housing could dampen spending. An International Monetary Fund study of global housing markets found a dollar decline in stock wealth led to a 4¢ drop in spending while a dollar decline in housing wealth led to a 7¢ cut in spending.

Equity has given owners a personal ATM: Households withdrew a record $600 billion in equity last year by selling homes, refinancing or taking home-equity loans, according to the Federal Reserve Board. Economists say half or more of that went to consumer spending-new kitchens, furnishings, cars. That source will shrink if home prices stabilize or fall or if, as seems likely, long-term interest rates rise. Looming payment resets for adjustable and interest-only mortgages add to the problem.

"People are going to be really, really squeezed," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. He said many baby boomers, with little savings outside their homes, will feel pressure to set aside more cash for retirement.

Even the best case doesn't look good: Goldman Sachs projects a weaker real-estate sector will reduce gross domestic product about 1.5 percentage points in `07 and '08 and "raise the risk of recession."

Optimists will note nominal (before inflation) U.S. housing prices have risen every year since 1950. Pessimists may note real U.S. home prices have fallen seven times in the past 25 years, including every recession except for 2001. Local and statewide drops are common, typically tied to recession or regional shocks ('80s oil price fall in Texas, '90s defense cuts in California).

The housing market now is in uncharted territory after an unprecedented boom. The most troubling prospect is not a wholesale crash in prices nationally-unlikely-but a sustained sideways market with limited upside in most areas and declines or flattening in the most inflated regions.

History shows that recovery to local housing markets can take a decade or more. That's a problem for an economy so dependent on housing to fuel its growth.

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