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Market psychology

• During the last decade, the total value of owner-occupied housing units in the six New England states quadrupled from under $300 billion to $1. 29 trillion, adding nearly $1 trillion to household balance sheets. • Also during the last decade, existing home sales nationwide grew steadily to record levels, peaking at 7. 2 million in September 2005; new home sales peaked at 1. 35 million in October 2005; and housing starts hit a new high of 2. 27 million in January 2006. Home improvement spending hit $138 billion per year in 2003.

• In the third quarter of 2006, construction employment reached all-time highs in both the nation (7. 5 million) and New England (more than 300,000). These are, respectively, 34 and 40 percent higher than a decade ago. The housing boom reverberated far beyond the housing sector itself. Significant numbers of people work in real estate, from brokers and bankers to builders, appliance dealers, and construction workers. Factoring in all sectors, estimates suggest that between 12 and 18 percent of total U. S. employment was directly or closely linked to real estate over the last five years. Clearly, the housing market has been an engine of growth and stability during this period.

Understanding the past to anticipate the future The housing boom was fueled by a number of factors, including: • Demographics. Baby Boomers entered the housing market with a vengeance in the 1970s and 1980s. To some extent, Boomers have surprised us. They have not behaved as other generations. Boomers look at housing as previous generations looked at cars and TVs: rather than owning just one house, in many cases they own two and, sometimes, three or four. • Interest rates and a very liquid mortgage market. Rates have been down for a long time at levels that have significantly increased housing affordability.

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But in addition to low rates, the mortgage market has been transformed in the past decade in ways that have expanded demand for housing. First, sub-prime lending grew significantly. Large numbers of households that previously would not have qualified for credit now do, which has been a major factor in the rise of the homeownership rate to nearly 70 percent. Second, new and exotic mortgage instruments, such as pay option adjustable rate mortgages and interest-only or negative amortization loans, have reduced initial carrying costs to very low levels.

• The stock market and investment choices. When the stock market is strong, people have more wealth, some of which naturally finds its way into housing. The housing market did well during the dot-com bubble. There is also evidence that when the stock market falters, real estate is a good refuge. Something stands out when comparing an investment in a house with a block of common stock: If you think of buying a house outright and living in it, you earn a rate of return that comes in the form of valuable housing services, even if the house doesn’t appreciate.

This “imputed rent” can be seen as analogous to the dividend that comes with a share of stock. In a downturn, the dividend on common stocks goes away as profits fall. Not so with a house, whose dividend stream is essentially fixed in real terms. Holding a home is thus a good way to preserve a positive return, even if the value falls. • Foreign demand. When asked about the differences between the housing market in the last five years and the housing market of two decades ago, developers and real estate agents inevitably point to an increase in the number of foreign buyers.

While it is difficult to find hard data to support the claim, it is clear that the number of buyers whose primary residence is abroad has increased and, when added to demand from immigrants, the impact on home prices has been significant. • Supply restrictions. Some cite zoning and other restrictions that limit supply and drive up prices. And data show that price have not escalated as steeply in parts of the country where housing supply has kept pace with or exceeded growing demand. Though there are exceptions—Las Vegas and parts of Florida come to mind—supply does not appear to adjust quickly in areas experiencing big housing booms.

• Market psychology and expectations People’s views of the future can drive prices up—and, of course, down. When people buy an asset, they are buying the future. People are willing to pay more for an asset that they expect to increase in value. If their expectations are based on past price changes, even small price increases can lead to a rapidly escalating price level. Much evidence suggests that exuberant expectations played a major role in the booms of the last 30 years. A sea change Now the boom seems to be over. Volumes are decreasing substantially.

Housing starts in August 2006 were down to 1. 66 million from 2. 2 million per year earlier, a fall of about 25 percent. Existing sales fell by about 14 percent, from 7. 3 million to 6. 3 million. In addition, home prices are falling. In seven of the ten metropolitan areas in which the S&P Case- Shiller repeat sales indexes are published, prices are down, as is the U. S. composite index. And the Chicago Mercantile Exchange’s futures market shows virtually all markets in what futures traders call “backwardation,” meaning that the futures price is below the spot price of housing.

Some of the factors behind the boom have changed: • There has been a nationwide change in the psychology of the market, fueled in part by a stream of magazine covers and news stories portraying a popping “housing bubble. ” • Housing prices have been increasing faster than incomes, particularly on the East and West Coasts, and that cannot continue forever. Indeed, for most families on the coasts, housing has become increasingly unaffordable. In the long run, this income constraint must bind.

Indeed, during the house price busts of the 1990s in both California and New England, prices did not rise again until the median house price to median income ratio was back to its original level. • Evidence indicates overbuilding. As demand has dropped, the inventory of unsold homes has risen and the number of new units has run ahead of household formation. • Aging Boomers are entering a period when, rather than fueling the market, they are creating a drag. As they retire, become empty nesters, or otherwise seek to downsize, many are moving into urban condo markets.

Others are leaving high-priced markets such as Boston and buying into less expensive markets. Many are finding it difficult to sell their suburban homes, at least at the prices they had come to expect. • Finally, sub-prime and exotic mortgage lenders seem to have run out of new households to qualify for credit. As Wall Street begins to recognize that the nation’s portfolio of mortgage paper now contains much more risk than it did a decade ago, the homeownership rate is unlikely to rise much further. The sub-prime market has never been tested in a down housing market, and many fear serious default problems.

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