By Steve Schifferes
Economics reporter, BBC News, Cleveland, Ohio
A glut of unsold homes is depressing US house prices
The sudden tightening of credit on high-risk sub-prime mortgages has led to a property price crash in the US, with devastating effects on the whole economy.
The unprecedented decline in US house prices may also lead to further pain for financial institutions, who collectively own more than $1 trillion worth of sub-prime debt.
One of those who has been hard-hit by the sudden change in the housing market is Suzi Savino, a real estate agent in the pleasant suburb of Westlake, to the west of the city of Cleveland, Ohio.
Real estate agents are independent professionals who get paid a fee for each house they sell.
Suzie Savino has seen her income as a real estate agent plummet
During the housing boom, Suzi earned a six-figure income, which helped pay for the good things in life, such as a home in an upscale neighbourhood and a nice car.
But this year, Suzi's earnings are down by 70% - and houses are just not selling.
The situation is so bad that she is thinking of leaving the industry - but she would have to sell a house she owns (and inherited from her mother) in order to make up the loss of family income.
Sitting around her kitchen table for coffee, a group of real estate agents and mortgage brokers in the area were clear what was to blame.
They said that the wave of foreclosures and evictions of people who had sub-prime mortgages was having a chilling effect on the housing market - and those foreclosures had now spread from the inner city to suburbs such as Westlake.
Vaughn Martin, her boss at Remax, says that he has to work twice as hard just to keep his head above water. With a huge inventory of unsold homes on his books, his clients are asking to see 30 or 40 properties, and if the buyers do not accept their offers, walking away rather than negotiating.
House price crash
Housing markets are local, and few areas have experienced the 30% decline in average house prices that has hit Cleveland, the sub-prime capital of the US.
But average house prices across the US are declining for the first time since the Great Depression in the 1930s, and the magnitude of the collapse has surprised experts.
There is nearly a year's supply of unsold houses standing vacant.
And the housing crash is now extending to the formerly "hot" housing markets in Southern California, Arizona, Nevada and Florida, where expanding populations and a strong economy were expected to keep prices high.
Mark Zandi, an economist at Moody's, who is tracking the housing market,
expects the fall in house prices to accelerate from 5% this year to 10% in 2008.
He says that prices could end up 10-15% lower than the peak of 2006 - if policymakers move quickly to stem the wave of foreclosures.
But if they don't, and if interest rates are forced up by the inflationary worries, he says prices could fall by 15% to 20%.
Mr Zandi says there are three factors that have caused the property crash:
- speculative purchase of homes in hot areas by investors who intended to "flip" them, reselling quickly at a profit;
- the availability of easy credit, where mortgages were granted to people who could not really afford them;
- and the over-supply of new houses by builders.
House building industry in retreat
The devastating effect of a property crash is taking its toll right across the building industry.
Enzo is surviving as a builder by only making custom-built homes
And nowhere is the pain more evident than among house builders.
At the National Association of Home Builders annual construction industry forecast conference, no one was enjoying the fancy lunch their organisation had put on.
Instead, their ashen faces showed that they had only just grasped how serious the overall situation had become.
The NAHB's chief economist, David Sieders, had just told them that house building would contract by 50% in the next two years, cutting employment by 1-2 million jobs and wiping out many firms - and he fears that prices might not start rising again until 2010.
John Regan is a medium-size builder in the Washington DC area who has just completed a high-end condominium project in the upscale suburb of McLean, Virginia.
But he has only sold a few of the 20 units in his development, and he faces huge carrying costs to pay for the money he has borrowed from the bank to finance the development.
He reckons that - by putting all his life savings into the pot - he and his partner have enough cash to hold out for a year before they will go bankrupt.
Ironically, one of the few people who bought one of his $1m apartments was a director of the World Bank - who drove a very hard bargain, as someone only too aware of the distress in the housing market.
Mr Regan faces another problem. Unlike the large builders, he cannot afford to offer deep discounts or he won't make any profit.
In the DC area, big builders are offering up to 30% discounts on their fancy homes.
Much of the US house building industry, however, is now dominated by large-scale builders, such as Toll Brothers or DR Horton, which are listed companies.
They have been forced to cut the prices of their new homes by as much as 30%, unloading property at any price to avoid bankruptcy.
And this is further depressing housing prices, especially in the "hot" areas where the big builders had concentrated their efforts.
One smaller builder who looks set to survive the turmoil in the industry is Enzo Perfetto, who builds custom-built homes in the eastern suburbs of Cleveland.
A million construction workers are expected to lose their jobs
Mr Perfetto has two advantages: he only builds a home when a customer orders a home, and thus is not carrying an inventory of unsold houses that he has to finance; and in Cleveland, house prices were too low to attract the large house building companies as rivals.
But nevertheless his business is down, from about 30 houses a year to between 20 and 25 this year.
Small builders like him are also cushioned by the fact that they employ all their labour on a contract basis, getting up to 70 different crews in to build each home, employing several hundred people for a few months.
But it also means that they can shed labour more easily in a downturn - adding to unemployment.
The biggest problem that is likely to drive house prices down further is the complete breakdown of the system of mortgage finance in the US.
During the last decade, financial institutions shifted from directly providing their customers' mortgages to relying on the credit markets for financing - similar to the system employed by the Northern Rock in the UK.
By 2006, 70% of US mortgages were financed in this way.
But in August, the credit markets suddenly woke up to the fact that many of the mortgage-backed securities they were being sold by the banks were much more risky than they had realised.
They were worried that nearly half of all those with sub-prime mortgages were behind on their payments, and one in five are expected to go into foreclosure - thus putting their investments at risk.
And so they have stopped buying mortgage-backed securities altogether, unless they are backed by the government, causing the supply of mortgages to dry up.
The result is that many banks are unable to originate mortgages because they are unable to sell them on, and there has been a sharp tightening of credit all around.
The majority of lenders are now tightening up conditions for prime as well as sub-prime lending, with higher deposits, a better credit score, a higher income-to-loan ratio and a lower loan-to-value ratio being demanded.
TYPES OF US MORTGAGES
Sub-prime: at a higher rate of interest for people with poor credit history and low income
Alt-A: at a higher rate of interest for people with poor credit history but better jobs
Jumbo: mortgages over $417,000 and not backed by government guarantee
Prime: mortgages under $417,000 backed by government guarantee with stricter loan conditions (also called 'conforming')
And it looks like the tightening is spreading to personal loans and commercial property loans.
The head of Freddie Mac, the federally-sponsored agency that also lends on the wholesale mortgage market, is in no doubt how serious a crisis this is.
"This is the first time we have had an absolute decline in housing prices in the US since the Great Depression and it's the first time we have had this kind of impact on the housing market without it being driven by macro-economic declines," Dick Syron told the BBC.
He said that the secondary market for all non-conforming mortgages (ie those not guaranteed by Freddie Mac or other government sponsored agencies) had viritually dried. up.
How will the property crash hurt the overall US economy, the biggest in the world, which last quarter was growing at an annual rate of 3.9%?
The US Treasury Secretary, Hank Paulson, acknowledges: "The ongoing housing correction is not ending as quickly as it might have appeared late last year.
"And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet."
The US government and the Federal Reserve believe that the housing slump, on its own, will cut US growth by 1% to 1.5%, slowing the economy to around 2.5% next year - a view currently shared by the IMF.
But there is considerable uncertainty whether the economy will revive in the second half of 2008.
A full-blown credit crunch, in which consumers stop spending on other items, would be much more serious.
The US consumer boom has financed by credit and also helped by a significant amount of equity withdrawal, where people get cash for spending by remortgaging.
This peaked at $850bn in 2006, or 7% of consumer spending.
The key question is whether consumers will stop spending when they discover that their house is worth less than they thought.
The former boss of the Fed, Alan Greenspan, told the BBC that there was a 30-40% chance of a full-blown recession when people realise how bad the housing situation is, and that Fed studies had shown there was a very real - but delayed - wealth effect.
Others, such as Merrill Lynch, put the chances of an absolute decline in the economy, at above 50%.
So there is a wide divergence of views among economists as to whether the US economy will recover in the second half of 2008.
Much will depend on the actions of Mr Greenspan's successor at the Fed, Ben Bernanke.
The Fed moved quickly to cut interest rates by 0.5% in September and made another 0.25% rate cut in October.
As Mr Bernanke explained, there was a risk that "the housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest.
"By doing more sooner, [the Fed] might be able to forestall some of the potential adverse effects of the disruption in financial markets."
However, there are signs that Fed governors are split over the wisdom of further rate cuts, and some want to take back the cuts they have already made, as the worries about the effect of higher oil prices on inflation grow.
If that were to happen, says Mark Zandi, the consequences for the housing market could be severe, with price declines of up to 30% in some areas.
And that, in turn, would multiply the losses in the financial sector.
So Wall Street, at least, is still betting on further rate cuts to save the day.