The current deflation of home prices is changing America.
It's a real estate storm that made landfall like a slow-moving Gulf Coast hurricane here in south Florida and in other once-booming housing markets last year. In recent months it has gathered momentum and spread, shaping up to become perhaps the worst home-price slump since the 1920s and '30s.
The bust promises to have lasting effects. Among them:
•It is defining the limits, for now, of what President Bush has called the "ownership society." A surging foreclosure rate means that the rate of homeownership, after a historic rise, is falling.
•It's forcing a rethink of economic policy. The Federal Reserve is expected to ease interest rates this Tuesday. Over the longer term, today's hard lessons might influence the way the Fed and the mortgage market operate.
•It affects the mood of America entering the year of an up-for-grabs presidential election.
•It marks a pocketbook shift for consumers – and perhaps even global investors – from an era of housing-fueled wealth to belt-tightening. Real estate can no longer be viewed as a surefire investment.
"We are in the aftermath of the biggest housing boom in history," says Robert Shiller, a Yale University economist. "We are in a period of exceptional uncertainty about the value of our homes."
It is that issue – how far home prices rose – that sets this bust apart from other US housing downturns in the past century. This is more than a typical cycle where the pace of home building plummets. And this goes well beyond a crisis of subprime borrowers.
That's because this housing cycle now puts the wider economy at risk through several channels. First, the dive in home sales and construction subtracts directly from economic growth. Second, the erosion of property values is beginning to affect consumer confidence and spending. Perhaps more serious, write-downs of bad loans are crimping the health of banks, raising concerns that the flow of credit could be choked off despite Federal Reserve efforts to keep interest rates low.
In the boom, prices up 90 percent
What caused US home prices, as tracked by the Standard & Poor's Case-Shiller index, to shoot up nearly 90 percent in the first six years of this decade?
Easy credit laid the foundation for the run-up. But it also gathered a momentum of its own. As people saw the annual gains in home values outstrip the interest on a loan, they piled into the market.
Some worried that if they didn't scramble to buy, they'd never get another chance. Others were investors eager to "flip" homes for quick profits.
When home values finally maxed out in 2006 – not because of any general trouble in the economy but because asking prices outstripped the means of new buyers – the stage was set for a reversal. Speculators backed out of the market and defaults began to rise for subprime borrowers, who face higher interest rates because they present a higher risk to lenders. When adjusted for inflation, housing prices have fallen an average of 8.9 percent this year, according to Mr. Shiller (see chart below). Most economists expect them to fall further.
Economists differ on whether this housing slump is tipping the nation into its first recession since 2001. It is certainly a big drag on growth.
Recession or no, it appears clear that some of the repercussions will be long-lasting.
Start with a historic surge in foreclosures that has made some neighborhoods look like disaster zones. The problem may not crest for several years.
Here in Florida, many of the buyers who got burned were investors who expected to buy and then quickly resell homes in a rising market.
"There's a lot of people that stuck their neck out," says Richard Ray, a longtime resident who works at a marina in Cape Coral, with a rate of foreclosures in process – 5.4 percent of all mortgages – that leads the nation.
But here and nationwide, many people who never intended to ride a real estate wave are also at risk.
"You see all these empty houses now," says Ann Bala, a Cape Coral resident who is losing her home. An injury sidelined her from work, and then she was squeezed between a rising mortgage rate and a falling home value. "It's not even worth $100,000 anymore," she says.
"My phone has been ringing off the hook," says Steve Jones, who heads the Home Ownership Resource Center, which counsels people at risk of foreclosure in the area.
In a parallel trend, homeownership is in decline.
New mortgage products and new channels of credit funded by Wall Street investors helped turn 5 million renters into homeowners in the short span of one decade. By 2004, 69 percent of American households owned their homes, up from 64 percent a decade earlier.
It was what Washington politicians had hoped for, a symbol of American dreams coming true. President Clinton had signed a 1997 tax law, which made it easier for home sellers to keep their real estate profits without having to pay capital-gains taxes. Mr. Bush emphasized the goal of creating "ownership society" – where more Americans can have personal stakes in retirement accounts as well as houses.
But in this decade's hothouse of loose lending, many home buyers were really renters by another name, paying interest but having little chance to build home equity unless property values kept rising.
Homeownership expected to fall
Now some analysts believe the homeownership rate will come down to about 67 percent.
The bursting of the housing bubble also represents a period of lost wealth, even for people who keep their homes. Some $1 trillion or more is being marked down from household balance sheets, and that has ripple effects on consumer spending.
Retiree homeowners also face a squeeze, as lost housing value erodes their nest eggs.
More broadly, America's access to home equity loans and "cash out" mortgage refinancings is dwindling alongside property values.
And there could be global ripples as well. Worldwide markets have been buoyant for real estate and other investments fueled by borrowing. From commodities to stocks to emerging-nation bonds, assets have been rising in value.
It's unclear if the party in global markets is winding down for now. How things go in the United States economy could hold the key.
For now, a low unemployment rate and rising paychecks have been helping to offset housing's impact.
But the crunch has dampened American spirits just in time for presidential primary elections. One major survey of consumer confidence has fallen for four straight months – a possible leading indicator of recession. This makes the economy a volatile campaign issue, perhaps eclipsing Iraq.
And policy responses to the housing crunch will be a focus for the next president, as they are for Bush. For now, the White House and Congress are looking at ways to slow the rise in foreclosures – including an interest-rate freeze for some borrowers announced by the president last week.
Further down the road, new laws and private-sector measures could reshape the financial industry. "Nonbank" lenders could be brought under the wing of federal regulators, among other things. Even the Fed could rethink its role in the economy.
Critics say that the world's central bankers kept interest rates too low in 2003 and 2004, because they focused too much on official inflation indexes and not enough on warning signs in assets like homes.
"The Fed takes no responsibility for asset bubbles," says Dean Baker, an economist at the Center for Economic and Policy Research in Washington. "I think that's something that will be reexamined."