The New Year has opened up with signs of life in the housing market and a chorus of pundits proclaiming that the worst is behind us. Could it be true? Will the residential real estate market fare better in 2007 than it did in 2006?

As I survey the scene, I am left with the distinct impression that it will not. Every indicator of housing market health seems to be in worse shape now that it was a year ago.

  • Supply and demand. It’s true that housing activity picked up in December, at least as compared to the abyssmal months that came before it. But inventory is still higher and sales lower than they were at this time last year.
  • Must-sell inventory. Too much inventory does not itself cause price declines of any significance because sellers can always wait around to get the price they want. What really grinds down prices is an excess of “must-sell inventory” — homes put up for sale by builders or by owners that, whether due to job loss, loan reset, divorce, relocation, or anything else, cannot afford to wait very long.

    Notices of default, which are the nastygrams sent to borrowers who haven’t been making mortgage payments, are a good proxy for must-sell inventory because they indicate how many homeowners are in financial distress. By this number, this year certainly appears less promising than last: more than twice as many notices of default were delivered in December 2006 than in December 2005.

    It is likely that must-sell inventory will continue to rise throughout much of 2007 due to housing-related job losses, new construction being completed, and the fact that far more exotic (and often underwater) loans are going to reset this year than did in 2006.

  • Sentiment. Euphoric optimism was the the rocket fuel that launched the San Diego housing market into orbit. No matter how high prices got, people still bought in because they thought they could sell for even more.

    Now that fuel tank is running low. While most San Diegans are cautiously optimistic, or at least not terribly pessimistic, there is no question that sentiment has darkened quite a bit from the sanguine mood that was widespread at the beginning of 2006. We begin 2007 with a lot more people wondering why they would pay so dearly for a home that has a good chance of declining in value.

  • EZ credit. Sentiment could only have carried the real estate rocket so high without the booster provided by the widespread availability of exotic mortgages, which included negative-amortization, interest-only, low-down payment, and stated-income loans. Such loans are still available but it seems that the ranks of their purveyors are thinning. Multiple subprime lenders have shut down their operations in just a couple of months, often citing a lack of investor demand for the mortgage-backed securities of which they formerly couldn’t get enough.

    A tightening of lending conditions would make it tougher for buyers to pay prices at these levels. It would also prevent current owners from refinancing their way out of impending loan resets. The resulting combination of decreased demand and increased must-sell inventory would almost certainly put downward pressure on prices.

It is certainly within the realm of possibility that the situation will improve later in the year, but a snapshot of current conditions reveals a market that is much more vulnerable than it was a year ago. As tough a time as the San Diego housing market had in 2006, it appears that 2007 is shaping up to be even tougher.


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