The Worst-Case Scenario for Housing

Forecasters say a 40 percent drop in home prices from their peak is possible, though quite unlikely.

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A year ago, most economists talked in worried tones about the possibility that American home prices could slip after almost doubling during the prior decade. At worst, fretted Wall Street's more bearish forecasters, prices could drop as much as 20 percent from their peak in a more dire version of the last housing downturn during the early 1990s, when new-home sales dipped but existing homes held their value.

Fast-forward to today, and the scope of those concerns looks almost quaint. Home prices are already falling fast (with builders offering huge rebates on new homes), and the only question now is: Just how low can they go?  Forecasts by Moody's Economy.com now use a 20 percent drop in median existing-home prices from their 2005 peak as a baseline, with prices weakening through at least mid-2009. The forecast assumes the United States is already in a mild recession.

And that is the good news. "Our weaker scenario...is a 25 percent decline in prices," says Celia Chen, Moody's director of housing economics. "That would be in the case of a housing and credit crash and still a moderate recession." There are new worst-case whispers as well. "You want the darkest? Forty percent," she says. "There's your apocalypse."

That's right. In Moody's most pessimistic (and most unlikely) scenario, existing-home prices plummet by 40 percent from their peak. A drop like that would certainly plunge the economy into a deep recession, push unemployment to around 9 percent, and hamstring economic growth in a way that could take years to undo. The shock of falling home prices and tight credit markets would spill into everything from consumer spending to business investment.

Ouch. Mix in the huge glut of unsold houses on the market, and such a catastrophe would be a recipe for a huge devaluation of not just homes but other assets, like automobiles. Tight credit would exacerbate the pain, forcing interest rates on bank loans to climb. It would also coincide with a generation of retiring baby boomers who watched home prices soar and pared back their personal savings accordingly, notes Merrill Lynch.

Last year, the primary culprit behind the turmoil in the housing, credit, and equity markets was the threat of defaults on subprime mortgages. The accompanying rise in default and foreclosure activity is distressing, but in some ways it's also old news. The next villain, if the credit crunch continues, will be corporate debt. "If the credit tightening spills over into the corporate debt market in a significant way, that would result in a much deeper recession than we're expecting, and that in turn would drag home prices down further," Chen says.

Worse-than-expected home price declines come on top of the damage already done by several months of housing-related turmoil. "These are almost the 1979-82 [numbers]—the worst housing depression of the postwar era," says Richard DeKaser, chief economist at National City Corp. Back then, however, double-digit inflation and interest rates were the rule. Today, all of those factors are relatively in check.

Still, the worst scenarios will most likely prove no more than a cautionary tale. Home prices remain a largely local phenomenon, with the largest declines coming in parts of the country that watched prices soar the most during the boom. Also, there are rosier forecasts than Moody's. Lawrence Yun, the chief economist at the National Association of Realtors, says the worst outcome for housing would require a period of stagflation—slow growth and prolonged job losses coupled with rising inflation. Most analysts expect the economy to avoid that '70s-era threat as inflation cools amid slower growth.

Yun expects the economy and the housing market to recover in the second half as Federal Reserve interest rate cuts and the government stimulus kick in. "In terms of home sales activity," he says, "we may be scratching the bottom." Even if that turns out to be true, it will be a long time before cocktail party chat is dominated by tales of how much your home has gone up in value.