Home prices are falling again. This morning, the Case-Schiller Index data for August (actually a three month average of June, July and August) was released. For the month, on a seasonally adjusted basis, the composite 10 city index (C-10) fell 0.17% while the broader composite 20 (C-20) was down 0.28%.

The government has poured huge resources into supporting the housing market. Most notably through the homebuyer tax credit and through the Fed buying up massive amounts of mortgage-backed paper. The covering of tens of billions of losses at Fannie Mae and Freddie Mac are also part of the government effort to prop up housing prices.

For awhile those programs did manage to succeed in stabilizing prices and even caused a slight rebound. Now the government support is fading, and so are housing prices. The effect of the government support can still be seen in the year-over-year data.

Relative to a year ago, the C-10 is up 2.53% while the C-20 is up 1.67%. However, as the first graph (from http://www.calculatedriskblog.com/) shows, those gains are starting to evaporate. Relative to the peak in April 2006, prices are down 29.22% for the C-10 and 28.83% for the C-20.

For the month, the declines were very widespread, with 19 of the 20 metropolitan areas posting declines. Only New York avoided that fate — and just barely — posting an increase of just 0.01.  Two other cities, Washington DC (-0.03%) and Boston (-0.07%) were close to being unchanged.

The biggest declines were mostly in the West and were a mixture of the cities that have been hard hit all along in the housing bust, and those that up until this point have been relatively immune.  Hardest hit was Phoenix, which along with Las Vegas has been the poster child of the housing bust. It dropped 2.21% on the month to bring its decline since the April 2006 national peak to 52.92%.

Denver, which has been one of the least-affected cities, was tied with Cleveland for the second worst decline with a drop of 1.14%, and Dallas, the single least-affected city from the peak was right on their heels with a decline of 1.13% on the month.

On a year-over-year basis, prices are up in just 8 cities and down in 12. The three cities tracked in California have all fared the best on a year-over-year basis, with San Francisco up 7.72%, followed by San Diego up 6.91%, and LA up 5.32%. All three were among the hardest hit early in the bust, but have started to rebound — well, at least until this month.

The second graph below (also from http://www.calculatedriskblog.com/) tracks the performance of each of the 20 cities on a cumulative basis. The dark blue bar shows the decline up until the end of 2007, the light blue bar until the end of 2008 and so on. Thus, if a bar is shorter to the downside than the previous bar it indicated that prices rebounded in that city during the period.

When the homebuyer tax credit expired at the end of June (for closing) existing home sales collapsed. People rushed to complete the sale in June to take advantage of the credit, and that pulled forward sales that would have ordinarily have happened in July or August.

The collapse in sales pushed the months of supply to an all-time record high in July of 12.5 months. That has since declined to 10.7 months in September. The absolute level of inventories in September was down 1.9% from August, but was up 8.9% from a year ago.

Just like any other market, supply and demand are going to be the things that determine the direction of prices. The current “inventory to sales ratio” of 10.7 months is as bad as it was during the worst of the home price collapse during 2007 and 2008. This clearly indicates to me that the price decline the Case Schiller index posted for August will not be its last.

If existing home prices are falling, then so is the wealth of the vast majority of middle-class Americans. Housing equity is the major store of wealth for most of the middle class. Well at least it used to be before prices collapsed. That wealth was probably destined to be used to help finance retirements and college educations.

Now, if people still want to be able to retire someday or put their kids through college, they will have to save more out of current income to make up for that loss of wealth. That which you save you don’t spend. The lack of spending is going to be a major drag on the economy.

More Mortgages to Head Underwater

Also, currently about 23% of all houses with mortgages are “underwater.” As housing prices fall, more and more homeowners are pushed below the waves, and those who are already underwater find themselves even deeper below the waves.

Just being underwater is significant, since being underwater is a necessary, but not sufficient, condition for a foreclosure to happen (if you have any positive equity you are better off selling the home and getting something, rather than letting the bank take it and get nothing, regardless of your cashflow situation).

However, depth matters as well. A house is also a home, and as such, non-economic considerations are important. Few people are going to let the bank take their house just because the mortgage on it is $1,000 more than the house is worth, particularly if they have the cashflow to continue paying the mortgage.

That calculation becomes very different if someone is $100,000 underwater on their home.  Add in one or both of the breadwinners in the family being unemployed, and you have a recipe for either foreclosure or people simply walking away from their homes.

For millions, simply walking away is the most rational thing they can do economically. Collectively, though, that causes huge damage to the economy.

New Home Construction Also Hit

In addition, as long as home prices are falling due to a massive excess inventory of existing homes, there is very little reason to be building new homes. Each new home built results in a lot of economic activity.

For starters, it employs construction workers, a group that has been harder hit than any other in the Great Recession, accounting for more than one in four jobs lost. When they have jobs, they are far more likely to go shopping at Wal-Mart (WMT) or out to dinner at the Olive Garden (part of Darden Restaurants, DRI). As they do, it means more work for people stocking the shelves at Wal-Mart and cooking the food at Olive Garden.

New houses also use a lot of building materials, most of which are still produced here in the U.S.  Thus, homebuilding also supports the jobs of lumberjacks working for Weyerhaeuser (WY) and people making roofing materials at Johns Manville (part of Berkshire Hathaway, BRK.B).

Normally, residential investment acts as the starter engine for the overall economy. The blown starter engine is the key reason why the main engine of the overall economy just refuses to turn over and we have such a sluggish recovery. Another down leg in housing prices is not going to help the situation. To put it mildly.

Housing Becoming More Affordable

Fortunately, housing prices are much more reasonable now than they were back in 2006, particularly relative to rents (see the next graph, again from http://www.calculatedriskblog.com/). Record low mortgage rates also make housing relatively more affordable.

However, note that while we are no longer at extreme levels relative to history, we are still above the long-term average. There is nothing to prevent prices from overshooting to the downside, just as they overshot to the upside.

On the other hand, it seems unlikely that the decline in this current second down-leg of the housing market is going to be as severe as the first leg. Most likely we will see a nationwide decline of between 5 and 10% over the next year.

That decline, however, will hurt and will leave a mark. Eventually, a rising population will absorb the excess inventory, but it is going to be a slow process. And until that happens, the economy is likely to stay soft.
 

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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