A Vicious Downward Cycle?

Certainly a major event like a war, a nuclear attack, a recession, George Bush growing a brain, etc. would be sufficient to cause a decline in the housing market. But instead, it will probably be something seemingly minor. So what might be the innocuous event (and here) that starts the vicious cycle that sends the housing market down? I think it might be as simple as a change in mass expectations.

Try this on for size:

If expectations change, if enough people think house appreciation is flat or small, then there will be less demand for houses. Certainly, people would have a harder time justifying paying such stratospheric prices for a house ("why buy a house when it won't increase in value very much, if at all, in the next few years and I can rent the equivalent house for much less at least for now? And if I rent now and prices decline, then I can buy more house later. It's a win-win.").

People who bought a house recently will be unwilling to sell below their cost, so most of them will just sit and wait, hoping; some might take the hit because they are forced to, but most won't.

But what about all those people who bought their house a while ago? They can afford to sell at a steep discount because they've built up significant equity. If they can afford to wait to sell, then they too will try holding out for top dollar. But what about those folks who bought a long time ago and must sell sooner rather than later for whatever reason? They will mark their house price down not because they want to but because they have to and because they can afford to. Because house prices are set "at the margin" these folks just reset the sale value of all the houses owned by the "hold out, wait and see" crowd as well as for the next person who bought a long time ago and is now deciding to sell and can afford to discount. And so on and so forth...

Since house prices aren't appreciating much, if at all, the cash-out refi (aka "housing ATM") fails, resulting in people spending less on stuff and services. Companies that make stuff and provide services aren't earning as much as before, so these companies lay off some employees. These laid off employees have difficulty making their housing payments or find work somewhere else and have to relocate and so have to sell their house.

And so on and so forth...

Some choice quotes:

If there's indeed a U.S. housing bubble - something most analysts now seem to acknowledge - it's deflation will have an impact, and perhaps a serious one.

We're probably going to find out over the coming months, because the evidence keeps piling up that the air is leaking out of the U.S. housing market.

The latest sign comes from sales of existing homes in December, which surprised analysts by dropping an unexpectedly sharp 5.7 per cent, to the lowest level in two years.

Price gains, which had been soaring at an annual rate of 16 per cent two months earlier, chilled to just over 10 per cent. The backlog of unsold homes, which had risen recently, remained high.

There are plenty of other signs that residential real estate is losing its powerful ability to boost economic growth.

Ian Shepherdson, chief U.S. economist with High Frequency Economics, expects price increases to slow much more, deflating homebuyers' expectations of future price gains. "This will be the trigger for a serious collapse in home sales later this year," he predicts. "The housing market is a bubble and it will burst."

All this is scary stuff if you believe that when a bubble bursts, prices plummet. Happily, that's not always the case. For the housing market, all that would be required to burst the bubble and collapse speculative activity would be for prices to plateau, or even to grow much more slowly.

This would still exert quite a drag on U.S. economic growth. Beyond the substantial impact of any pullback in home-building, the so-called "wealth effect" would evaporate.

The bad news is that this benign picture assumes that nothing else goes wrong - with interest rates, with the global economy or with highly speculative markets like California's, where it's at least conceivable that housing could crash, not just deflate.

It seems it is already happening. The number of listings in the Bay Area showing price reductions has soared.