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Cracks in the Economy?

The housing market in Detroit is a mess. Such a mess that nobody tries to deny it, not even the real estate agents. "The market is very, very bad," laments Jennifer Weight, hosting a deserted Sunday open house in the suburb of Bloomfield Hills. "It's terrible."

Across the country, in the anti-Detroit that is San Diego, real estate is also slumping. The gloom, however, is far less pervasive. "Yes, it's a troublesome market, but it's not terrible," contends broker Leona Kline.

The reason for the difference in attitude is pretty simple. In metropolitan Detroit, the 11% drop in home prices over the past year was just one more sign of a local economy in decline thanks to the troubles of the auto industry. In San Diego, the drop of 7.3% came out of the clear blue sky. The city still has jobs to offer. Beaches too.

But it is the downturn in sunny San Diego that poses the far bigger risk to the U.S. economy. Detroit, Cleveland and some smaller Rust Belt cities are experiencing a traditional bust, in which economic woes spread to housing. In San Diego, the housing decline seems to be a self-generated phenomenon, the product of too-high prices and too-crazy lending practices. Now the "housing market is dragging down the rest of the economy," says Alan Gin, an economist at the University of San Diego. The same is true in and around Los Angeles, San Francisco, Phoenix, Las Vegas, Miami, Washington, New York City and Tampa, Fla.--all metro areas where house prices skyrocketed until 2006 and have since fallen in the face of otherwise positive economic news. Nationally, house prices dropped 3.2% in the 12 months ending in June, while the economy grew 1.9%.

For much of this year it was tempting to see this disconnect as a good thing: strength elsewhere was compensating for the slowdown in housing. But when the Labor Department reported in September that job creation had lurched into reverse after four years of gains, the tune on Wall Street and elsewhere shifted abruptly. Economists began fretting that, for the first time, a real estate bust would throw the country into recession--a sustained period when the economy shrinks instead of grows and lots of people lose their jobs.

Forecasters are, as a group, notoriously bad at predicting inflection points, so you shouldn't take this dire talk to the bank just yet. At the Economic Cycle Research Institute, an outfit with a good record of at least noticing when recessions have begun, the indicators still point toward growth--albeit less convincingly than two months ago. "Having a jobs report come in negative does not mean that a recession has started," says managing director Lakshman Achuthan. But the risk is there, and Achuthan guesses it will worsen if loan markets fail to calm down. If a month from now a borrower with good credit still can't get a jumbo mortgage at a reasonable rate, a recession will be much likelier.


THAT A REAL ESTATE BUST MIGHT LAND US IN a recession is in a way fitting because it was a real estate boom that kept the last recession, in 2001, so brief and shallow. Trying to stave off deflation in the wake of the stock-market crash, Alan Greenspan's Federal Reserve cut the short-term interest rates that determine what homeowners pay on adjustable-rate mortgages. Meanwhile, investors desperate for someplace other than the stock market to put their money piled into mortgage securities, driving down the cost of fixed-rate loans. Housing markets, already doing well amid the strong economic growth of the late 1990s, exploded.

To a remarkable extent, housing drove the entire economy. Real estate, residential construction and three other housing-related Labor Department job categories together add up to 6.6% of U.S. employment. But they accounted for 46% of the new jobs created in the U.S. between January 2001 and May 2006, when the sector peaked.

The main reason for the boom's doom was that in the nation's San Diegos, double-digit annual price increases put most homes out of the reach of middle-income buyers. The mortgage industry and its funders on Wall Street responded with laxer lending standards and creative loans (no downpayment, teaser rate, interest only, etc.) that really made sense for borrowers only if prices kept going up and they could sell at a profit or refinance. When prices stopped rising last year, the edifice began to crumble.

It's in the nature of real estate that the crumbling may continue for a while yet. "It's way too premature to be talking about light at the end of the tunnel--it's still pitch black," says Ian Shepherdson, chief U.S. economist at High Frequency Economics, a research firm. Shepherdson, not a congenitally bearish sort, was one of several prominent forecasters who began warning of housing troubles in 2005. Now he sees huge quantities of unsold inventory, which will lead to more cutbacks in construction, which will lead to more job losses and so on. "I don't want to call it an endless loop, because it will end," he says. "But not anytime soon."


WHEN CONFRONTED WITH SUCH GLOOMY talk, many in the real estate business offer a classic response. "People don't buy real estate on a national basis," says Tom Kunz, CEO of real estate giant Century 21. "They buy it on a local basis." Sure enough, many parts of the country aren't in trouble. Prices are still rising in Seattle and Portland, Ore. In Atlanta, Dallas and Charlotte, N.C., prices never went up all that much, and they're not falling now. The same appears to be true in many smaller cities and towns.

But most of the country's big metro areas are caught in the downdraft. With mortgage lending now very much a national business--and a troubled one--real estate may not be as local as it used to be. It may not even be national: house prices have been rising sharply in Europe, Australia, South Africa and China. Two countries at the leading edge of this boom, the U.K. and Australia, saw housing markets sputter in 2004 and 2005 but then recover. This may indicate that a quick recovery is possible in the U.S. It could also mean that the global boom will end only in a global bust--and U.S. mortgage troubles are now ominously making themselves felt around the world.


THESE ARE THE KINDS OF THOUGHTS THAT occupy Yale economist Robert Shiller, who with Karl Case of Wellesley has done more than anyone else to document the postmillennium real estate boom and warn about the inevitable bust. Shiller first made his name in the early 1980s attacking the notion, then widely accepted, that the stock market rationally reflects the true value of the companies whose shares are traded on it. He and real estate specialist Case then teamed up to show that home prices are even more subject to booms and busts than stocks. They did it by measuring repeat sales, which give a better picture of price movements than the figures published by the real estate industry. In 1991 they turned this into the business that supplied the price data used in this article.

After publishing a best-selling critique of the stock bubble, Irrational Exuberance, just as the market peaked in March 2000, Shiller set to work adding a chapter on real estate for the second edition. As part of that effort, he cobbled together an inflation-adjusted index of home prices going back to 1890, which showed that a) the price runup from 1997 to 2006 was by far the biggest on record and b) home prices can fall for decades. Put those two together, Shiller argues, and it's at least possible that we're due for an epic decline in prices. "People think that home prices go up a lot," he says. "But home prices in 1990 were at about the same level as in 1890." Shiller allows that the scarcity of property near the coasts might mean prices there will remain high, but then notes, "We can't make any more of the land, but we can build huge high-rises on the beach."

Huge high-rises on the beach, in fact, played a major role in Florida's boom and bust. There are 40,000 condominium units being built right now in greater Miami, and consultant Lewis Goodkin estimates it will take five to seven years just to work through all that inventory. That's five to seven years of downward pressure on local housing prices, construction employment and the like. The great test of the coming months and years is whether the U.S. economy is strong enough to withstand that kind of pressure without buckling. Right now things aren't looking good, but this is an equation with too many variables--Fed rate cuts, congressional bailouts, the ebb and flow of the global economy--to solve in advance.

Apart from the risk that it will bring a recession, though, a housing boom turned bust is far from an unmitigated disaster. Some buyers will get great deals on Miami condos, that's certain. And in the San Diego suburb of La Mesa, the downturn has allowed Amy and John Tuttle to finally buy a house. "We tried to buy homes a few years ago, but the homes were too expensive," says Amy, 31, a clinical psychologist. "We put three bids on three different houses, and I think we were simply outbid." In August they closed on a recently foreclosed house priced at $405,000--less than they had been willing to pay three years ago.

If Shiller is right that house prices are subject to bouts of irrational exuberance--and he seems to be--this is the happy flip side. Somewhere along the path to and from irrational pessimism, this real estate bust may deliver the place you've been looking for.