by Calculated Risk on 8/25/2005 06:52:00 PM

Floyd Norris, chief financial correspondent of The New York Times, has an interesting take on the housing market:

If housing prices fall, will mortgages cushion the downfall, or make it worse? Put another way, will more overstretched homeowners be forced to sell?

At issue is whether financial innovations that have made it easier for Americans to buy homes have also made the system less stable and more vulnerable to shocks that could drive many of them from their homes, having lost all they invested in them.

Mr. Norris reviews previous housing slowdowns and contrasts housing, bought with mortgages, to stock, bought on margin. I recommend reading his comments.

The interesting and somewhat novel observation is that Mr. Norris believes we can tell, when housing starts to slow down, if it is an ordinary housing slowdown or a possible disaster by whether or not transaction volumes decline significantly for existing home sales.

But if and when a fall comes, watch the volume of home sales, particularly of existing homes. Back in 1978, almost four million sales of such homes were counted by the National Association of Realtors. By 1982, amid recession and rising interest rates, the figure was under two million.
...
If [then number of transactions] falls rapidly, that will be an indication that not much has changed, and the damage is likely to be limited.

But if sales volume stays high, that could indicate that the mortgage innovations are hurting. Then we could see rising numbers of foreclosures as homeowners discover they cannot sell their homes for what they owe but also cannot pay their suddenly higher monthly mortgage bills.

I've been expecting volumes to drop significantly (what Mr. Norris suggests is normal). Of course the "limited damage" would be a slow down in GDP growth or a mild recession.

If volumes stay high while prices drop, Mr. Norris argues we are in for tough times.