by Calculated Risk on 11/27/2007 05:34:00 PM

Goldman Sachs Chief Economist Jan Hatzius released a new report on housing today: Housing (Still) Holds the Key to Fed Policy

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Note: The following excerpts are used with permission.

In this new report, Goldman revised down their housing outlook significantly (here is their August forecast). Goldman now sees housing starts falling to 750K (their earlier forecast was for starts to fall to 1.1 million units).

On housing prices:

Home prices are also likely to decline substantially. If the economy narrowly escapes a full-blown recession—as we continue to expect in our baseline forecast—a peak-to-trough decline of 15% in house prices is the most likely outcome. This would imply price declines in states such as Florida of up to 30%. If the economy does enter a recession, prices could decline as much as 30% nationwide.

On the impact of less Mortgage Equity Withdrawal (MEW) on consumer spending:

Consumer spending growth has remained stable over the last 1-2 years as rising equity prices and sturdy income growth have offset the drag from falling mortgage equity withdrawal (MEW) and slowing home prices. Nevertheless, consumption has underperformed income growth, as predicted by our MEW-augmented consumption model. Going forward, our model points to a more substantial drag of housing on real consumer spending growth, with a slowdown from the recent 3% pace to a 1% annualized rate in early 2008.

Click on graph for larger image.

On negative equity:

The basic problem is that house price declines create large amounts of negative equity. Homeowners with negative equity lose their ability to respond to adverse financial events such as job loss or mortgage reset by refinancing or selling their home, and they therefore become much more likely to default. The importance of this problem is illustrated in Exhibit 16, which shows the distribution of home equity among US mortgage holders at the end of 2006 according to an analysis by First American CoreLogic, Inc. About 7% of US mortgage holders had negative equity at that point, and another 14% had equity of less than 15%. Thus, 21% of all mortgage holders—holding about $3 trillion in aggregate mortgage debt given the average mortgage debt held by the vulnerable borrowers—would be put into a negative-equity position if home prices fell by 15%.

There is much more in the report. Goldman now puts the odds of a recession in 2008 at around 40%, and they see the unemployment rate rising to 5.5% by the end of 2008.

In the past, such a rise in the unemployment rate has invariably come in the context of an overall recession ... The risk that it would do so again is high ... however, our analysis does not imply a recession when taken at face value. Instead, it points to a long period of below-trend growth.

I'll post more on the details of their analysis - and offer my view - later this week. Goldman has definitely turned significantly more bearish on housing and the economy.