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What Halts Home Price Deflation? Fear of Losing a Bargain

11/28/2007 by Alex Carrick, RCD Canadian Chief Economist

The main reason for concern about the U.S. economy, and whether or not it will slip into recession, has to do with home prices. The subprime mortgage crisis had a direct impact in several ways, but it is the residual impact on home prices that is the most serious threat.

Three Direct Consequences
The liquidity crisis caused by subprime mortgage defaults first resulted in a certain number of individuals and families at the lower end of the income scale losing their homes. Second, a number of financial firms went under or had to raise loan loss provisions, weakening their equity positions in financial markets.

A third consequence has been a tightening of lending standards. However, firms with legitimate loan requirements and good collateral have not been shut out from borrowing and the Federal Reserve has made it clear that this will not be allowed to happen.


The Most Serious Fall-out has been the Impact on Home Prices
Instead, the most serious fall-out from the subprime mortgage collapse has been the impact on home prices. The extra stock of existing and new houses for sale as a result of foreclosures has shot up in many regions. This has caused a stabilization or drop in home prices, rather than their usual upward climb. It is the long-term steady upward advance in home prices that makes home ownership so desirable, as an investment, if for no other reason.

Buying a home is a costly endeavour. A drop in home prices can quickly deteriorate into a deflationary spiral. Once house prices start to decline, prospective buyers run for the sidelines, waiting for prices to fall further. Why would anyone buy at such a time, given the expectation that prices might drop again? Under these circumstances, prices and extra inventory keep spiraling downward.

So far, the drop in home prices has not affected overall wealth to nearly the same degree as the collapse in 2001. A drop in an individual’s wealth is what cuts into consumer confidence and reduces the incentive to spend on goods and services. In anticipation of this, businesses begin to cut back as well.

It is a Matter of Altering Buyer Psychology
What halts home price deflation? Several factors can help to bring buyers back into the market and these are being tried to various degrees across the U.S. There are incentive packages to go along with the purchase price. These include bonus appliances, free trips and in some cases, a new car. Also, demolition is taking some excess home inventory off the market. Continuing employment and income gains also play a role in regions where the economy is not in a structural, habitual decline.

In the final analysis, however, the most effective turnaround tool, no matter how realized, is the fear of losing a bargain. Once buyer sentiment shifts in the direction of thinking that prices may never be lower, the market starts to gather momentum again. This is a matter of altering buyer psychology.

If the U.S. can make it through the coming holiday season with a fair amount of retail spending enthusiasm, enough confidence may be restored in “business as usual” that a start can be made in rebuilding housing markets by late spring or early summer of next year.


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