Resident Fellow Desmond Lachman

Like the Iraq war, the present cooling in the housing market displays every sign of getting worse. The housing bubble has already burst under the weight of rising interest rates and the ever-deepening mortgage market crisis for those borrowers with weak credit histories. The bursting comes after home prices at the national level had increased spectacularly by 80 percent between 2000 and 2006.

The housing market is now characterised by falling home prices nationwide for the first time in 15 years. It is also characterised by very high vacancy rates and record inventories of unsold homes. Further muddying the waters are congressional housing market initiatives such as Mr. Frank's proposal to create an “affordable housing fund” to be financed by an effective tax on Fannie Mae and Freddie Mac.

In the run-up to the 2008 election, it is more than likely that home prices will be falling at an accelerating pace. The crisis in the subprime mortgage market, which accounted for as much as 20 per cent of all mortgages in 2006, could in itself result in a 10 per cent drop in housing demand in 2007. It could do so as many subprime mortgage lenders shut down and as mortgage lending standards are tightened. Housing demand could also be crimped as more than $500bn in adjustable rate mortgages are reset at higher interest rates in 2007 and as speculative demand for housing dries up. To make matters worse, rapidly rising default rates could result in as many as 500,000 foreclosed properties returning to an already saturated housing market in 2007.

Unlike Iraq, the unravelling of the housing market is a bread-and-butter issue that has a direct impact on most voters' pocketbooks. After all, 70 per cent of US households own their homes. For the bulk of those households, their home is their main source of wealth. Increasing home prices have also been most households' source of financial security as home prices kept increasing year after year until the middle of 2006.

At an emotive level, the travails of the US housing market will receive increasing political attention as the 2008 election approaches. Scenes will become commonplace of single mothers or minority homeowners being evicted, unable to cope with rising interest rates on their adjustable rate mortgages. The owners can be expected to charge that those mortgages were foist upon them by deceptive lenders, who knew full well that they would not be able to meet those mortgages' terms.

Politically more important will be the fallout on the overall economy's performance. A 30 per cent decline in housing construction could shave up to 1.5 percentage points off gross domestic product growth. In the same way that rising home prices induced home owners to borrow against their homes to increase consumption, declining home prices could put that process in reverse. This prospect has prompted Alan Greenspan, former Federal Reserve chairman, to suggest that there is a one-third chance that the US economy slips into recession by year-end.

The recent congressional hearings on the housing market, chaired by Senator Chris Dodd and Mr. Frank are suggestive as to how blame will be apportioned for the housing market debacle in the forthcoming election. It will be asked whether the regulators and the Federal Reserve were not fast asleep at the wheel when lending standards were irresponsibly relaxed. At the same time, the investment banks and mortgage originators will be put in the dock for predatory lending practices. Judging by recent comments from Mr. Frank, this could lead to proposals to stick investors in mortgage-backed securities with the losses when subprime borrowers default. In an early sign of the impact of that political pressure, at yesterday's House hearings, officials from Freddie Mac and Fannie Mae unveiled plans to help subprime borrowers refinance their mortgages.

All of this is not to say that Iraq will not be a prominent feature in the 2008 election campaign. Yet it could share the political spotlight with a housing market debacle that could push the entire economy into a recession.

Desmond Lachman is a resident fellow at AEI.