Home Prices May Expose Economy to Credit Peril

By KATE BERRY

Staff Reporter

L.A. continues to defy the pressures of skyrocketing home prices and massive consumer debt, according to several economists whose mid-year forecasts project increasing job growth for the rest of the year and into 2005.

There is some concern that with interest rates picking up, homeowners with adjustable rate mortgages might find themselves vulnerable, especially new homebuyers who have purchased near the top of the market. Another concern: overleveraging among homeowners who have tapped equity lines of credit.

“Consumers are completely out of whack on their balance sheets, inflation is kicking in and interest rates are going up,” said Christopher Thornberg, senior economist at UCLA’s Anderson School, which this week releases its quarterly report for Southern California.

But Thornberg and other regional economists are relatively upbeat about the near-term prospects for Southern California, and while real estate prices are likely to edge lower in the coming months after a stunning period of monthly double-digit increases, the drop is unlikely to approach the free-fall of the early 1990s, when the aerospace industry collapsed, riots broke out and the Northridge earthquake devastated the region.

A report last week by Chapman University projected that home prices in California will fall 4.4 percent next year hardly alarming considering that in May median prices in Los Angeles County jumped 26 percent from the like period a year earlier. Some of that decline has been starting to be felt by mortgage brokers, who note a recent flattening of listing prices, a lengthening of listing times and a decline in the number of multiple offers.

Consumer spending

The question regional economists are asking is not so much whether Southern California is in a potentially dangerous real estate bubble most downplay that prospect but whether homeowners and consumers in general are leveraged to the point where even a small adjustment in interest rates or levels of job creation could put them in financial jeopardy.

That, in turn, could affect levels of consumer spending everything from car purchases to restaurant meals and might serve to dampen growth. The concern is especially relevant in a region where so many of the jobs being created are in lower-pay service industries.

For the moment, there is scant evidence that such a pullback is taking place or about to. Unlike the Bay Area after the dot-com meltdown, Los Angeles has more than held its own in the last few years helped by a 22 percent jump in the number of jobs created since 2001 in the so-called informal economy, which include workers who don’t show up in traditional payroll surveys.

Conventional wisdom among mortgage brokers is that once interest rates rise above 7.5 percent, the purchase market is likely to contract. At this point, despite a slight upturn in anticipation of the Federal Reserve boosting rates next week, rates remain well below that figure.

Record-low rates have, in fact, resulted in a 39 percent plunge in default rates for Los Angeles County during the first quarter. Given the rapid appreciation of home prices, homeowners in financial trouble can sell their homes and pay off what they owe and even walk away with some money.

Steven Cochrane, director of regional economics at Economy.com, an economic forecasting firm in Westchester, Pa., said the Los Angeles economy remains “very stable” and credit quality remains strong.

He pointed to both the low level of defaults and bankruptcies. “I think it says that the economy has been stable for quite some time and that households are taking advantage of the rapidly-building equity in their homes by refinancing to cover any fiscal shortfalls,” Cochrane said.

While reported job growth has slipped 2.5 percent over the last three years, the decline in San Jose, by contrast, is 22.1 percent. Meanwhile, the latest job market survey by Manpower Inc., an employment services firm, finds that employers surveyed in Los Angeles expect to hire significantly more workers in the third quarter (the percentages vary according to the portion of Los Angeles surveyed). Retail activity appears to be solid as local merchants prepare for the best summer for tourism since before the terrorist attacks in 2001.

Not accelerated growth

Brad Kemp, a labor research analyst for the state of California’s labor market information division, believes other factors are working in favor of the Los Angeles economy. These include a rise in defense spending (which has been offset by job declines in commercial aerospace), the increased flow of goods through the ports (primarily because of the falling U.S. dollar), and overall strength in the entertainment industry.

“It’s very reasonable but not large growth, but it’s very positive given the fact that it’s been stagnant,” said Kemp. “Still, it is in no way accelerated growth.”

All these signs generally match a national ratcheting up of the economy. The Conference Board’s index of leading economic indicators, which tracks the U.S. economy’s likely performance over the next three to six months, rose 0.5 percent in May, following a 0.1 percent rise in April. This uptick, along with a jump in the producer price index, will likely lead the Fed to raise interest rates.

And that could set off a local pullback, especially in real estate.

The long-term decline in rates has been the single factor pushing housing prices higher in the past decade, unleashing a torrent of consumer spending that has helped sustain the economy during the most recent downturn and jobless recovery.

Ted Grose, a broker with All Nationwide Funding Group and director of consumer research and economics at the California Association of Mortgage Brokers, believes the most recent homebuyers and those who are overleveraged and in sub-prime loans could be at risk of default in the next year or so as interest rates rise.

More worrisome to some real estate experts and economists is the vast array of investment products that have made it easy in the past five to seven years for risky homeowners to get a mortgage. Currently, adjustable-rate mortgages on interest-only loans account for an estimated 30 percent of home loans both nationally and locally.

“For people that are properly coached by the loan originator, those products can be valuable tools for getting a house,” said Grose, who described a recent homebuyer he knows as having put no money down on an interest-only loan for a house in Los Angeles that cost $650,000. “If not properly coached and the tool is used to stretch the buyer beyond their realistic limits of debt service, that’s a whole other issue and we’re not going to see the consequence of that for another year.”

For years, economists have warned of rising consumer debt, which has increased nearly 35 percent in the past five years to a record $2.03 trillion in April, according to the Federal Reserve. Recent data show consumers have trimmed their credit cards but added debt on conventional loans. Non-revolving credit, which includes loans for cars, vacations, boats and education, rose 6.7 percent in April to $1.3 trillion, according to the Federal Reserve, while revolving credit card debt fell 5.1 percent to $751 billion.

Still, Americans have accepted high debt levels for years and so it’s unclear the extent of the interest rate hike on consumers.

Thornberg thinks about half of the home price appreciation in Los Angeles is justified while one-quarter can be attributed to low interest rates, and another quarter blamed on the so-called “bubble” in prices.

“So half of the appreciation is at risk right now and with inflation in the system everyone wants a soft landing,” he said.