As Housing Prices Cool,
Americans Keep Spending

A year into the housing market's slowdown, Americans have yet to snap shut their wallets, defying predictions that the cooling market would have a chilling effect on consumer spending.

This year, despite what appears to be the most significant housing-market slump in more than a decade, the nation's consumers have increased their purchases of goods and services at an inflation-adjusted annual rate of more than 3% -- just as they have for the past two years. "They're not backing off," says Janet Hoffman, managing partner of consulting firm Accenture Ltd.'s North American retail practice.

In recent years, the long run-up in real-estate prices, coupled with a proliferation of low-interest financing options, allowed many consumers to borrow against the rising value of their homes to pay for cars, vacations and home improvements, among other things. Many economists assumed that a slowdown in the overheated housing market would reverse that trend, leading to a big pullback in spending.

So far, however, only half of that equation is panning out: Americans aren't using their houses like ATMs as much as they once did. Even so, their willingness to spend hasn't suffered, though economists don't agree on why.

Data developed by former Federal Reserve Chairman Alan Greenspan and Fed economist James Kennedy suggest consumers "extracted" cash from their homes -- such as through cash-out refinancings or home-equity loans -- at an annual rate of $497 billion in the second quarter. That was down sharply from a peak of $871 billion in the third quarter of 2005.

Bob Moulton, a mortgage broker with Americana Mortgage Group Inc., Manhasset, N.Y., says new applications for home-equity lines of credit and cash-out mortgage refinancings are down 50% from a year ago. Aside from the fact that home prices aren't rising as they used to, higher interest rates are the primary culprit.

Donna Simoes, an office manager in Williston Park, N.Y., took out a $200,000 home-equity line of credit with an interest rate of just under 4% two years ago to finance a bathroom remodeling and other projects. Today, the rate is up to 7.75%, and she rarely uses the credit line. "As the rate started to rise, my stomach started to fall," Ms. Simoes recalls. "I'm not willing to pay that amount of interest."

Even though consumers appear to be tapping home equity less than they have in the past, they are still finding ways to sustain their spending. Even stores that are heavily dependent on the state of the housing market are benefiting from those outlays. Sales at building-material and garden-supply centers are up more than 8% from a year earlier, outpacing the 6.7% year-to-date jump in overall retail sales, according to the Commerce Department. Sales at furniture and home-furnishing outlets are up 6.5% from last year.

There are several possible explanations. First, while housing is slumping -- the median sales price of an existing home is down 1.7% from a year ago, according to the National Association of Realtors -- other parts of the economy aren't. Unemployment remains low at 4.7%, employers are adding workers and incomes are rising. Corporate profits are up, businesses are increasing their capital spending, and exports have picked up this year. Moreover, the sharp drop in gasoline prices that began in August has given consumers a quick boost in purchasing power.

"There are pretty significant offsetting factors, including the fading energy tax and the healthy stock market," says Michelle Meyer, an economist with Lehman Brothers.

A second possibility is that not enough time has elapsed and that the impact of the cooling housing market may still be coming. "It's likely to take another year or so to see the pronounced effects," says Tim McGee, chief economist at U.S. Trust. If the housing market continues to deteriorate over the coming year, Mr. McGee and some other economists say, the decline in home-equity borrowings will combine with a reverse "wealth effect," in which consumers spend less because they feel less wealthy, to depress spending and shave one percentage point or so from economic growth in 2007.

Other observers, however, say that during the housing boom economists exaggerated the role of home-equity borrowing as a driver of consumer spending, and that's why a slowdown or modest decline in real-estate appreciation won't have much impact on consumer buying habits now. "The run-up in housing values over the past several years did not spur much of a bigger-than-expected increase in consumer spending...so we wonder about how large a spending effect one should expect to accompany a fall in housing prices, if that were to occur," Boston Fed President Cathy Minehan said last month.

Ms. Minehan said much of the equity consumers extracted from their homes over the past few years was used to reduce other forms of consumer debt and make home improvements, and that "overall household balance sheets today continue to look fairly strong."

A recent survey done for Deutsche Bank Securities found that homeowners spent only about 14% of the money they cashed out of their homes -- and that didn't go back into their real-estate investments -- on consumer goods and services. The rest was either used to make other investments or to repay debt. Vinay Pande, chief investment adviser at Deutsche Bank Securities, says the survey found consumers "were unconcerned about a housing bubble," so declining house prices probably would have only a slight impact on their spending.

Even if Ms. Minehan and Mr. Pande are underestimating the potential impact of reduced home-equity borrowing, there are other reasons to suspect that consumers will keep spending even as the housing correction plays out. The overwhelming majority of mortgage debt and home-equity loans are held by Americans in the upper half of the income range. Households in the top 10% of income hold 42% of the value of home-equity lines of credit, according to data from the Fed's 2004 Survey of Consumer Finances. Those affluent consumers have already racked up sizable gains in the value of their homes in recent years and can most likely afford to weather a modest pullback without cutting back their spending.

"If you look at the appreciation over the last three to five years, it's still way up," said Pat Conroy of Deloitte & Touche. "Even though we've had a very small downturn the past six to 12 months, that really hasn't put a huge damper on the consumer's mind-set."

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