War With Iraq May Threaten Housing Market

N E W  Y O R K, Nov. 1, 2002 -- The housing bubble is a lot like the devil. Even people who don't believe in it fear its power.

The idea that the real estate market could implode as a result of a new war in the Middle East is a frightening prospect, for both home owners and the economy in general.

If we judge by history, we could have reason to be afraid.

That Was Then …

Before the Persian Gulf War in 1991, economists had high hopes for the housing market.

The economy was already in a recession, but interest rates were supposed to drop and home sales were supposed to rise.

It sounded great on paper — until Iraq invaded Kuwait in August 1990.

The summer of Iraq's invasion, oil prices rocketed, interest rates shot up to fend off inflation and all the cheery optimism about the housing market got lost in the shuffle.

Thirty-year fixed mortgage rates in 1990 climbed steadily after Iraq invaded. The annual average interest rate on a 30-year fixed mortgage was about 10 percent, while the home price appreciation rate rose only 2.8 percent.

The housing market slugged along for years before it picked up again in the mid- to late 1990s.

By comparison, last year, which was one of the best the housing market had experienced in decades, the home price appreciation rate was 6.3 percent, and the average 30-year fixed mortgage rate was 6.9 percent.

Will we see a repeat of 1991 — or worse — in the event of another attack on Iraq? Could the housing market take a direct hit? Despite the warning signs, there's some evidence that it won't.

… This Is Now

The main reason is that this is not 1991.

This year, according to the National Association of Realtors, home prices are expected to appreciate 6.8 percent.

While there is little faith that the current 6 percent-plus price appreciation rate can be sustained, economists at NAR are forecasting that price growth could drop as low as 4.1 percent in 2003.

But even if prices drop below the 4 percent mark, or only appreciate 2 percent to 3 percent, that's hardly the nuclear meltdown that some members of the media and banking industry would have you believe.

During the last war, the economy was already suffering, and increased interest rates simply didn't encourage real estate purchases. It also didn't help that the unemployment rate surged to 6.8 percent in 1991, up from 5.6 percent in 1990.

The good news today is that while unemployment and interest rates are commonly regarded as the two most likely pins to prick the housing bubble, neither is especially sharp — for the moment.

Work In Progress

One of the reasons for this relative optimism is a marginally declining unemployment rate.

In September, the rate eased to 5.6 percent after peaking in April 2002 at 6 percent.

Many analysts think that number to come down next year as well.

As one might expect, in correlation with the unemployment rate, mortgage delinquency and foreclosure rates rose 13 basis points to 1.23 percent during the second quarter, according to the Mortgage Bankers Association of America.

Although the rise in the mortgage delinquency and foreclosure rates may seem like an ominous sign that the housing market is in danger, the opposite may be true. The default rate rise is often a lagging indicator of an economic recovery.

"Typically, mortgage delinquency rates peak about a year after an economic recovery begins," says Freddie Mac Chief Economist Frank Nothaft.

"The last loan [that] families go delinquent on is the mortgage. First, families will first dip into their savings, and then they'll go delinquent on auto loans or credit card loans," he adds. "As a last resort, people will go delinquent on mortgage loans."

So, if the economy doesn't face rising unemployment and assuming a surplus of housing inventory doesn't hit the market, the only remaining threat comes from rising interest rates.

The Fed’s Role

During the Persian Gulf War in 1991, the Federal Reserve hiked interest rates in order to avoid inflation. The opposite is true today.

In fact, some economists believe the Fed may have to cut interest rates to avoid deflation, although that seems an unlikely scenario since deflation is not considered an immediate threat.

Today, however, even if the Fed were to hike rates, they wouldn't be overly punitive.

Analysts project mortgage interest rates could rise and level off between 6.5 percent and 7 percent in 2003. (The Mortgage Bankers Association of America is forecasting the average 30-year fixed mortgage rate will come in at 6.5 percent).

Of course, even a moderate rate hike could deter home sales, even if it's only psychological. But most Americans could live quite comfortably with a 7 percent rate.

As opposed to the quick victory the allies enjoyed in the Gulf War, a drawn-out campaign in Iraq will doubtless upset many of the economic models currently being used to forecast the future.

As a result, rates could rise faster than now predicted. But at the same time, housing prices may fall, just as they did in the years after 1991.

So, lower rates and more expensive homes, or higher rates and less expensive homes?

One thing is for sure: The sustained growth in real estate appreciation is unlikely to continue, but if people worry that the real estate market could crash as quickly or as devastatingly as the equities market, the war would have to be long and brutal indeed.

For more, go to Forbes.com..