• The Mortgage Bankers Association's Market Composite Index, which measures mortgage applications volume, shot up 11.4% for the week ended December 8, and is now up 16.5% from a year ago.
• The refinance index shot up 15.8%, while the refinance share of mortgage activity rose to its highest level since April 2004, at 52.6% of total applications. The refinance index is now up 59.8% from a year ago.
• The purchases index, which excludes refinancing, rose 8.7% during the week, and now is down just 3.0% from a year ago.
• The average contract interest rate for 30-year fixed-rate mortgages rose 4 basis points, to 6.02%, after last week's 15-basis-point drop, to 5.98%, the lowest rate since October 2005.

The Mortgage Bankers Association's (MBA) Weekly Mortgage Applications Survey, usually a yawner, has been getting a lot of attention ever since Alan Greenspan pointed out in a late-October speech that purchase applications had been steadily inching up. He interpreted these increases as "early signs of stabilization." Since he made that speech, the MBA Purchase Index has steadily improved. Moreover, two other indicators appear to have hit inflection points: inventories of both existing and new homes are no longer rising, and existing home sales have not budged in three months. Do these welcomed numbers imply that housing—at last—is turning around? They appear to be a "light at the end of the tunnel." Unfortunately, even if sales have turned around—and it is much too soon to make that call—the worst of the housing downturn is yet to come. Housing will be a bigger drag on growth in the fourth quarter than it was in the third. It will also take a huge bite out of growth in the first quarter of 2007. After that, however, the bite from housing will get progressively smaller.

Why is demand beginning to stabilize? Mainly, it is because both interest rates and home prices have dropped. Since the end of June, the 30-year fixed mortgage rate that the MBA tracks has fallen 84 basis points, to 6.02% (in the week ended December 8). In addition to this, the National Association of Realtors (NAR) reported that the median price of an existing home dropped 3.4% between October 2005 and October 2006. But the NAR's reported number understates the actual drop in prices, since it does not account for incentives—such as the seller offering to pay closing costs, or cash rebates. The evidence is anecdotal, but incentives have reportedly become common in the current buyer's market. Very likely, housing prices have dropped a lot more than the official numbers indicate, especially in the Midwest, where housing markets are weakest, and in the coastal cities, where prices have appreciated the most.

The declines in interest rates and home prices are significant. A 10% drop in house prices and a 100-basis-point drop in interest rates each lower the median homeowner's monthly mortgage payment about 10%. Over the life of a loan, the savings are huge. Until recently, homebuyers have been sitting on the sidelines waiting for great deals. Their patience has paid off. Buying a new home is a much better deal than it was five months ago.

Suppose sales have stabilized. How, then, can the worst be yet to come? Unfortunately, housing starts and permits are still falling. Until inventories are drawn down—and stronger sales will help do this—starts will continue to fall. This means that spending on residential construction will also continue to drop. In October, spending on single-family construction fell 3.9%, according to the Census Bureau's put-in-place estimates. The drop in November and December is likely to be larger than this, unless housing starts stage an unexpected rebound. Our view is that one should expect residential construction to take about 1.4 percentage points off GDP growth in both the fourth quarter of 2006 and the first of 2007. Afterward, the bites will get progressively smaller.

A key number to watch will be November's single-family housing permits, which will be released December 19. This number matters more for the outlook than the housing starts number, because it is a much more accurate estimate (housing starts bounce around from month to month due to unusual weather and measurement errors). Permits have dropped over nine straight months and we expect another 3% drop for November. A positive number would be an early Christmas present. A drop much larger than 3% will indicate that our near-term housing forecast is still too optimistic.

by Patrick Newport and Margaret Rolley

www.globalinsight.com

www.wmrc.com