Re: The downward pressure will be self-reinforcing, as lower prices will limit the ability of homeowners to borrow against equity. This will curtail consumer spending

I am skeptical about this. How many people borrow against home equity to buy a new TV or take a vacation? Some do I'm sure, but I suspect they are a distinct minority. Many people either don't own a home or else don't have enough equity to borrow against, and many who do are more sensible than to do so for trivial purposes.

If housing prices fall to such a degree, what effect with that have on local real estate taxes and local governments' abilities to provide services etc.?

You provide a good snapshot of the present state of the real estate market, and a reasonable prognosis of what's to come, but your analysis is cursory at best, and seems disconnected from what precedes it. The Fed may be a convenient target, but it actually has relatively little responsibility for what happens in the real estate market.

There are two interrelated phenomenon that combined to produce the present bubble. The first is the cyclical nature of the real estate market. It booms and it busts, as it has for centuries. The second is the radical expansion of consumer credit that we've witnessed over the past two decades. That expansion served to fuel a larger-than-normal boom; we're still plunging downward into the corresponding bust.

In theory, broader access to the housing market is part of the liberal creed of equal opportunity. It's worth noting that the political left was (at least) as responsible as the right for aiding and abbetting the credit revolution. The problem was the creation of a marketplace that allowed lenders to extend ill-advised loans, bundle them, and sell them off to investors. While the market boomed, it all worked splendidly. Consumers who ran into trouble could always take out a subprime home equity loan to extract cash from their home, or if they need to, sell it for a profit. When the rate of increase began to slow, however, problems emerged. Consumers awakened to find themselves with loans that they couldn't afford, which were not infrequently worth more than the equity they retained in the property. They began to default. Most lenders didn't mind - they'd passed the bag to investors in CDOs. And where had the money come from to purchase these pools of risk? Why, from the burgeoning (and largely unregulated) world of hedge funds. And who were their investors? Institutions. That is, increasingly, pension funds. Of course, not all loans were sold into this private marketplace. Those extended to many of the poorest households were federally subsidized, in a program enthusiastically backed by the Dems. Secure in the knowledge that the government was assuming the risk, builders inflated the prices of their poorly built homes and assured consumers that appreciation would cover the cost, then signed them up for federally-guaranteed loans. That's the Beazer fraud case to which you alluded.

To sum up, this crisis wasn't caused by loose monetary policy, but by negligent regulators. The result is perverse - the very working Americans who were supposed to benefit from expanded credit are now being turned out of their homes, and soon they'll take a second hit as their pension funds or their government absorbs the losses.

You want to blame someone? The first place to look is the Office of the Comptroller of the Currency, and to a lesser extent, the Office of Thrift Supervision. These obscure regulatory agencies were asleep at the switch, and failed to set and enforce effective guidelines to protect consumers of loans. But there's plenty of blame to go around. When the executive branch failed to exercise its discretionary powers appropriately, Congress should have mandated action, updating antiquated laws to address the host of innovative financial products that have entered the marketplace over the past two decades. State legislatures should have stepped in to fill the federal void. And, let's be blunt - consumers should have exercised greater caution.

But the buck stops here. Too many of us, myself included, applauded expanding home ownership. Where were you, Mr. Baker, when record numbers of working Americans purchased their first homes during the past two decades? It all seemed great. But in the euphoria, I failed to pay enough attention to the easy credit that was fueling the boom. With better regulation, we could have had (much) of the benefit without (much) of the loss. Hopefully, we'll learn that lesson before the next boom.

Because home values are viewed as investment, rather than consumption, throughout most markets in the the United, cowardly money actually seeks housing as a shelter.

This means that:

1. Interest rates do matter immensely. Suppressed rates encourage people to sign a mortgage for an amount larger than they ought to chance, and leave no room for error when the time comes to liquidate the old home by selling to someone who might have to pay more for money. In fact, housing has become an immense inflation trap, because it politically punishes the central banker who would try to steer away from inflation before the vortex takes control.

2. Over-investment in housing means that people who have money put it into cavernous great rooms and stainless steel appliances and a long commute to the next-door neighbor, rather than into efficient communities.

Moreover, one important measure of value absent from the macroeconomic debate is the "replacement cost" which every commercial investor considers. At this moment, housing prices are still thirty or forty percent higher than they were when builders were pouring new inventory onto the market. They've slowed down, but only because they've been tooled toward the over-investment market. Fundamentally, there is still a lot of potential for profit in building new homes into this market, even though those homes will be more more practical than the fancy souffles that have risen in the last fifteen years. Here the driving forces are land and materials, and only heavy raw materials inflation will prevent the market from levelling off a replacement cost well below today's market Adjusted for the inevitable effect of inflation on interest rates, we are looking at a major collapse.

But the last to be pitied are those holding big debts. They'll pay off their mortgages with funny money, the scrip that retirees with "low-risk, fixed-income" funds will try to trade for bread.

Ellen,

I'm all for assigning responsibility to consumers. But when you see interviews with people who took out a larger mortgage than they could actually afford, they generally offer some version of: it was complicated, but I assumed they wouldn't make the loan if I couldn't pay it.

That's actually a fairly compelling argument. Consumers rely on three safeguards. They assume government regulators weed out dishonest lenders. They assume that the banks have a vested interest in only lending to people who can pay back loans. And they assume that the broker has their best interest at heart.

Alas, regulators have been remiss in failing to effectively police the marketplace. Banks, until very recently, really did strive to make only reasonable loans - but CDOs have changed the structural incentives. And, perhaps most crucially, brokers have no obligation to serve the interests of their clients. That sets them apart from virtually every other licensed profession. Ordinarily, if you pay a fee to a professional, you can safely assume that they're obligated to work on your behalf. Most brokers present themselves that way. But in fact, brokers have every incentive to make their commission by selling you a loan, and face no sanction for making irresponsible loans.

If the housing market is going to rely on the ability of consumers to understand the 20 pages of convoluted legalese that constitutes most mortgage contracts, we're in a lot of trouble. But if we ask consumers to exercise a degree of caution, and then change the structure of incentives so that banks and brokers aren't trying to sell them products they shouldn't be buying, there's hope.

Re: 4 % of consumer spending from the 1990s to 2005, according to the Fed.

A single digit number then (unless a trailing zero was left off). And how much of that "spending" consisted of nothing more than transferring credit card or student loan debt onto a HELOC?
This just isn't significant. Meanwhile send Chicken Little back to the barnyard.

Another ripple to expect: public education funding relies heavily on local property taxes.

For example, in Kentucky, we're very proud of our improved education funding--which takes us to about 85% of national average per pupil. After-inflation dollars per pupil have grown over the last decade and a half almost entirely because of local funding growth, and more than 80% of the local growth has come from growing property value per pupil. Our school boards have not had to brave voter recalls to get that money, because of the real estate growth.

Slow the housing market and education funding will change immediately. Show a decline, and schools could be in deep trouble.

Real bad news -- unfortunately economists never like to talk about such things -- as they say, "who could have known?"

Could we kindly cease and desist treating adults (and in their absence discussing them) as if they were children.

Hey, sublingual; don't have a tantrum.  I was talking about adults, not children! 

While most people would not take out a home equity loan to buy a TV or a car they will quite happily take out a home equity loan to pay off their credit card debt or retire the high interest car loan.

Then having 'cleared their debts' as they see it they run up the credit cards once again.

Same thing happens with home equity loans to pay for college or for home improvements.

Home improvements are a little more complicated, some people will be unable to afford home improvements, others will upgrade their existing home because they can't afford to move.

Real estate taxes are not tightly linked to housing prices. Basically, the locality takes the assessed value of all the real estate, and divides the total tax to be collected proportionally over the properties according to their valuation. So of the town or city needs to collect $100, and there are just two properties, each worth $1000, it will set the tax rate to get $50 from each property owner. But if the properties are each worth $2000 or $500, it will still set the tax rate to get $50 from each property owner.

Where the upswing in residential property values has made a huge difference is in areas where industrial and commercial properties have been flat or declining in value - or at least not rising as fast as residential properties. In that situation, the tax burden has been shifted to the residential property owners and away from the business property owners. This is certainly the case, for instance, through much of New England. A fall in housing valuations will shift the tax burden back towards businesses, which some of us will consider a very good thing.

At least in some areas the higher end of the housing market is doing fine. In New York City it's still going up. In rural New England it also is holding its own or better. However the lower end of the rural New England market has gotten much softer - a reluctance to drop asking prices is resulting in stuff sitting on the market forever. However, McMansions have never become the style here - the lower-end houses are scaled to be heated economically; it's only at the high end where real mansions (not the imitation stuff) show up.

Re: While most people would not take out a home equity loan to buy a TV or a car they will quite happily take out a home equity loan to pay off their credit card debt or retire the high interest car loan.

Of course! Once upon a time, during a really bad couple of months, I shilled HELOCs for a bank; "Pay off your high interest debt" was the chief sales line we used. We certainly didn't hawk them as a means to fund Hawaiian get-aways or purchase plasma screen TVs. But does paying off old loans count as current consumption? Maybe it does in official figures, but that seems kind of nutty.
Also, I do think we need to remember that most US consummers are NOT drowning in debt. Those scary figures that are often trotted out are based on averages that are skewed high by a relatively small number of cases of extreme indebtedness, people who are probably in the fast lane for a bankruptcy court. Most US consummers in fact have no revolving (=older than 30 days) credit card debt at all. So even if in principle the value of their house declines by, say, 10%, how does that affect their spending? I don't see a connection. Spending depends on income after all; if your income declines then yes, you spend less. But unless you are planning to sell your home in the near future its decline in value is purely theoretical. And indeed, I've seen articles claiming that people simply don't accept that their home has declined in value; most are still in the mindset that real estate always and everywhere appreciates. They may well be wrong (in fact they are, and should be: houses are overpriced and SHOULD decline so tthe economy can right itself), but their behavior will not be affected by something they do not believe in the first place.

No prudent act goes unpunished--people who DIDN'T buy into the anyone can own a house with no money down hype, will see their rent payments rise, as demand from former homeowners pushes rental prices up.