Housing Meltdown Why home prices could drop 25% more on average before the market finally hits bottom

As Washington policymakers struggle to keep the U.S. out of recession, the swirling confusion over the housing market is making their job a lot tougher. Will American consumers keep shopping or be forced to pull back? Will banks lend freely or be hamstrung by mortgage defaults? What are the best policy options right now? Those and other important questions simply can't be answered without a good idea of whether home prices will rise, flatten out, or keep dropping.

Some experts have begun to suggest that a bottom is in sight. Pali Research analyst Stephen East wrote in a research note to his firm's clients on Jan. 25 that "the sun is not shining very brightly, but at least the worst of the storm has likely passed." With optimism budding, Standard & Poor's beaten-down index of homebuilder stocks soared 49% from Jan. 15 through Jan. 29.

But it's considerably more likely that the storm is still gathering force. On Jan. 30 the government said annual economic growth slowed to just 0.6% in the fourth quarter as home construction plunged at a 24% annual rate. The Standard & Poor's/Case-Shiller 20-city home price index fell 7.7% in November from the year before, the biggest decline since the index was created in 2000.

And that could be just the start. Brace yourself: Home prices could sink an additional 25% over the next two or three years, returning values to their 2000 levels in inflation-adjusted terms. That's even with the Federal Reserve's half-percentage-point rate cut on Jan. 30

While a 25% decline is unprecedented in modern times, some economists are beginning to talk about it. "We now see potential for another 25% to 30% downside over the next two years," says David A. Rosenberg, North American economist for Merrill Lynch (MER), who until recently had expected a much smaller slide.

Shocking though it might seem, a decline of 25% from here would merely reverse the market's spectacular appreciation during the boom. It would put the national price level right back on its long-term growth trend line, a surprisingly modest 0.4% a year after inflation. There's a recent model for this kind of return to normalcy after the bursting of a financial bubble. The stock market decline that began in 2000 erased most of the gains of the boom of the second half of the 1990s, leaving investors with ordinary-sized returns.

Why might housing prices plunge violently from here? Remember the two powerful forces that pushed them up: lax lending standards and the conviction that housing is a fail-safe investment. Now both are working in reverse, depressing demand for housing faster than homebuilders can rein in supply. By reinstituting safeguards such as down payments and proof of income, lenders have disqualified thousands of potential buyers. And many people who do qualify have lost the desire to buy. "A down market is getting baked into expectations," says Chris Flanagan, head of research in JPMorgan Chase's (JPM) asset-backed securities group. "People say: I'm not buying until prices are lower.'" He predicts prices will fall about 25%, bottoming in 2010.

Nobody can be sure how far prices will decline. Still, if prices drop that much, it could mean big trouble for the U.S. economy, which is already on the brink of recession. It would blow a hole in the balance sheets of banks and households, slicing more than $5 trillion off household wealth. That's roughly the size of the drop in stock market wealth from the peak in early 2000, a big reason for the recession of 2001. Yale economist Robert J. Shiller, a longtime housing bear, points out that a housing decline that started in 1925 and ran until 1932 weakened banks and contributed to the Great Depression, which started in the U.S. in 1929