Are the national and local economies doomed to enter a recession during 2008? Maybe. Alan Greenspan, former Federal Reserve Board chairman, recently suggested that there is a 50-50 chance of a national recession. Others who still believe in “soft landings” put the odds of a recession at 30 percent. Regardless of which camp you think is correct, most all believe a recession is a definite possibility. What’s behind the doom and gloom?

Three interrelated, repeating events are behind the soft outlook for the new year.

First, the recent housing data is some of the weakest since the start of the residential real estate downturn nearly two years ago. Home sales, starts and prices are all still falling, both locally and nationally, giving rise to fears that the bottom of the correction has not been reached.

Second, this wave of weakness was triggered by stress in the mortgage market, caused in part by the spillover of the credit market tightening. Many of Wall Street’s largest and most widely recognized financial institutions have found themselves woefully undercapitalized to deal with the number of subprime mortgages in their investment portfolios. This higher risk and uncertainty has led to stock downgrades and tighter lending requirements across the board, leaving the financial markets in significant turmoil.

Third, home foreclosures are on the rise. Twelve percent of subprime mortgages in the United States are delinquent at least 60 days and 7 percent are in foreclosure, with a high concentration of these problem loans in California and places like San Diego. The numbers of foreclosures is expected to rise during the first half of 2008 when these subprime adjustable rate mortgages hit their interest rate resets, forcing homeowners to pay higher mortgage bills. If they can’t afford it they may face foreclosure (more on this below).

The housing recession will continue to have spillover effects on other parts of the economy. The imbalance between demand and supply will depress prices, reducing consumer wealth and home equity, implying slower consumption growth and lower retail sales. Additional spillover effects include more job losses in construction, real estate and financial services.

Although the San Diego Association of Governments is not forecasting a recession during 2008, the economic performance of both the local and national economy is expected to be weaker than 2007. Nationally, after adjusting for inflation, the Gross Domestic Product (the value of all goods and services produced in the economy during one year) is expected to increase 1.8 percent during 2008, down from an estimated 2.2 percent rate of growth during 2007. Locally, the Gross Metropolitan Product is expected to increase 1.5 percent to $167.6 billion, a rate below the nation’s for the third year in a row. Perhaps more telling, the rate of growth in San Diego’s GMP has outpaced the nation’s in only five of the last 18 years (see chart).

Last Year’s Scorecard

Last year at this time, the San Diego Association of Governments expected the rate of growth of the national and local economies to slow during 2007, which they did. However, both the local and national economies slowed more than we anticipated. Nationally we expected GDP to increase by 2.7 percent during 2007; it appears that it will be closer to 2.2 percent. Locally we expected GMP to increase by 2.4 percent; it appears that it may be closer to 2 percent. We correctly anticipated that San Diego’s economy would grow slower than the nation’s. Furthermore, we believed the primary reason for the slowdown would be continued problems in the housing market; however we did not foresee the credit crunch in the financial markets, or the substantial rise in home foreclosures.

Going into 2007, Sandag expected inflationary pressures to keep the trend-setting federal funds rate at or above 5 percent. In light of the credit crunch in the financial markets, beginning in September 2007, the federal funds rate has been cut three times to 4.25 percent, so we missed this one by a wide margin. The Fed board’s willingness to cut the federal funds rate is likely tied to the success of getting inflation, measured by the rate of change in the core Personal Consumption Expenditures Index, below 2 percent annually, a desire to spur growth to keep the national economy from falling into a recession and to provide liquidity to credit-starved financial markets.

On the labor force, Sandag expected job growth to be weaker and the unemployment rate to increase, both locally and nationally. Although we were correct on the direction for both of these statistics, it appears that job growth will be much weaker than expected and the unemployment rate will be much higher than predicted. Locally, job gains during 2007 may be 10,000, which is lower than the 15,000 predicted, and about half as many jobs as were created during 2006. We correctly anticipated the specific areas of job strength and weakness with significant job gains in the leisure and hospitality sectors and continued weakness in construction and construction-related services such as real estate and financial services. The local unemployment rate rose faster than anticipated during 2007 and ended the year above the nation, which we did not expect, but below the state, which we did expect.

Last, Sandag expected the median price of a home in San Diego to decline by 5 percent during 2007, falling to $465,000. This is pretty much in line with what occurred. We did not expect the residential real estate market to collapse without an economic meltdown. Since there wasn’t one, home prices declined modestly despite declining sales, rising inventories and soaring foreclosures.

Labor Markets: A Mixed Bag

Job growth during 2008 is expected to slow both nationally and locally, pushing the unemployment rate up, even as the region adds 10,000 jobs. Areas of strength will be leisure and hospitality, high technology and health services. The growth in high-tech jobs is expected to be supported by a continuation of the growing amount of venture capital funds flowing into the region attracted by the region’s diverse base of technology companies and innovative products and research. During 2008, between $1.5 billion and $2 billion of venture capital funds will be invested in San Diego, approaching levels last seen during the dot-com boom years.

Another area of strength that appeared late during 2007 is rising exports. The resilience and ability of the national economy to ward off a recession may in part be attributable to the benefits from trade. The declining dollar has boosted U.S. exports to record levels, partially offsetting the downward tug on the economy from turbulence in the housing and mortgage markets. The 2007 trade deficit should be nearly 10 percent smaller than the 2006 deficit. Trade is on a tear; solid export growth is the one silver lining in an otherwise cloudy outlook.

The increase in exports seems to have more than offset any downside effects of the sliding dollar. More specifically, the slide in the dollar has fueled higher import prices, most spectacularly for oil, imposing higher costs on consumers and producers alike and threatening to raise domestic inflation.

The slow economic growth forecast locally for 2008 stems from expected weakness in five sectors: construction, real estate and financial services, retail outlets, agriculture and government. The weakness in construction, real estate and financial services is a carryover from the past two years. The bottom of the current residential real estate recession should be reached during the second or third quarter of 2008. The weakness in retail outlets reflects the effect of depressed home prices on consumers’ balance sheets, expected weak employment growth and rising unemployment.

Agriculture’s weakness is related to three problems: the cold spell this past winter that damaged local crops; the damage to local crops from the October wildfires; and the looming water shortages in the state that may force farmers to reduce water consumption by 30 percent this year.

Government employment in California will soften as the state struggles to get a recently announced and unexpectedly large $14 billion deficit under control. The state will likely look at all levels of government to help close the widening gap, as well as opportunities to cut expenditures and/or raise taxes and fees.

Housing: Will the Slowdown Deepen?

New home sales in San Diego have declined 60 percent from their peak during 2004 through the third quarter of 2007. In response, builders have cut construction in an attempt to minimize the inventory overhang. There looks to be about eight months’ supply of new units on the market as of third quarter 2007. More importantly, this level has been stable over the past year.

The median price of a new single-family home peaked during the fourth quarter 2005 at nearly $949,000. During the third quarter of 2007 the median price for a new single-family home declined to about $821,000, a fall of nearly 14 percent. The size of the homes built has also declined from 3,227 square feet during 2005 to 2,967 square feet during 2007. Adjusting for the size differences, the median price of a new single family home has decreased 6 percent, on a per square foot basis, between the peak reached during 2005 and the third quarter 2007.

We expect most of the pain of the remaining portion of the housing recession during 2008 to be in the existing home market. This segment has significant exposure to subprime loans and possible foreclosures. Nationwide, some are predicting a total of 2 million homes will be foreclosed in 2008 and 2009 (unless government intervenes, which is being discussed). This, in turn, will likely add to the already bloated inventory and depress prices, as foreclosures typically sell at a 20 percent to 25 percent discount.

The use of subprime loans has increased nationwide, rising from about 2 percent of conventional loans (mortgages for less than $417,000) during most of 2003 to 15 percent during the first two quarters of 2007. In California, more than 50 percent of the loans made during 2005 were not conventional but jumbos, loan amounts above the $417,000 cutoff point. Although data for California is not available, nationwide about 80 percent of the jumbo loans used subprime rates. Together, conventional and jumbo loans in California using subprime rates may account for about 50 percent of all originations over the period 2005-2006. These are the loans posing the greatest risk of delinquency and/or foreclosure.

In California, notices of default and foreclosures have risen dramatically. Default notices — the first sign of trouble for homeowners — totaled nearly 54,000 during the second quarter of 2007 compared with nearly 21,000 a year earlier and a long run average of 34,000. More than 17,400 translated into foreclosures during the first quarter of 2007, up from about 2,000 a year earlier. The number of foreclosures has surpassed the all-time high of 15,418 reached during the third quarter of 1996. There is a great deal of uncertainty surrounding the size and extent of the subprime problem, especially for high home price areas like San Diego.

Within this setting, Sandag expects the median price of a home in San Diego to decline by about 5 percent during 2008, falling to $440,000. We do not expect the housing market to implode. We don’t expect a major collapse in the residential real estate market as long as the economy and job growth remain positive and any change in interest rates is modest. On this last point, expect the Federal Reserve to be accommodating, lowering the federal funds rate slowly during 2008 by 100 basis points to 3.25 percent. To be this accommodating, the Federal Reserve Board is expecting inflation, as measured by the PCE index, to remain within a range of 1 percent to 2 percent increase on an annual basis. This is doable with a slow-growing economy.

Overall, the downside risks are significant for both the local and national economies; both seem to be teetering on the brink of recession. One more shock or sneeze may be enough to cause the train wreck most are trying vigorously to avoid.

Marney Cox is the chief economist for the San Diego Association of Governments.