As home values fall, is the US heading for the much-feared 'hard landing'?

You can see it even here in America's capital region, still enjoying a decade-old economic boom: new-built downtown apartments that have to be let for want of buyers, the For Sale signs in neighbourhoods rich and poor that stick around for months; and nuggets of news like the one on the front page of yesterday's Washington Post - that assessed property values in nearby Fairfax County, the second wealthiest county in the US, have just fallen for the first time since 1998.

Such is the local snapshot of America's visible housing market slump, the worst in almost two decades, that has had forecasters fearing the worst.

After a dozen years of sustained growth, interrupted only by the brief 2000-2001 recession, might not the economy be heading for the dreaded "hard landing"? Falling home values, they worried, would only discourage owners from cashing in home equity to fuel the consumer spending that has helped power that growth. At the same time, rising interest rates were driving up mortgage repayments, eating up spare cash. Overstretched buyers, drawn into a red hot market by taking on over-large loans with teaser initial rates, would be forced to put their homes on an already overloaded market - adding to the downward pressure on prices, and perhaps dragging other squeezed mortgage holders over the brink.

This worse-case scenario, however, hasn't happened - at least not yet. After dipping to just 2 per cent in the third quarter of 2006, the economy expanded by an impressive 3.5 per cent in the last three months of the year.

Just by coincidence, the release of the figures fell on the very day of Ben Bernanke's first anniversary at the helm of the Federal Reserve. After a slightly rocky start to his tenure, the Fed's new chairman received plaudits from all sides. By judiciously halting the steady rise in short-term rates a few months earlier, he had achieved that elusive "soft landing", notwithstanding the continuing travails of the vital housing market.

The latest figures yesterday from the National Association of Realtors if anything bear out this thesis. True, the median price of an existing home dropped to $210,600 (£107,500) last month, 3.1 per cent down on January 2006. But the number of sales jumped by a similar amount, suggesting buyers and sellers are adjusting to changed circumstances. "I've been hemming and hawing for the last few months on whether we've reached rock bottom," David Lereah, the NAR's chief economist, told the Associated Press.

Now, he believes, the nadir may have been five months ago. That too - at least until yesterday - was the mood of the markets.

Construction stocks have taken a beating, but for much of this month Wall Street indices were surging to new highs. Inflation was under control and growth prospects looked solid again. America's great real-estate bubble had not burst, but had lost air with a soft and manageable hiss. The worst, it seemed, was over.

But the visible housing crisis is only part of the story. In the past couple of weeks, trouble has been brewing at the opposite end of the market, among the lenders who, by showering loans on borrowers who in a saner age would never have qualified for them, did much to pump up the bubble in the first place.

Sub-prime mortgages, usually at rates two or three points higher than prime mortgages, are the housing market's equivalent of junk bonds, offering high interest rates to buyers, but with a higher risk that the underlying investment will go bad. Over the past six years, sub-prime lending has soared from $100bn to $800bn as lenders threw money at borrowers, often without the slightest check on the latter's ability to keep up their payments. In all, outstanding sub-prime loans total $1.3 trillion, according to the FDIC, the government regulatory agency which insures deposits at more than 8,600 US banks and savings institutions.

A refined system has emerged, whereby dodgy loans are increasingly bundled together into mortgage-backed securities (MBSs), in essence bonds secured by property and sold on to investors, both private and public. Everyone has seemed a winner. The banks that extended the loans pushed the risk off their books, while investors netted higher interest rates and investment banks who arranged the MBS raked in juicy fees.

Everything hummed along nicely, so long as steadily rising house values allowed struggling borrowers to refinance their loans. But now prices are tumbling and the entire edifice is wobbling. Ancestors of the MBS featured in the infamous Savings and Loans crisis of the late 1980s, fuelled in good measure by an earlier property boom. Is history about to repeat itself? Defaults and delinquent loans are set to surge in 2007. Millions of sub-prime borrowers face having their homes repossessed this year. Some experts warn that the rate of sub-prime foreclosures could hit 20 per cent.

That forecast may be too gloomy, But every indicator is pointing in the wrong direction.

Late payments on residential mortgages jumped 15 per cent in the fourth quarter of 2006, while "non-current" loans, with payments more than 90 days late, rose by $3bn in the same period, three times as much as in the third quarter. The UBS bank says that 4 per cent of bundled sub-primes are delinquent, more than at the height of the short-lived recession in 2001 - and all this at a moment when officially the national economy is still performing strongly.

Now the lenders are feeling the pain too. A few smaller lenders have collapsed. Sub-prime specialists such as New Century Financial, Washington Mutual and NovaStar Financial have seen their stock prices plunge after warning of problems. HSBC, the largest European bank and one of the industry's most aggressive operators, this month sent a shiver through markets with the announcement that its bad-debt charges for 2006 would hit $10.5bn, 20 per cent higher than previously forecast, because of problems with its US mortgage business.

Optimists insist the worst is over, as lenders have learnt their lesson. But many institutions, faced with increasing sub-prime losses, will have to set aside extra reserves, cutting into future earnings and generating more market disfavour.

Perhaps a surprisingly resilient economy will shrug off these setbacks. But Wall Street's opening plunge yesterday reflected not only the sell-off in China and an unexpectedly steep fall in durable goods orders in January - adding weight to the former Fed chairman Alan Greenspan's prediction on Monday that a recession was still possible in 2007.

The housing crisis haunts traders as well: not the visible crisis which has caused such misery for builders, estate agents and the home buyers who have borrowed money; but for the lenders who thought they were on a killing to nothing and are now discovering that they too cannot defy the laws of economic gravity.

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