How time flies. The slowdown that has gripped the housing industry is coming upon its first anniversary. New-home sales began a continued downward spiral in November 2005; since then, they've tail-spun down 20.3 percent from October 2005 to July 2006 according to the U.S. Census Bureau. Builders are startled and asking, “What the heck happened?”

There are two parts to the explanation. One is pretty straightforward supply and demand economics. The other: home builders response–to date–to those supply and demand dynamics. Still, the big, puzzling difference about this downturn is that the country is not in a recession. Negative macroeconomic forces are not around to shoulder the blame, at least not yet.

In the early 1980s, housing slowed as the result of a recession. Mortgage rates rose to over 15 percent in response to the Federal Reserve raising interest rates to combat high inflation. In the early 1990s, housing slowed again a result of another recession. Job loss, concerns and uncertainty surrounding the first Gulf War, and the affect of the S&L crisis on real estate lending contributed to this recession.

The current housing downturn finds the economy healthy. Unemployment remains low, mortgage rates are now plateauing at historical lows, and corporate profits and household income have been growing.

DEMAND HITS A WALL So what happened this time? The buyer behavior and buyer psychology that fueled the demand for housing suddenly reversed course, creating an astonishingly quick drop in new-home sales. As sales stalled, builders continued to build new homes. The result: excess inventory.

But, why did buyer demand change? This is more complex. Let's start by taking a look at a piece of the buyer psychology mystery: the role of anticipated house appreciation on buyer decision making. A buyer's decision to purchase a home is most strongly influenced by the annual cost of the purchase, according to “Assessing High Housing Prices: Bubbles, Fundamentals and Misperceptions,” a study by Charles Himmelberg, a senior economist at the Federal Reserve Bank of New York; Christopher Mayer, a professor of finance and economics at Columbia University; and Todd Sinai, an associate professor of real estate at the University of Pennsylvania.

They note that as the anticipated annual cost of housing declines, buyer demand increases. Conversely, as the annual cost of housing increases, buyer demand decreases.

What goes into a buyer's sense of anticipated annual cost of owning? There's expected capital gain associated with owning a home. Buyers reduce costs of ownership by the expected gain due to appreciation.

Himmelberg, Mayer, and Sinai calculate the annual cost of housing by adding the interest income that could have been earned if the cash used in the purchase would have been invested, plus real estate taxes, plus maintenance costs, and, finally, they add in a risk premium for the risk associated with owning as opposed to renting. From this total, they subtract the tax benefits of homeownership and the expected capital gain. This is looking at home-ownership from the perspective of a household's pocketbook rather than from a macro vantage point.

The significance of real estate tax increases, maintenance costs, and the risk premium of owning are minor when compared with the affect of mortgage rates and the expected appreciation on the annual cost of housing. The big surge in demand for housing has been characterized by historically low interest rates and high rates of price appreciation.