Why Wasn\’t the Risk of a Housing Price Decline Taken Into Account? ERP #2

This is the second of four posts based on figures from the 2012 Economic Report of the President. For an overview and the first post, start here.

When I give talks about the causes of the recession, people often shake their heads in disbelief at the thought that few investors were taking the risk of a housing price decline into account. I think this disbelief is a case of 20:20 hindsight. Investors didn\’t take the risk of a national housing price decline into account  because they hadn\’t seen anything like it before. Here\’s a figure showing comparing the housing price declines nationwide during the Great Depression,  and then comparisons with more local housing price declines in Boston in 1989 and in California in 1990. Sure, investors knew that housing prices could nosedive in a local market, and some were even braced for the possibility of a modest housing price decline nationwide. But for the country as a whole, predicting in 2005 or 2006 that national housing prices would drop much farther and faster than during the Great Depression would have been a prediction outside all historical experience. I admire the clairvoyance of the few who truly saw it coming, but I can\’t reasonably blame those who didn\’t.

The evidence does offer some hints that the decline in U.S. housing prices may be just about over. For example, one measure of a price bubble is to look at the ratio of housing prices to rents. When this ratio rises sharply, then it may be a signal that prices are getting out of line. But that ratio has now fallen back to pre-crisis levels. Similarly, the ratio of mortgage value per home-owning household has trended up over time, as the economy has grown. During the housing price bubble, that trend launched like a rocket, but now it has been flat for a few years, and is not too far out of line with the longer-term trend.

At the most basic level, the national average of actual housing prices does seem to have levelled out since early 2009. Indeed, futures markets that were predicting a continued drop in housing prices as of January 2009 have seen housing prices hold up better than expected at that time.

Will U.S. Housing Prices Finally Bottom Out in 2012?

John V. Duca, David Luttrell and Anthony Murphy of the Dallas Fed ask: \”When Will the U.S. Housing Market Stabilize?  Their answer, like that of the August CBO report I posted about a few weeks ago, is that housing prices are likely to bottom out in 2012. 

In describing patterns of construction and building permits in recent decades, they write: \”During the subprime boom, construction of single-family homes surged to a high of 1.8 million units per year, far above the 1.1 million units required to cover population growth and physical depreciation of structures. Construction then collapsed, falling roughly 75 percent from the peak by mid-2009.\” As their figure shows, this decline appears to have bottomed out at a level fairly similar to that experienced in the deep recessions of the early 1980s.

They emphasize the role of swings in the loan-to-value ratio: \”More people qualified for a mortgage during the so-called subprime boom because lenders eased the minimum down-payment ratios, maximum debt-payment-to-income ratios, minimum credit scores and other criteria. The relaxed credit standards can be seen in a new survey-based data series on the average mortgage-loanto-
house-price ratio, or loan-to-value (LTV) ratio, for first-time homebuyers (Chart 3), or its counterpart, the downpayment ratio. The average, cyclically adjusted LTV ratio rose to as high as
94 percent (that is, a 6 percent down payment) at the height of the subprime boom, before retreating during the bust. The ratio was about 88 percent (12 percent down payment) during the 1990s.\”

Their simulation results suggest that housing prices will bottom out in late 2011 or 2012. \”During the boom and subsequent bust, house prices were affected by unusual factors, including large swings
in mortgage financing standards and tax credits for first-time homebuyers. … Our econometric models of U.S. house prices, estimated using data through third quarter 2009, take account of these factors, as well as conventional drivers of housing demand. This exercise, carried out in early 2010, predicted
that house prices would resume declining after the expiration of the U.S. tax credit in mid-2010, falling about 5 to 6 percent after third quarter 2010 before likely hitting bottom in late 2011 or early 2012 (Chart 4). … Since early 2010, our simulation has tracked the actual movement in the Freddie Mac purchase-only home price index.\”