House prices falling and worries rising

Today we received updates on U.S. house prices from two different sources. The OFHEO national house price index recorded a 1.3% decline in the price of a typical U.S. home during the fourth quarter of 2007, while the S&P/Case-Shiller home price index registered a 5.7% decline during the last three months of 2007. Here in San Diego, the respective numbers showed a 2.6% decline according to OFHEO and 9.1% decline from Case-Shiller during the quarter. For the year as a whole, Case-Shiller calculates that home prices fell 9.8% nationally and 15% locally.

Home price index for San Diego as reported by OFHEO and
S&P/Case-Shiller, each normalized so that August 2005 = $545,000.

This tendency for the Case-Shiller index to record a stronger drop in home prices than OFHEO was also observed during the 1991 housing downturn. The two indexes apply the same basic methodology to different data sets. OFHEO is based on mortgages handled by Fannie Mae and Freddie Mac, while Case-Shiller uses publicly recorded data on all home sales in selected communities. It appears to be the case that the nonconforming mortgages that don’t get to the GSEs were characterized by a bigger run-up in the boom, and should experience a bigger decline now, since nonconforming mortgages will be more affected by the breakdown of the private mortgage securitization process.

The 9.1% fourth-quarter drop for San Diego recorded by Case-Shiller is similar to the 7.4% decline in the median asking price of homes for sale reported by Housing Tracker. Although the latter is a much less satisfactory measure conceptually, it has the benefit of being more up-to-date than Case-Shiller. The San Diego median asking price has fallen an additional 5.9% since December, the most recent value for the Case-Shiller index.

Home prices for San Diego as reported by OFHEO and
S&P/Case-Shiller, and median asking price of homes for sale in San Diego (from Housing Tracker).

The reason to be concerned about this is that the farther house prices fall, the greater the number of homeowners who move into the category of negative net equity, that is, owe more on their mortgage than the home is worth. And the farther into the red a household becomes, the greater the incentive and propensity for the homeowner to default on the loan. More defaults mean more losses and greater risk of insolvency for large financial institutions.

And if you think the economy can continue to hum along without those institutions continuing to extend credit, well, we may get some interesting additional data relevant for your hypothesis in a rather short while.

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20 thoughts on “House prices falling and worries rising

  1. jg

    ‘…greater risk of insolvency for large financial institutions…’
    Simple analysis for Bank of America:
    Assets of $1.5 trillion
    Liabilities/loans of $1.4 trillion
    Equity of $0.1 trillion
    An equity-to-asset ratio is 9%
    A drop in the value of their assets of 10% will wipe out their equity
    And such a drop is a real possibility, given that 10% of their assets are mortgage-backed securities and another 50% of their assets are mortgage, individual, and business loans.
    Today, over at CR, I saw data showing 90 day fault/foreclosure/REO rates approaching 30% on the mortgages underlying a AAA CDO, only one year post-issue.
    I’m guessing that many, if not all, of the big banks will be on death’s door within the next year or two.
    Yes, Professor, there is great risk of insolvency for large financial institutions.

  2. PrefBlog

    Is Crony Capitalism Really Returning to America?

    Menzie Chinn writes in Econbrowser a very gloomy piece about the state of the US banking industry and urges a bail-out … of some kind:
    As I’ve said before, “Just say ‘no’” is not a viable policy. The key point is to…

  3. Buzzcut

    It’s funny, the spring home sellers are starting to come online, and the few that I’ve looked at are completely unrealistic in terms of price (i.e. hundreds of thousands of dollars higher than where they should be).
    Some people just aren’t getting the message!

  4. Rich Berger

    I believe the OFHEO showed a drop of 0.3% year to year, not quite as doomy as the Case-Shiller index. Looking at some of the coverage yesterday, this rather minor decline seemed to have been soft-pedaled in favor of the more alarmist numbers.

  5. JDH

    That’s a good point, Rich. After I put up the post I realized I’d made a mistake in failing to mention the year-to-year OFHEO values for balance. As you say, the year-to-year OFHEO national decline was only 0.3%. For San Diego, the OFHEO year-to-year decline was 7.2%.

  6. Gavin

    Existing homeowners, especially those who bought recently may be worse off with falling house prices. If they have negative equity they are more likely to default and increase the insolvency risk for lenders.
    However on the bright side new homeowners will be paying much smaller fractions of their incomes on mortgage payments and are less likely to lose their house to foreclosure. According to this Chicago Fed paper that studied factors responsible for successfully keeping a home (
    “Higher ratios of (mortgage) payment to income are significantly and negatively related to success.”
    It will also be much healthier for a society to have families pay smaller fractions of their income on housing.

  7. Anonymous

    However on the bright side new homeowners will be paying much smaller fractions of their incomes on mortgage payments and are less likely to lose their house to foreclosure…It will also be much healthier for a society to have families pay smaller fractions of their income on housing.
    Gavin is completely right. Not only does a massive drop in house prices have real winners (all future buyers) but it is also better from the economy’s point of view. Why in the world is it a “good” thing for the price of a basic necessity like housing to be so high in relation to income? Imagine if food and energy prices were substantially higher than a decade ago. Wouldn’t people be complaining? Oh wait, they already are.

  8. Rich Berger

    With so much economic data available, it’s far too easy to select the data that supports your argument. I guessed that housing prices in my area (Northern NJ/NY Metro) had peaked in late 2005, based on listings and sales, and have been falling since. I have been in my house since 1986, which was about the peak of the 1980-1986 boom, and prices fell for about 5 years afterward. The rise was relatively slow until about 1996-7. The current situation is similar.
    Much pain has been felt by those who misjudged risk, but this too shall pass.

  9. Anonymous

    Appraisal fraud continues to influence the OFHEO data set. Y/Y the all transactions Home Price Index (HPI) increased 0.8% whereas the purchase only HPI declined 0.29%. From the OFHEO report:

    An important factor that has affected the House Price Index in some recent quarters is
    the influence of refinancings on the overall index. The figure below shows percent
    changes in the HPI for the United States as a whole over the prior four quarters
    compared with changes in an index constructed using only house prices associated with
    mortgages used for house purchases. The trend is generally the same, but the
    purchase-only index has exhibited greater price weakness over the latest year. Over
    the past four quarters, the all-transactions HPI rose 0.8 percent, while the purchase-only
    index fell 0.3 percent.

    The OFHEO is being quite generous to themselves. Appraisal fraud has been obvious to this writer since 2004.Q1.

  10. James I. Hymas

    According to the Cleveland Fed:

    About one-third of all domestic banks and two-thirds of all foreign banks surveyed reported having tightened standards for these types of loans for small as well as large and medium-sized firms. The remaining fraction of banks reported little change. The reasons cited for tightening included a less favorable economic outlook, a reduced tolerance for risk, and worsening of industry-specific problems. A large fraction of domestic and foreign banks increased the cost of credit lines and the premiums charged on loans to riskier borrowers. About two-fifths of the domestic banks and nearly eight-tenths of the foreign banks surveyed raised lending spreads (loan rates over the cost of funds).

    While this is hardly a quantitative survey, I note that the net percent of banks tightening is increasing, but still at about half of recessionary levels.

  11. Joseph Somsel

    While being in negative equity is certainly a risk factor of default, another factor is, what are the after-tax rents for comparable housing?
    After all, most owners of owner-occupied housing are still going to need a place to live. Give up your home and you go rent one. Their old place either gets new owner-occupants or goes up for rent. If rents are not a bargain relative to your mortgage payments, you keep the house.
    For speculator-owned housing offered on the rental market, losing the property would either convert it into an owner-ocupied home or keep it as a rental unit but with a lower cost basis.
    How declining prices affect the rental market seems to depend on the portion of speculator walkaways and, critically, on migration patterns, ie population pressure.
    Here in Silicon Valley, prices seem stable at worst. That’s because of the solid economy and the continued influx of people wanting to work and live here.
    Squeezing out speculators is, therefore, a desirable social outcome, at least from a family prospective.

  12. DickF

    Anecdote: Orlando FL – A friend, a legal alien, first time home buyer, got a great deal. The builder threw in some money and most of the closing while my friend threw in 20% down. Has about 7% equity based on selling prices for comparible property over and above her 20% down. A modest recovery in prices back to what they were in the next couple of years could give her close to 35-40% equity. There is a silver lining to falling prices.

  13. fred

    And if you think the economy can continue to hum along without those institutions continuing to extend credit, well, we may get some interesting additional data relevant for your hypothesis in a rather short while.
    Poppycock. If the existing banks go bust but the government opens the floodgates of fiscal stimulus (2 or 3 trillion dollar deficits), then there will be plenty of cash rich investors (Warren Buffett, Sultan of Dubai, etc) ready to jump in and start up new banks and the real economic system will roll along quite nicely. Now if the banks go bust but the government fails to provide enough fiscal stimulus, then sure, the Fed will end up pushing on a string. An economist named John Maynard Keynes discussed all this in detail 70 years ago.

  14. E. Poole

    Was it Jeffrey Sachs who suggested that the crumbling Soviet Union change all the wheels at once so-to-speak when shifting from authoritarian planned socialism to a rich, western model of political economy?

    A comparison of recent Chinese-Russian experiences suggests that gradualism works best.

    It is perhaps a misleading to compare institutional rates of changes in these instances but it is amusing to contemplate how much a ‘rip the bandage off’ approach to US financial and monetary policy could cause acute short-term pain, and how the US should carefully tread moving forward like a fragile, unstable developping country built on shaky foundations of social solidarity.

    My fear is that Bernanke loudly signals shattered US self confidence similar to the loud signal of fear and confusion that the incarceration of a child soldier and denial of habeaus corpus sends to the world.

    Here is how Bernanke affects my outlook as a retail investor. I was bearish than most last mid-summer, got out 100%, nibbled back in a bit (deep-value base metals and oil and gas plays), but stayed mostly in cash and fixed-income, and now a short-term ‘no-brainer’ arbitrage play. (Aren’t they all?)

    These days, most of the street is much more bearish than I am. Yet I hesitate to increase the weight of equities because fed policy is projecting an economy that implies a secular bear market according to my caribou shoulder blades. Great for traders perhaps, but not so great for buy ‘n hold me. I even tend to hold options whether they are bought as insurance or highly-levered naked bets….

    The yield curve is upward sloping; overnight markets are liquid. What more can be done?

  15. David Leitch

    The actual number of new unsold homes for sale declined this month and has been declining from a 50 year high for about the past six monhts. This indicates, in my opinion, that starts are falling below sales, that inventory is falling and therefore that the situation is improving. Its terrible for volume builder profits in the short term of course but clearing the inventory is the first priority. Forget about the months sales indicator its irrelevant its the absolute inventory level we care about.

  16. esb

    David Leitch:
    You need to spend some time over at Calculated Risk so as to disabuse yourself of this erroneous notion.
    The operative concept here is “cancellations.”

  17. calmo

    Nobody at the Fed is as smart as Gavin with this remark:
    It will also be much healthier for a society to have families pay smaller fractions of their income on housing.
    They would rather leave those house prices in the hands of “the market” and deny that there ever was any housing bubble, –that according to their OER, house prices are reasonable, although official inflation somewhat higher than the target…as if we are likely to see an increase in the FF rate.
    It’s becoming clear that they think their interest rate changes are also in the hands of the market…last bastion of those who still think we can avoid a recession.

  18. Dr. D

    These Repeat Sales Indices (RSIs) as used by both C-S and OFHEO have major problems when used to estimate the present-period valuation of housing: the accuracy and precision of an RSI depends very much on the number of samples covering any given period, and thus the current period is always far less accurate than prior periods, even with an active housing market. (Current period is subject to large revisions.) C-S takes steps to reduce these problems (much larger sample sets), but is still subject to this issue — analyze the revision history of the indices!
    Most importantly, though, the housing market is currently ‘closed’: there are very, very few transactions (relative to norms), thus few samples are available to construct the recent past component of these index series, and further, the only transactions being completed are effectively ‘forced-sale’ situations, transactions with artificially low prices induced by seller-specific circumstances.
    So it is a colossal error to assume that these indices accurately represent the current value of housing….
    We’ll know better in March-April what houses are really worth.

  19. David Leitch

    We look at cancellations constantly. I have a spread sheet here for the 10 major builders showing quarterly cancellations. The cancellation rate has not changed much over the past 18 months for that sample. So although the inventory graph understates the actual inventory it should be a relatively constant error and therefore its still reasonable to assume inventories are coming down.
    Note that the homebuilders have rallied lately, too early probably, but that is the nature of markets.

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