Two Views on Housing

As the housing market continues to flounder despite historical stimulus and artificially low interest rates, we thought it might be a good idea to share a couple of different views on the situation going forward. Our view more closely resembles that of Mr. Schiff's, however the extent of the decline in prices is very hard to even ballpark. What we do feel confident about is that home prices will fall further.

Question #1 for 2011: House Prices

www.calculatedriskblog.com

Two weeks ago I posted some questions for next year: Ten Economic Questions for 2011. I'm working through the questions and trying to add some predictions, or at least some thoughts for each question before the end of year.

1) House Prices: How much further will house prices fall on the national repeat sales indexes (Case-Shiller, CoreLogic)? Will house prices bottom in 2011?

Real House Prices

The following graph shows the Case-Shiller Composite 20 index, and the CoreLogic House Price Index in real terms (adjusted for inflation using CPI less shelter).

In real terms, both indexes are back to early 2001 prices. Also both indexes are at post-bubble lows.

As I've noted before, I don't expect real prices to fall to '98 levels. In many areas - if the population is increasing - house prices increase slightly faster than inflation over time, so there is an upward slope in real prices.

If real prices fall to 100 on this index (seems possible) that implies about a 10% decline in real prices. However what everyone wants to know is the change in nominal prices (not inflation adjusted). If real prices eventually fall 10%, that doesn't mean nominal prices will fall that far. House prices tend to be sticky downwards, except in areas with a large number of foreclosures. That is key a reason why prices have been falling for years, instead of adjusting immediately.

There is no perfect gauge of "normal" house prices. Changes in house prices depend on local supply and demand. Heck, there is no perfect measure of house prices!

That said, probably the three most useful measures of house prices are 1) real house prices, 2) the house price-to-rent ratio, and 3) the house price-to-median household income ratio. These are just general guides.

continue reading......

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Home Prices Are Still Too High

They would have to decline another 20% just to get back to the historical trend line.

By PETER D. SCHIFF / Appeared Wall Street Journal

Most economists concede that a lasting general recovery is unlikely without a recovery in the housing market. A marked increase in defaults and foreclosures from today's already elevated levels could produce losses that overwhelm banks and trigger another, deeper financial crisis. Study after study has shown that defaults go up when falling prices put mortgage holders "underwater." As a result, the trajectory of home prices has tremendous economic significance.

Earlier this year market observers breathed easier when national prices stabilized. But the "robo-signing"-induced slowdown in the foreclosure market, the recent upward spike in home mortgage rates, and third quarter 2010 declines in the Standard & Poor's Case–Shiller home-price index—including very bad October numbers reported this week—have sparked concerns that a "double dip" in home prices is probable. A longer-term view of home price trends should sharply magnify this fear.

Even those economists worried about renewed price dips would be unlikely to believe that the vicious contractions of 2007 and 2008 (where prices fell about 30% nationally in just two years) could return. But they underestimate how distorted the market had become and how little it has since normalized.

By all accounts, the home price boom that began in January 1998, when the previous 1989 peak was finally surpassed, and topped out in June 2006 was extraordinary. The 173% gain in the Case-Shiller 10-City Index (the only monthly data metric that predates the year 2000) in those nine years averaged an eye-popping 19.2% per year. As we know now, those gains had very little to do with market fundamentals, and everything to do with distortionary government policies that set off a national mania for real-estate wealth and a torrent of temporarily easy credit.

If we assume the bubble was artificial, we can instead imagine that home prices should have followed a more traditional path during that time. In stock-market terms, prices should have followed a trend line. When you do these extrapolations (see lower line in the nearby chart), a sobering picture emerges. In his book "Irrational Exuberance," Yale economist Robert Shiller (co-creator of the Case-Shiller indices along with economists Karl Case and Allan Weiss), determined that in the 100 years between 1900 and 2000, home prices in the U.S. increased an average 3.35% per year, just a tad above the average rate of inflation. This period includes the Great Depression when home prices sank significantly, but it also includes the frothy postwar years of the 1950s and '60s, as well as the strong market of the early-to-mid 1980s, and the surge in the late '90s.

In January 1998 the 10-City Index was at 82.7. If home prices had followed the 3.35% annual 100 year trend line, then the index would have arrived at 126.7 in October 2010. This week, Case-Shiller announced that figure to be 159.0. This would suggest that the index would need to decline an additional 20.3% from current levels just to get back to the trend line.

How has the market found the strength to stop its descent? No one is making the case that fundamentals have improved. Instead, there is widespread agreement that government intervention stopped the free fall. The home buyer's tax credit, record low interest rates, government mortgage-assistance programs, and the increased presence of Fannie Mae, Freddie Mac and the Federal Housing Administration in the mortgage-buying business have, for now, put something of a floor under house prices. Without these artificial props, prices would have likely continued to fall.

Where would prices go if these props were removed? Given the current conditions in the real-estate market, with bloated inventories, 9.8% unemployment, a dysfunctional mortgage industry and shattered illusions of real-estate riches, does it makes sense that prices should simply fall back to the trend line? I would argue that they should overshoot on the downside.

With a bleak economic prospect stretching far out into the future, I feel that a 10% dip below the 100-year trend line is a reasonable expectation within the next five years, particularly if mortgage rates rise to more typical levels of 6%. That would put the index at 114.02, or prices 28.3% below where we are now. Even a 5% dip would put us at 120.36, or 24.32% below current prices. If rates stay low, price dips may be less severe, but inflation will be higher.

From my perspective, homes are still overvalued not just because of these long-term price trends, but from a sober analysis of the current economy. The country is overly indebted, savings-depleted and underemployed. Without government guarantees no private lenders would be active in the mortgage market, and without ridiculously low interest rates from the Federal Reserve any available credit would cost home buyers much more. These are not conditions that inspire confidence for a recovery in prices.

In trying to maintain artificial prices, government policies are keeping new buyers from entering the market, exposing taxpayers to untold trillions in liabilities and delaying a real recovery. We should recognize this reality and not pin our hopes on a return to price normalcy that never was that normal to begin with.

Mr. Schiff is president of Euro Pacific Capital and author of "How an Economy Grows and Why it Crashes" (Wiley, 2010).