Even when the housing situation stops getting worse, statistically, prices will keep falling

TO BE NOTED: From Accrued Interest:

"Monday, April 27, 2009

Home Prices: A little higher! A little higher!

I'm getting tired of hearing that home prices still need to fall further. You can be the most bullish guy in the whole world on housing and you'd still have to admit that statistically home prices have to keep falling.

Consider how the major home price indices, both the FHFA and Case-Shiller, use repeat sales to calculate home price changes. Basically they look for homes that have sold twice, and measure the price change between the two sales periods. So if a home sells to the Skywalker family in 2004 for $100,000 and then to the Organa-Solo family in 2007 for $115,000, we'd call that one data point indicating that homes rose by 15% over those three years. (Do we think that Amidala's house was foreclosed on after she died? Or was there family money there?) Combine this with millions of other data points, and you can get some pretty solid estimates.


Now, I don't know of any better way to measure home price changes. Certainly I don't like using appraised values, especially in a market like this one. But the paired sales method is bound to lag reality in a market like this one.


Consider what we have in housing. Too many houses were built, and too many borrowers got funding that shouldn't. The former means there is too large a supply of homes, and the later means that foreclosures are creating even more supply of homes!


We in the financial business are used to things moving fast, but the housing market doesn't work like that. The foreclosure process is slow, and given the ever-changing world of government programs, I think many banks have been especially slow to initiate foreclosures. On top of that you have loan mods, a large percentage of which will re-default. For these reasons and others, I'm sure we will still be dealing with large numbers of foreclosures a year from now.

And remember that foreclosures aren't going to be evenly distributed across the country. They will be focused in areas where the bubble was worst. In other words, areas where there was already too much supply from builders! Areas where the gap between supply and demand is widest.

Demand for housing is also quite inelastic. I already have a home. Lower prices in and of itself doesn't incent me to buy another house, because I'd have to sell the one I have anyway. It isn't like when the Gap needs to clear out excess sweater inventory. They can make everything half off and unload it all. America needs to do a half-off homes sale, but can't actually get anyone to come to the mall to buy.

So it is inevitable that as actual transactions start to pick up, those transactions will show lower and lower prices, especially where foreclosures are high. Even when the housing situation stops getting worse, statistically, prices will keep falling. But we can't get to a bottom unless transactions pick up (which they have), and inventories are cleared out. The fact that increased transactions largely represent increased foreclosures is neither here nor there. We know foreclosures are coming. Let's get them out of the way.

Put all this together, and I'm watching stats like Existing Home Sales and NAHB confidence survey much more closely than today's Case-Shiller Index. On that basis, its reasonable to see the decline in housing finally abating. But only a fool would say that prices are about to bottom."

OFHEO suggests we hit bottom and CS suggests that we're still going down?

TO BE NOTED: From Supply And Demand:

"Case-Shiller OFHEO faceoff

Two readers generously offered their valuable insights on the Case-Shiller OFHEO gap I noted earlier this morning.

Professor Nunes says that the CS index puts too much weight on particular regions. He has a paper showing how Case-Shiller and OFHEO agree much more region-by-region.

It looks like he has an important and very useful point. (I must also confess that he sent me the paper last fall, and I failed to remember his contribution).

Does the regional aggregation issue explain whether which series is right about January: OFHEO suggests we hit bottom and CS suggests that we're still going down? (Note: Professor Nunes does not like national (as opposed to regional) analysis of housing, so he may be understandably unwilling to answer). Note that OFHEO said that nearly all regions (the West being a notable exception) increased in January.

Sean MacLeod of Metacapital Management emails that "those in the mortgage finance market believe the OFHEO data to be c#$p." He prefers Case-Shiller and a third series, RadarLogic.

I am not sure CS is so much better. In particular, CS says that national housing prices almost doubled (relative to construction costs!) during the boom, which seems reasonable for a couple of regions, but a huge exaggeration for most of America. On the other hand, the OFHEO index was late in showing the bust (see the chart below, which measures both relative to the residential construction PPI). That's why I look at both, and support the Employment for Economists Act!

Many thanks to Mr. MacLeod and Professor Nunes! Housing prices are an incredibly important economic indicator these days, so their insights are worth many times more what I and the readers of this blog are paying for them!

Posted by Casey B. Mulligan at 9:05 AM

"Mortgage applications in the U.S. last week reached a five-year high as borrowing costs slid. "

Interesting news from Bloomberg:"By Shobhana Chandra

Dec. 31 (Bloomberg) -- Mortgage applications in the U.S. last week reached a five-year high as borrowing costs slid.( GOOD NEWS )

The Mortgage Bankers Association’s index of applications to purchase a home or refinance a loan rose to 1,245.7, the highest level since 2003, from the prior week’s 1,245.4. The group’s purchase gauge climbed 1.4 percent and the refinancing measure fell 0.4 percent.

The drop in borrowing costs, sparked in part by the Federal Reserve’s plan to buy mortgage-backed securities, is the lone bright spot in a market plagued by record foreclosures and plunging home values. While lower rates will help owners reduce monthly payments( AND DEBT. GOOD NEWS ), they have yet to stimulated sales( I DIDN'T THINK IT WOULD ), indicating the housing slump will persist for a fourth year.

“We’ve seen a bit of recovery in mortgage applications as borrowing costs are easing,” John Herrmann, president of Herrmann Forecasting LLC in Summit, New Jersey, said before the report. “The housing market has not yet reached a bottom. Sales and prices will continue to grind lower into next year.”

The Fed in November announced a program to reduce the cost and increase the availability of credit for homebuyers. Yesterday, the central bank selected four firms to manage a $500 billion purchase of mortgage-backed securities, to be completed by June. Only fixed-rate agency mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae are eligible assets for the program, the Fed said.

The mortgage bankers’ purchase index increased to 320.9 last week, from 316.5 the prior week. The measure reached an eight- year low of 248.5 in mid November and peaked at a record 529.3 in June 2005.( GOOD NEWS )

Refinancing

The refinancing gauge decreased to 6,733.8 from the prior week’s five-year high of 6,758.6.

The average rate on a 30-year fixed-rate loan dropped to 5.03 percent, the second-lowest level since records began in 1990, from 5.04 percent the prior week. At the current rate, monthly borrowing costs for each $100,000 of a loan would be about $539, or $91 less than the end of October, when the rate was 6.47 percent.

The share of applicants seeking to refinance loans slid to 82.9 percent of total applications, from a record 83.2 percent the prior week.

Today’s report also showed the average rate on a 15-year fixed mortgage decreased to 4.79 percent, the lowest level since March 2004, from 4.91 percent the prior week. The rate on a one- year adjustable mortgage dropped to 6.15 percent from 6.36 percent.

Mounting foreclosures and slumping sales are accelerating the drop in property values. Home prices in 20 major U.S. cities declined 18 percent in October from the same month last year, the most on record, the S&P/Case-Shiller index showed yesterday.

The Washington-based Mortgage Bankers Association’s loan survey, compiled every week since 1990, covers about half of all U.S. retail residential mortgage originations."

I guess the view that dropping rates wouldn't vastly increase home sales is turning out to be correct. We might see a bottom to the decline in housing prices if the mortgage rates stay low and housing prices drop further. However, it looks like my original 5 % more will be more like 10% more ( On average ).

"In order for these mortgages to rejuvenate the housing market, they have to be available to everyone. "

Here's a plan I have to consider, although I earlier thought that it would not go anywhere because of the possible price tag. I am going to wait and say more about it when it is actually proposed. From the Economist's View:

"Effective Nationalization of the Mortgage Finance Sector"

James Kwak says it's likely that the new administration will get behind the Hubbard and Mayer plan to have Fannie and Freddie buy mortgages and refinance them at 4.5%:

We Have a Winner?, by James Kwak: After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer... Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.

I say “unlikely” not only because Hubbard was the chairman of President Bush’s Council of Economic Advisors, but because it doesn’t look like a Democratic plan; then again, it doesn’t look much like a Republican plan, either. ... Before getting to the policy specifics, though, I want to outline two of the premises...

First, Hubbard and Mayer, like many others, have the goal of preventing an overcorrection on the downside (housing prices falling further than where they need to go to be reasonable). But unlike many others, they have calculated where prices need to go( THIS BOTHERS ME ), and one of their central arguments is that we are already there, and therefore housing prices should be propped up right now( THIS MIGHT TRUE, BUT IT'S HARD TO TELL ). This was surprising to me, since I am familiar with Case-Shiller charts like this one from Calculated Risk..., which seem to show prices still more than 50% above their 2000 levels (nominal prices, but in a low inflation environment). ...( THESE CHARTS ARE OF LIMITED USE. BUT THEY ARE USEFUL, AND, SO, YES, I'M NOT SURE WHY THEY'RE SO SURE )

Second, Hubbard and Mayer argue that housing prices are mainly a function of real mortgage rates. While they acknowledge that other factors took over at the peak of the boom, their model shows that most housing price appreciation through 2005 was due to fundamentals, primarily low mortgage rates( OK ). ... Right now, they argue, mortgage rates are historically high relative to Treasury bond yields, and those high mortgage rates are pushing housing prices below their long-term levels. (Mortgage rates are only historically high because Treasury yields are world-historically low, but we’ll come back to that.)( I AGREE )

Given those premises, the policy proposal is simple: force mortgage rates down to 4.5% (by reducing the cost of Fannie/Freddie debt relative to Treasuries), thereby propping up housing prices at a level that Hubbard and Mayer think is sustainable. ...( YIKES )

Now here’s the surprising part. In order for these mortgages to rejuvenate the housing market, they have to be available to everyone. This isn’t a program for reducing mortgage foreclosures; this is a program for boosting housing sales and refinancings across the board. ...( YIKES )

The goals of the program are to stop the slide in housing prices, stimulate the economy by unfreezing home sales and through the wealth effect of increased housing prices, and stabilize the value of mortgage-backed securities, thereby aiding the financial sector. ... ( WE SEE THAT )

One question is whether the loans will be sustainable. ... Fannie and Freddie could face the problem of getting stuck with riskier mortgages while the private sector keeps the better ones( MAYBE ). But in any case there are signs that some version of this plan will be brought to the floor.

Brad DeLong:

Glenn Hubbard and Charlie Mayer call for the effective nationalization of the mortgage finance sector. ... All in all, I approve of the plan: having Fannie and Freddie buy up mortgages at market prices and refinance them at 4.5% could do a lot of good for the country and make a fortune for the government.( I'M A BIG FAN OF DeLONG, BUT THIS REMINDS ME OF WHAT WILLIAM GROSS SAID ABOUT THE ORIGINAL PLAN FOR TARP. NAMELY, BUYING TOXIC ASSETS, FINANCING THEM CHEAPLY, AND THEN SELLING THEM FOR A LARGE PROFIT DOWN THE LINE. I SEE THAT IT COULD WORK, BUT IT STILL SEEMS RISKY )

I am, however, gobsmacked to see Glenn Hubbard proposing it."

"that it was optimism that raised housing prices, not much of anything tangible during the boom."

I often find myself agreeing with Casey Mulligan, although I'm not sure why. But once again, I agree with his basic point:

"Professor White showed that one-year real interest rates were low during the housing boom. That’s a good starting point because, if the Fed can affect anything real, it is the short-term interest rate. Now let’s use that information to demonstrate that the impact on housing prices is minimal.

Since I will demonstrate that the housing-price impact is small, I will assume that the supply of housing is fixed; an elastic supply of housing would only reduce the price impact below what I calculate here.

Each house in place today produces services for a number of years. To a good approximation, we can assume that each house lasts forever, except that it depreciates exponentially (but slowly). The market value of the house is the present value of those services. Low interest rates can raise housing prices (although not much), because future services are discounted less.

Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year.

A 100-basis-point-lower interest rate for one year would justify paying about $202,000 for a house that would ultimately be worth $200,000. A 100-basis-point-lower interest rate for two years would raise purchase prices by about two percent. (Actually, it would be less, because of the discounting of the second year, not to mention the supply response.) A 200-basis-point reduction for two years would raise purchase prices by less than four percent, etc.

Thus, interest-rate reductions for a short horizon do raise housing prices, but not much by the standards of this recent housing boom when housing prices were tens of percentage points higher (according to Case-Shiller, practically 100 percent higher). A house that would ultimately be worth $200,000 was actually selling for something in the neighborhood of $300,000.

Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last."

I agree with this. The low interest rates do not explain this crisis. At best, they are a necessary condition.

"Second, such a claim gets closer to my hypothesis: that it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble."

What does optimism mean?

1.	a disposition or tendency to look on the more favorable side of events or conditions and to expect the most favorable outcome.

2.	the belief that good ultimately predominates over evil in the world.

3.	the belief that goodness pervades reality.

4.	the doctrine that the existing world is the best of all possible worlds.

It would seem that it is 1 that he means. The most favorable outcome in:
1) Interest Rates
2) Future Tastes
3) Future Technology

I prefer "wishful thinking":

interpretation of facts, actions, words, etc., as one would like them to be rather than as they really are; imagining as actual what is not.

I prefer this phrase because I believe that people knew that they were taking risks, but chose to ignore them. There was a real disposition to ignore reality and history and even common sense.I'm not quite sure that they were optimistic. There was too much uncertainty in the world and too little faith in the Bush Administration for optimism. I hope that I'm making the difference clear.

I believe that much of this malady has to do with a general belief in the incompetence of the Bush Administration. So, my views, they don't qualify as a theory, predict that there will be a major change in the perception of our situation after we have left President Bush behind. The swearing in of President Obama should lead to more optimism, if you will, than we see now. I don't like how many predictions I've given on this blog. Perhaps it's time to sign off.