Thursday, December 30, 2010

Home Prices Are Still Too High

The Wall Street Journal ran an interesting editorial discussing current home prices versus the prices houses would have been expected to sell for if the residential real estate bubble had not occurred.
...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. 
...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..., 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.
An alternative way to look at this data is to ask how many years before the trend line index reaches the current index level.  It would take approximately 7 years to close the gap (126.7*(1.0335)^y = 159.0). 
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.
There were two ways that Fannie Mae, Freddie Mac and the Federal housing Administration have increased their presence in the mortgage buying business.  First, Congress mandated that they increase the size of the mortgage that was eligible as a conforming mortgage.  This increase in size was designed to prop up property prices as it was (is?) difficult to get a jumbo mortgage.  Second, with the demise of the private residential mortgage backed securities market, agency backed mortgages became the only alternative.
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.
If house prices without all the government props would currently be 10% below the trend line, an index value of 114.02, it would take 11 years at trend line growth to reach the index value of house prices with all the government props, 159.

Is the government willing to pursue policies to artificially prop up house prices for the next decade?  Does the US have the financial wherewithal to prop up house prices for the next decade?
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.
As pointed out by the columnist earlier, the underlying trend of prices increasing by 3.35% per year occurred through both good and bad times (including the Great Depression).   Presumably it should still be continuing.
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.
The conclusion from the analysis is that the US government is exposing taxpayers to considerable risk by artificially propping up house prices.  The risk is not that house prices will continue to correct.  The columnist identifies a number of factors that support an ongoing correction.  Left off the list is demographics.  What is going to happen to all the houses that the baby boomers have and want to sell as they go into retirement?  

The risk is that the US government will spend a significant amount of its resources and have little left to fight another economic downturn.

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