Just how out of line are house prices?

In Wednesday's post, I referenced commentary from several bloggers regarding the sizeable decline in housing prices reported by Zillow earlier this week. As I discussed yesterday, the rat-through-the-snake process of working down existing and prospective distressed properties is likely far from over, and how that process plays out will no doubt have an impact on how much prices will ultimately adjust.

Recently, Barry Ritholtz's The Big Picture blog featured an update of a New York Times chart that suggests there will be a significant adjustment going forward:

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Prior to the crisis, I was persistently advised that the better way to think about the "right" home price is to focus on price-rent ratios, because rents reflect the fundamental flow of implicit or explicit income generated by a housing asset. In retrospect that advice looks pretty good, so I am inclined to think in those terms today. A simple back-of-the envelope calculation for this ratio—essentially comparing the path of the S&P/Case-Shiller composite price index for 20 metropolitan regions to the time path of the rent of primary residences in the consumer price index—tells a somewhat different story than the New York Times chart used in the aforementioned Ritholtz blog post:

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According to this calculation, current prices have nearly returned to levels relative to rents that prevailed in the decade prior to the housing boom that began in the late 1990s.

Of course, the price-rent ratio is not the most sophisticated of calculations. David Leonhardt shows the results from other such calculations that suggest prices relative to rents are still elevated, at least relative to the average that prevailed in the 1990s. But the adjustment that would be required to bring current levels back into line with the precrisis average is still much lower than suggested by the Ritholtz graph.

How much farther prices fall is, I think, critical in the determination of how the economy will fare in the immediate future. Again, from President Lockhart:

"The housing sector also has indirect impacts on the economy. In particular, the direction of home prices is important for the economy because changes in home prices affect the health of both household and bank balance sheets. …

"The indirect influence of the housing sector on consumer activity and bank lending would almost certainly aggravate housing's impact on growth."

Here's hoping my chart is more predictive of housing prices than the alternative.

Update: The Calculated Risk blog does a thorough job and concludes that we don't have "to choose between real prices and price-to-rent graphs to ask 'how far out of line are house prices?' I think they are both showing that prices are not far above the historical lows."

Update: The Big Picture's Barry Ritholtz points me to his earlier argument against reliance on price-rent ratios.

By Dave Altig
senior vice president and research director at the Atlanta Fed

Is housing hurting the recovery?

Though the week is only half over, I'm going to nominate Stan Humphries and Zillow as bearers of the week's most distressing economic news:

"Home values fell three percent in the first quarter of this year, marking a pace of decline not seen since 2008 when the housing recession was at its worst. Home values fell one percent between February and March and 8.2 percent from March 2010."

Calculated Risk provides a handy table of how prices have affected equity values in homes by locale, as the Zillow Real Estate Research blog predicts the price-decline end is not so near:

"Previously, we anticipated a bottom in home values by the end of 2011. But with values falling by about 1 percent per month so far, it's unlikely that will happen. We now believe a bottom will come in 2012, at the earliest."

At The Curious Capitalist, on the other hand, Stephen Gandel says he's not so sure:

"To be sure, housing prices have fallen this year. But the Zillow numbers out today make the housing market look worse than it is. The problem is with how Zillow tracks home prices. Unlike other measures of the housing market, Zillow's numbers are not based on actual sales, but on estimates of what its model thinks your house, along with every other house in America is worth. Zillow's model is similar to how an appraiser figures out what your house is worth. It looks at past sales of houses that are similar to yours and then guesses what your house is worth. But by the time those sales are fed into Zillow's system they are months old. … If the housing market is turning, Zillow is going to miss it."

Is the housing market turning, particularly with respect to prices? Tough to say. If you want your glass half full, these words from the New York Fed's Liberty Street Economics might be the tonic for your tastes:

"This post gives our summary of the 2011:Q1 Quarterly Report on Household Debt and Credit, released today by the New York Fed. The report shows signs of healing in household balance sheets in the United States and the region, as measured by consumer debt levels, delinquency rates, foreclosure starts, and bankruptcies…

"Delinquency rates are generally down…

"New foreclosures fell nationally and in the region. About 368,000 individuals in the United States had a foreclosure notation added to their credit report between December 31 and March 31, a 17.7 percent decrease from the 2010:Q4 level. New foreclosure rates fell from 0.19 percent to 0.15 percent for all individuals nationwide…"

What may be the most important aspect of the report is highlighted by the Financial Times's Robin Harding: "…fewer new mortgages going bad, and some bad mortgages getting better." In fact, for the first time since the crisis began, the percentage of mortgages transitioning from 30 to 90 days delinquent to current exceeds the percentage transitioning to seriously delinquent (90-plus days).

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There is, of course, plenty of material for the housing-price bears. For example, the flow of seriously delinquent mortgages is quite elevated.

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According to estimates from CoreLogic, the supply of "distressed" homes is greater than 15 months at the current pace of sales:

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Kevin Drum thinks this all adds up to problems for the recovery (hat tip Free Exchange):

"Most analysts now expect that the housing market won't bottom out until sometime next year. Until that happens, it's unlikely that that the sluggish economic recovery we're seeing right now will improve much."

The view here at the Atlanta Fed—and the answer to the question posed in the title of this post—was provided earlier today by our president, Dennis Lockhart, in a speech given to the Atlanta Council for Quality Growth:

"…can we have high-quality growth while the residential real estate and commercial real estate sectors continue to be so weak? Not completely, in my opinion. The recovery will progress, but it will not be robust until we work through the economy's serious imbalances, including those in the real estate sector.

"As I look ahead, I think the most reasonable assumption is that improvement of the real estate sector will lag an otherwise improving economy. But I am encouraged by the fact that the economy is increasingly on firmer footing."

I will let you decide whether that glass is half-empty or half-full.

By Dave Altig
senior vice president and research director at the Atlanta Fed

Policy may have created the housing bubble, but which policy is to blame?

There is little dispute that misguided policy choices led to the housing boom-bust cycle from which we are still recovering. The debate about which policies were most culpable, however, rages on. The latest chapter in this dispute is now available in the proceedings from this year's edition of the Kansas City Fed's Jackson Hole Economic Policy Symposium.

In defense of monetary policy, Charles Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor—all of the Bank of England—write this:

"We argue that while relatively low policy rates compared to past experience contributed to the growth in credit and the rise in house prices in the run-up to the crisis, they played only a modest direct role."

Stanford University's John Taylor (still) isn't buying it:

"Their conclusion differs from mine for several reasons. First, they do not take account of much empirical work completed since the 2007 Jackson Hole conference. For example, Jarocinski and Smets (2008) of the European Central Bank estimated a VAR [vector autoregression] for the United States and found evidence that 'monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.' In a more recent study focusing directly on deviations from policy rules, Kahn (2010) of the Federal Reserve Bank of Kansas City finds that ‘When the Taylor rule deviations are excluded from the forecasting equation, the bubble in housing prices looks more like a bump.' "

I added the links to the papers cited by Taylor because they are thoughtful challenges by thoughtful people, and they deserve to be considered (though the Jaroconski and Smets article requires some tolerance of relatively sophisticated econometrics). That insightfulness, of course, does not mean they are completely persuasive; I still have my doubts.

Most of you are familiar with this picture of the "Taylor rule" referenced above—which prescribes a funds rate target based on the deviations of output from its potential and the deviation of inflation from a presumed target of 2 percent—compared with the actual path of the policy rate:

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Bean et al. make note of a speech from the beginning of the year by Chairman Bernanke in which he in turn notes (among other things) that the period in which policy deviates from this particular Taylor rule is also a period in which the lending standards were dramatically relaxed. To give but one example, data collected by my colleague Kris Gerardi indicate that in Massachusetts the median loan to value ratios (LTVs) for all borrowers rose from 0.82 in 2000 to 0.9 in 2006. For subprime borrowers, LTVs rose during that period from 0.85 to 1.0. The statistical results cited in Taylor's response do not control for such developments, making it difficult to come to a strong causal conclusion.

Second, this observation (from the Bean et al. paper) introduces even more uncertainty regarding the robustness of the chain of events leading from low interest rates to the housing bubble:

"Chart 1 shows that both UK and euro-area policy rates were less noticeably out of line with their respective Taylor benchmarks. That too is striking. Indeed, in the United Kingdom, they were actually above the benchmark for much of the relevant period, even though the United Kingdom saw one of the larger run-ups in debt and house prices during this period. And, in the euro area, countries such as Spain experienced substantial house price booms, while countries such as Germany did not. That need not imply that monetary policy was innocent in the run-up to the crisis…But this is hardly compelling evidence for assigning the central role to monetary policy, suggesting that other factors were more important."

As the Bank of England authors suggest, monetary policy was not necessarily innocent. But at a minimum, it's worth keeping in mind that the monetary policy transmission mechanism is a good bit more complicated than any simple story would indicate.

By Dave Altig, senior vice president and research director at the Atlanta Fed

Housing back in the news

Housing back in the news

Two reports released this week remind us of the difficulties still confronting the residential real estate market. First, the consumer price index (CPI) showed continued moderation. Yes, the overall number was up 3.4 percent on a monthly annualized basis, and even the core measure ticked up 2.2 percent. But over half of the core rise was related to rising new and used car prices following the expiration of the cash-for-clunkers program. The Cleveland Fed's median CPI, which isn't influenced by these outliers, was up only 1.2 percent and still suggestive of some considerable disinflationary pressure.

What does the CPI have to do with housing? Well, the shelter component of the index, which is derived largely from rents, was unchanged and has risen only 0.7 percent over the past year (see chart below). This performance represents unprecedented lows for this, the largest of the major CPI categories, and is a good indication of the downward price pressures being felt in the residential housing market.

More directly related to the state of housing was Tuesday's report on new home starts, which dropped sharply. Starts fell 10.6 percent in October, a surprising decline for a series that appeared to bottom out in April and stabilize in recent months. But perhaps a few bumps along the road to recovery are to be expected.

Some say that the falloff in new home construction last month was likely the result of uncertainty over the continuation of the first-time homebuyers program. That's a possibility, but here's something else to consider: There may be a lot more housing inventory out there than the official numbers suggest.

In recent months it appears that home prices as measured by the S&P/Case-Shiller Index have stabilized and begun to improve while home sales have picked up notably and listing inventories of new and existing homes have fallen. However, these listing inventories fail to capture a large share of the market including homes for sale by owner, potential buyers on the sideline waiting to see improvement, and foreclosure properties that have not yet made it to market but likely will eventually.

RealtyTrac reported that foreclosure activity slowed for the third straight month in October, down 3 percent from the previous month. However, those receiving notices of defaults increased 2 percent after declining 12 percent the prior month. Bottom line, foreclosure filings remain at high levels.

Amherst Securities released a report in September that took a stab at calculating the current shadow inventory of foreclosure properties using the Truilia listing database. In light of increased sales and slowing foreclosure filings, let's see how things are going:

Comparing the September report and the November numbers, we see that listing inventories declined 3 percent, which is to be expected with the pick-up in existing home sales numbers that the National Association of Realtors has been reporting in recent months. However, the shadow inventory of foreclosed homes grew by 9 percent (real estate owned, or REO, properties grew by 4 percent), helping to drive total inventory up 2 percent from September to November.

Homebuilding was a driving force in the economy in the years leading into the recession. Looking forward, though, the homebuilding industry is continuing to face significant obstacles, including inventory challenges. Those challenges translate into homebuilders being understandably wary to move ahead on new construction until foreclosures and REO inventories measurably subside. Thus, the homebuilding challenge continues.

By Whitney Mancuso, senior economic research analyst, and Mike Bryan, vice president, both in the Atlanta Fed's research department

Foreclosure mitigation: What we think we know

One of the most important challenges facing policymakers today is reducing the rate of mortgage foreclosures. It is a goal many think is at the heart of a sustained recovery in the U.S. economy. But as past attempts to reduce financial stress on homeowners have shown, the task is not easy. One of the complicating factors in formulating successful foreclosure mitigation policy is getting at the heart of the relationship between negative equity (the situation where the remaining mortgage balance is greater than the value of the house) and actual foreclosure.

Economic theory poses one categorical prediction about this relationship, which is that negative equity is a necessary condition for default. In other words, if a borrower is not in a position of negative equity, then he or she should never default. This conclusion follows simply from the fact that positive equity implies a borrower can sell the house, pay off the mortgage, and keep the difference—a better outcome under any circumstance compared with stopping payment on the mortgage and leaving the home.

What economic theory does not say is that if a borrower has negative equity, he or she should always default. The reason for this is that the owner could always default in the future, and thus there is value in waiting to see if house prices recover. Now, this value to waiting differs across borrowers and is sensitive to both the depth of negative equity and a borrower's financial situation. Why does a borrower's financial health matter? Well, the cost of waiting includes the monthly mortgage payment the borrower must continue to make. Borrowers who have plenty of wealth and a steady stream of income will be more willing to continue making payments than borrowers who are in financial distress, perhaps related to an unemployment spell or some other adverse financial shock.

So why does all of this matter in terms of thinking about a successful foreclosure mitigation program? Well, the appropriate policy prescription depends on the particular reason a borrower is currently considering default. I think it is useful to break things down in terms of three (not necessarily mutually exclusive) groups of mortgage borrowers:

• those in unaffordable mortgages from the very beginning, who were implicitly relying on increasing house prices to refinance or sell for a profit;
• those who have been hit by an adverse, but temporary, income/financial shock; and
• those who purchased the house for strictly investment purposes and now see little or no hope of making a profit.

Borrowers may find themselves with unaffordable mortgages for many reasons. One might be an unscrupulous mortgage broker, who steered the borrower into an unaffordable subprime loan in order to generate high origination fees. Another, related situation would be an unaffordable interest rate reset on a subprime adjustable-rate mortgage. Finally, some mortgages may be permanently unaffordable because a buyer misrepresented income or assets during the origination process, a situation made easier by the growth of low documentation mortgages.

A large part of the administration's new housing plan—summarized succinctly by the New York Times, with lots of commentary (negative and positive) rounded up at Economist's View—is reasonably interpreted as being directed squarely at borrowers in the unaffordable-mortgage group. If policy is to be aimed at helping this group, the prescription is to offer the borrower a permanent reduction in monthly payments, whether it comes from lowering the interest rate, lengthening the maturity, and/or reducing the outstanding principal balance on the loan. The measuring stick often used in such plans is the debt-to-income ratio (DTI), which is the borrower's monthly mortgage and/or total required debt payments relative to his or her gross monthly income. While the administration's plan would succeed in lowering DTIs, the policy is temporary in nature (five years), and it is unclear what would happen to these borrowers after the plan runs its course—especially if negative equity is still an issue.

Many borrowers might have been able to afford their mortgages while employed but can no longer do so after they have lost their jobs. When housing prices are rising and homeowners enjoy positive equity, then distressed borrowers are able to sell their homes to pay off their mortgages. Alternatively, such borrowers can undertake cash-out refinances to gain some much-needed liquidity. Note that problems can occur for people in this situation even when positive future equity is a realistic hope. If the borrower is unemployed and liquidity constrained, the cost of waiting to default is very high and potential future price gains are of little value. Default in this case is much more likely, even though future prospects might be reasonably good. In this case, foreclosure-prevention policy could simply be used to eliminate the financial friction. In this case a lender would offer "forbearance," in which the borrower pays significantly lower payments for some period, with the arrears made up (with interest) later on. In this light, it is notable that the administration's key payment reduction plan has a five-year window.

However, one important concern regarding the plan is that servicers/investors don't have enough incentives to substantially decrease current DTI ratios. For example, if a household has a DTI of 60 or 70 because of a job loss, the servicer is responsible for modifying the loan to get DTI down to 38 and then still has to kick in a 50 percent match to further reduce it to 31. The costs borne by the servicer/investor are much larger than those borne by the government, which may not be such a bad thing in principal but in practice may result in low participation rates.

Note also that while permanent relief is the prescribed course for borrowers in the unaffordable-mortgage group, temporary relief is indicated for those in the temporary economic distress group. This highlights the difficulties in constructing policies when the underlying sources of stress differ by individual. The existence of a class of borrowers that purchased and financed residential real estate primarily for investment purposes further complicates matters. People in this group are in much different circumstances than those in the other groups and will default much more ruthlessly. A so-called "ruthless defaulter" has given up hope of positive future equity and hence there are no potential price gains to value. Under the theory of ruthless default, one effective policy intervention is to lower the outstanding balance of the mortgage so that positive equity—or even the hope of positive equity in the near future—is restored. Alternatively, the lender could forestall default at least temporarily by cutting the monthly payment below the cost of renting an otherwise observable house.

Aimed as it is at owner-occupied housing, the administration's plan does not offer direct assistance to those in the investment class. That may not be too surprising, as it is hard to generate much political sympathy for a group carrying a label like "ruthless defaulter." In addition, the perverse incentives of government assistance that usually go by the name of moral hazard are arguably more severe for individuals who purchase properties for investment purposes. However, abandoned properties do add to the stock of unsold homes, independent of who owned them or why they owned them. This does not necessarily argue for policy relief for investment buyers, but it is potential issue that bears watching.

Finally, there may be commentators with the view that loan modifications are a failing proposition as a few studies have shown extremely high default rates on modifications performed in early 2008 (for example, see OCC and OTS Mortgage Metrics Report, Third Quarter 2008). But, according to the table below (based on my calculations), the problem seems to be that the wrong type of modification was being performed. Approximately two-thirds of the modifications performed by servicers in the first two quarters of 2008 had the effect of increasing the principal balance of the mortgage and, as a result, also increased the borrower's monthly mortgage payment. In light of the above discussion, we should not be surprised by high re-default rates on these loans. On the other hand, there is reason to believe that successful implementation of payment reduction programs may indeed help to stem the pace of foreclosures.

	# Loans Modified	Interest Rate Reductions		Principal Balance Reductions		Principal Balance Increases		Term Extensions
		#	%   total	#	%   total	#	%   total	#	%   total
Q107	13,900	200	1.25	600	3.75	13,100	81.88	2,100	13.13
Q207	21,600	700	3.00	200	0.86	20,700	88.84	1,700	7.30
Q307	24,600	700	2.55	300	1.09	23,600	86.13	2,800	10.22
Q407	32,300	3,600	9.65	1,000	2.68	28,000	75.07	4,700	12.60
Q108	33,000	7,100	18.11	400	1.02	25,500	65.05	6,200	15.82
Q208	41,200	10,600	22.36	900	1.90	30,100	63.50	5,800	12.24
Q308	52,600	17,300	28.22	200	0.33	36,000	58.73	7,800	12.72

Source: Lender Processing Services

By Kristopher Gerardi, research economist and assistant policy adviser at the Atlanta Fed

Underwater homeowners and foreclosure

One of the important policy questions that has developed from the recent turmoil in financial markets is, What steps should be taken to try and mitigate the rising tide of foreclosures? Many have identified “negative equity” as one of the primary culprits for the huge increase in foreclosures. Negative equity refers to the situation in which a homeowner would not be able to fully repay his mortgage from the proceeds of a sale. Mark Zandi, chief economist at Moody’s Economy.com, emphasizes the current role of negative equity in the housing crisis in a recent article.

There have been various policies put forth to try to address the negative equity issue. Perhaps the most popular is a widespread loan modification plan, in which lenders/servicers agree to write down or forgive a portion of the principal mortgage balance. A variation of this idea was included in the American Housing Rescue and Foreclosure Prevention Act of 2008. The specific plan was labeled a “rescue refinancing” package. This package consisted of a voluntary program in which a lender who agreed to write down the mortgage of a delinquent borrower to 85 percent of the current market value of the home could obtain a federal guarantee (through the FHA). The idea is basically that curing the problem of negative equity can solve the foreclosure problem. 

It turns out that my colleague, Kris Gerardi, who recently joined the Atlanta Fed by way of the Boston Fed and Boston  University, has conducted some research on this topic, which was discussed in yesterday’s Wall Street Journal.

“Christopher L. Foote, Kristopher Gerardi and Paul S. Willen of the Boston Federal Reserve Bank studied more than 100,000 homeowners who were underwater in Massachusetts in 1991 and found that just 6.4% of them lost their homes to foreclosure over the next three years, according to a paper published in the September issue of the Journal of Urban Economics (For non-subscribers, a version of the paper can be found on the Boston Fed’s working paper series). The vast majority of homeowners simply continued paying as usual because they focused on the affordability of their payments, not on what they owed, and they believed home values would eventually recover.”

“The economists found that homeowners typically lost their homes only after at least two things happened: Their home values dropped and they either couldn't afford the payments or they stopped making payments after losing hope that prices would eventually recover.”

In a follow-up article presented last week at a conference on “The Mortgage Meltdown, the Economy and Public Policy” at the University of California, Berkeley,  Gerardi and Willen consider the principal write-down policy discussed above:

“Many commentators have recently argued that lenders should eliminate negative equity for borrowers in such a position by writing down a portion of the principal balance on their respective loans. The argument runs that such a plan benefits the lender as well because the new principal balance exceeds the yield from foreclosure once one takes into account the costs of foreclosure. Many commentators have argued that this solution is so obvious that one wonders why lenders do not implement it on a large scale.”

What are the potential pitfalls? 

“Think of two mistakes a lender could make. One mistake is to not offer assistance to a borrower in distress. The lender loses here if the increased probability of foreclosure, and high costs incurred by foreclosure, make inaction more costly than assistance. We call this scenario “Type I Error.” But, there is another mistake, often overlooked, which is to assist a borrower who does not need the help. The lender loses here because it receives less in repayment from a borrower who would have paid off the mortgage in full. We refer to this case as ‘Type II Error.’”

That Type II error is, according to the authors, a nontrivial problem.  Using their empirical results as a basis, they conduct the following thought experiment:

“Our policy experiment here is to lower the principal so that the borrower moves from 20 percent negative equity to 10 percent positive equity. Types I and II error and net gains are measured as a percentage of the original loan balance.”

The results, as the authors say, “illustrate both the limits and the opportunities for principal reduction”:

“For most groups, Type II error is large relative to Type I error. The reason is straightforward: most borrowers will repay their loan, even if they are in negative equity positions. For the subprime single-family borrower, a 33 percent foreclosure rate implies a 67 percent repayment rate.”

There may be resolutions to this problem, but they wouldn’t be easy:

“One potential criticism of the above argument is that one could minimize Type II error by requiring proof that a borrower is likely to default. However, as a practical matter, this would be extremely difficult to enforce. Tax documents and even credit reports in many cases would not suffice, as many borrowers in need of assistance are likely suffering from very recent adverse events. Instead, policymakers would need to obtain and verify current information on income, wealth, employment status, and perhaps even more personal events, such as marital status. This would be extremely costly. Furthermore, [our results] suggest that even if qualification requirements reduced Type II error by half … [the only group for which] principal reduction makes economic sense is the multi-family, subprime borrower.”

Basically Gerardi and Willen are arguing that the key to a successful principal write-down policy would be to target the borrowers who are at the most risk of defaulting (in the absence of any assistance). For these borrowers, Type I error is high, while Type II error is very low. Their example is an owner of a multifamily property who financed the purchase with a subprime mortgage. In the Northeast, 2-4 family units are very common, where there's one owner who usually (but not always) lives in one unit and then rents out the other units. Since many of these owners relied on rental income to stay current on the mortgage, they were very susceptible to foreclosure. Further, there is an obvious externality to foreclosure on these properties, as the tenants (who have nothing to do with the delinquent mortgage) are also affected by foreclosure.

This discussion, however, is not to say that efforts to help households facing foreclosure are not effective. In fact, many organizations, from nonprofits to the U.S. government, are working to assist borrowers who face foreclosure.

Tricky business, this.

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

A home price index gets a new name (but it’s telling the same story)

Yesterday we got a peek at the latest home price data provided by the Federal Housing Finance Agency (FHFA). Never heard of it before? It’s the new agency that took conservatorship of Fannie Mae and Freddie Mac, the nation’s giant housing GSEs (government-sponsored enterprises). FHFA has also absorbed the Office of Federal Housing Enterprise Oversight, or OFHEO. So the popular OFHEO home price index is now the FHFA home price index. (Let me weigh in here—I like the sound of OFHEO better.)

The FHFA price index posted another sizeable decline in August (0.6 percent) and is down 6.5 percent from its peak in April 2007. Here’s what the home price index has done since 1991.

The national data mask some wide variations by region. While every part of the country has felt the decline in housing markets, the Pacific region has seen the largest price declines (off 21.5 percent since peaking in March 2007) and the East South Central (which includes Texas) has experienced the least slowing (off 1.7 percent since peaking in June of 2007). The South Atlantic Region, which includes much of the Atlanta Fed’s Sixth Federal Reserve District, has also been hit with an above national average decline as home prices are off about 7 percent since their peak in May 2007.

I suppose these regional variations aren’t too surprising. Stories of overbuilding and price speculation were most pronounced in areas such as California, Nevada, and Florida. These areas also rate tops among foreclosure rates according to data just released by RealtyTrac. Without getting into the thorny (albeit important) issue about what, exactly, constitutes a bubble, the “what goes up must come down” explanation may be a little overly simplistic.

Here’s a perspective published in the Federal Reserve Bank of Cleveland’s Commentary series a little more than a year ago. Davis, Ortalo-Magne, and Rupert say that home values, and especially relative home values, are really driven by fluctuations in the value of land. They argued that if you relax credit constraints, you unleash demand for housing, which because land is in fixed supply will produce a jump in home prices. And the subsequent declines we’ve seen to date? Well, constrain the credit, and the process works in reverse. The Davis et al. story works especially well if you think the housing boom and subsequent bust originated in the subprime market. Since these are exactly the homebuyers who were most credit constrained, the increased availability of credit significantly expanded the pool of potential home buyers.

Atlanta’s recent housing experience may be a good example of the relationship between land, demand, and home prices. As my boss, Atlanta Fed President and CEO Dennis Lockhart, noted in a speech earlier this week, Atlanta had a large expansion of new home building in the first half of this decade. The expansion in home building wasn’t impeded by natural barriers, like mountains and coastline. Atlanta has an abundance of low-cost land available for residential development, and in 2005 Atlanta’s single-family new home market was the strongest in the nation with 61,000 single-family housing permits. However, Atlanta did not experience the extreme home price appreciation seen in some areas, and Atlanta’s home price decline, while unpleasant, is much less than areas like Florida and the West Coast.

By Mike Bryan, vice president and economist at the Federal Reserve Bank of Atlanta

 

Wall Street worries, Main Street woes

A fair amount of the discussion around what now seems to be an imminent rescue plan to settle unsettled financial markets has been focused on a debate as to whether Main Street should pay or Wall Street should pay for the plan. Pimco’s William Gross, however, is suggesting it is a false choice:

“If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest—a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit.… But recent events have made it apparent that this downturn differs from recessions past.…

“And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from ‘troubled financial institutions’ to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury.…

“The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic.”

That assessment—that the goal is to get market-mechanisms working again—was expressed by Chairman Bernanke in his Tuesday testimony before the Senate Banking Committee:

“If you have an appropriate auction mechanism, together with other types of inputs, with flexibility to address different assets in different ways, I think what you will do is you will restart this market. And then you'll get a sense of what the more fundamental value is.”

It may be a good point to note that there is no guarantee that the magic worked by markets will be quick. Yesterday’s report on existing house sales and today’s news on new home sales—covered by the go-to guy Calculated Risk here and here—clearly indicate that the fundamental Main Street adjustments are not yet complete.

Unfortunately, it is difficult to make the case that the trip to stabilization of house prices will be a short one. Simple economics predicts this relationship: movements in house prices are the result, mainly, of movements in land prices (as shown in a good piece of analysis by Morris Davis and Jonathan Heathcote, respectively, from the University of Wisconsin-Madison and the Federal Reserve Board of Governors). The supply of land is fairly inelastic and as a result, changes in house prices should be determined primarily from demand factors. According to Gregory Mankiw and David Weil, this demand is related to the number of prime-aged, child-bearing households.

As the following chart illustrates, house-price growth (measured by the year-over-year growth rate of nominal house prices constructed by the Office of Federal Housing Enterprise Oversight, or OFHEO) and the growth rate of the civilian labor force (CLF)—a reasonable proxy for prime-aged, child-bearing households—were tightly linked for more than two decades.

That pattern broke down around the time of the 2001 recession. This deviation from presumed fundamentals is well known, and we can use the underlying economic theory to get a rough benchmark for how far from complete the adjustment process may be. Consider a hypothetical path for house prices such that the ratio of the growth rate of the OFHEO index to the growth rate of the civilian labor force is maintained at its pre-2001 historical value. That exercise suggests house-price appreciation of 3.3 percent, represented by the green dashed line in this chart:

An estimate of the “overvaluation” of housing is given roughly by the area below the red line (the actual growth in house prices) and above the hypothetical dashed line. With this alternative growth rate series, the OFHEO index would have been at a level of 301 in the second quarter of 2008, instead of the realized value of 381. If the ratio for the post-2000 period is to return to its historical value, house prices would drop 21 percent from second-quarter 2008 levels.

These numbers are, of course, just ballpark calculations. The future need not look exactly like the past, and even if it does there is no way to predict how close we have to get before economic conditions normalize. But to the extent that the past is in fact a reasonable guide, this simple exercise may provide a sense of how much work remains to be done.

By Pedro Silos, research economist and assistant policy adviser, and David Altig, research director, of the Federal Reserve Bank of Atlanta.

It Never Was Just Subprime

So now the dissecting of today's market jitters begins, and there is no shortage of diagnoses. Today's data releases -- described here, here, and here, for example -- were certainly not great, but the most popular explanation seems to be that market players have developed a newly found sense that the world is a risky place.  Barry Ritholtz sums it up nicely:

The Dow is off 395 points as I type this. There will be some short covering shortly, and a rally attempt. But what I want to address is the change that has taken place:

What has changed? What is different today than yesterday? Are the prospects of the economy and/or corporate profits so different today than they were merely a week ago?

What has changed is Credit: Risk appetite for anything less than AAA -- and that includes the ABX stretched definition of AAA (see WTF is going on in the ABX Markets?) -- has waned considerably.

The tinder, if not the spark, for the flare-up of credit concerns was this week's revelation from the mortgage lender Countrywide Financial that loan problems extend well beyond the subprime borrower.  From the Wall Street Journal (page C1 of the July 25 print edition):

By laying the blame for its earnings shortfall on rising defaults of prime home-equity loans -- many taken out by people who were straining to afford a house and didn't fully document their income -- Countrywide undermined the popular notion that only subprime borrowers are falling behind. And that could have a broad, negative impact on lenders' stocks.

And from from Joanna Ossinger's column at the WSJ Online:

Credit-market woes are partially rooted in the subprime-mortgage sector, which has been a source of market angst for months. But recently the problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled and as default rates have risen, even among prime borrowers. Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market.

It "all goes back to weakness in the mortgages," said Larry Peruzzi, equity trader at Boston Company Asset Management.

But a closer look at the Countrywide development is instructive, as it reveals that the source of the problem is, not surprisingly, non-conventional types of loans.  Again from the WSJ article:

Many of the home-equity loans that are going bad are "piggyback" loans to borrowers who took out a second mortgage because they couldn't afford a large down payment and didn't want to pay for mortgage insurance.

Now, with home prices falling in many areas, some borrowers owe more than their houses are worth. That is forcing Countrywide and others to increase provisions against losses.

Another concern is the $27.78 billion of pay option adjustable-rate mortgages held on the books of Countrywide's banking arm. These loans allow borrowers to pay no principal or less than full interest each month. If they choose that option, their loan balance grows. Payments are now overdue on 5.7% of these loans held by Countrywide, up from 1.6% a year earlier.

But here's the thing -- we surely have known for a while now that the building stress in mortgage markets is not a prime vs. subprime thing, but conventional-loan vs. non-conventional loan thing:

   

   

What seems like fresher news to me is the growing skittishness in credit markets that are not so clearly associated with the housing sector.  From the Financial Times:

Stock prices plunged on Thursday amid a flight from risky credits and fears about banks’ growing exposure to leveraged buy-out debts...

Investment bank stocks led the market lower on worries that they will have to use their balance sheets to fund private equity deals. The S&P investment bank index was down 5.3 per cent.

Concerns about the possibility of a credit contraction were exacerbated this week when banks gave up attempts to sell to investors $20bn of debt for the leveraged buy-outs of Chrysler and Alliance Boots, the UK retailer.

A Financial Times analysis shows that in recent weeks, bank balance sheets have absorbed more than $40bn of high-yield debt for buy-out deals that was meant to be sold to investors.

So you have your pick -- weak economic news, a broadening of housing market woes, a fading corporate debt market.  Or just choose all of the above and keep your fingers crossed that it's only a bad week and not a perfect storm.

The World According To Goldman Sachs (And Almost Everyone Else)

From my email, "A Tale of Two Tail Risks," from Goldman Sachs' Michael Vaknin:

• Sub-prime mortgage woes still hold centre-stage as housing fundamentals deteriorate further.
• A full-blown spillover from credit markets to other asset classes is unlikely as corporate sector and global macro fundamentals remain strong.
• Rather, credit market will feature less leverage, more convents, elevated volatility and gradual supply absorption.
• Upward risks to global inflation also remain high on the list of what investors worry about currently.
• On our baseline case, prudent monetary policy should limit a build-up of inflationary pressures.

Some details:

From a fundamental standpoint, there are two conflicting forces to consider. First, the ongoing deterioration in the residential housing market will continue to weigh on the mortgage market. Recent housing market data point to further inventory accumulation, while price indicators suggest the deceleration in house prices has gained more traction recently. The Case-Shiller 10- and 20-city composite indexes have declined sharply in April (7?% on annualized basis). The resulting decline in housing equity, along with the recent widening of mortgage rates and tightening of contractual mortgage conditions are all likely to keep credit investors on high alert.

On the bright side, corporate fundamentals remain fairly robust. Corporate default fundamentals are in good health, and from a macro perspective, corporate earnings are still supported by broadly favourable global demand conditions. While measures of industrial activity (including our Global Leading Indicator) have been somewhat softer than expected recently, from a level perspective the global manufacturing cycle remains comparatively strong, and a more broad-based weakness in the data is needed to shift this perception. Today's US ISM and the upcoming US payroll data are highly important in this respect.

That ISM report was, of course, a good one, although today's news on pending home sales failed to break the string of lousy housing data and factory orders for May were primarily lauded for being less bad than expected.  But put it together and the consensus seems to be that it all adds up to the Goldman Sachs story.  That's what came through in yesterday's round-up of forecasts from the Wall Street Journal, and the story that we're sticking to appeared again today in Bloomberg's coverage of the housing sales and orders reports:

Economists and the Federal Reserve predict growth will accelerate from its first quarter pace, the weakest since 2002, even as housing remains a burden. Fed Chairman Ben S. Bernanke said last month there was no sign of "major spillovers'' from the housing slide. Industry reports for June show manufacturers are raising production as businesses spend on investment.

"The second half is coming together almost perfectly according to the Fed's plan,'' said Mark Vitner, senior economist at Wachovia Corp. in Charlotte, North Carolina. "Housing is going to be a drag but if we get some strength in business spending then the economy will be able to handle it.''

Though some of the forecasters in that Wall Street Journal survey -- about 20 percent --- put inflationary risks at the top of their wish-not list, GS's Vaknin wants to ease their minds:

As global activity continues to grow at an above-trend rate and commodity prices remain elevated, a re-acceleration in consumer price inflation, particularly in the major markets, remains a clear risk to the outlook for financial asset returns. Consider that, on a year-on-year basis, headline inflation in advanced economies has accelerated from 1.7% in Q4:06 to around 2.0% currently, driven largely by higher food and energy prices. Such acceleration comes on the back of extended tightness in production capacity: According to the OECD, the output gap in this group of countries is about to move into a positive territory by year-end after hovering in negative levels since mid-2001.

Despite these seemingly worrying observations, we that think inflation, particularly in the G-7, should accelerate only moderately before stabilizing at benign levels early next year. Granted, elevated food and energy prices may keep headline inflation above core measures for a bit longer. But this should be seen in the context of two important developments: (1) US core inflation is on a genuine deceleration path, and (2) Monetary policy stance remains prudent in other major economies where upside inflation risks are clearly higher.

The "monetary policy stance" is key, and it probably explains why so many commentators are taking their predictions of a policy-rate cut off the table for the time being.