With the ongoing credit crisis, many policymakers continually state that the crisis will not be resolved until the housing market improves.  While this certainly includes an improvement in home sales, another aspect is house prices. The decline in house prices in a number of local real estate markets has undermined the economy in a number of key ways.  Just this week, in testimony before Congress, Fed Chairman Ben Bernanke called attention to this issue.

"The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy.  In the financial sphere, falling home prices and rising mortgage delinquencies have led to major losses at many financial institutions, losses only partially replaced by the raising of new capital."

Why do we care about home prices in general and what are key measures telling us?

Key impact of house prices on the economy

Home prices affect the economy much more broadly than suggested by the Fed chairman’s narrow focus.

• A home purchase is an important contribution to wealth accumulation in the U.S.  Generally, house price appreciation eventually leads to large capital gains for the homeowner when a house is eventually sold.

• Rising home prices boost the consumer sector through homeowners’ access to home equity lines of credit (HELOC) accounts.

• Rising home prices lift the construction industry.  Homebuilders accelerate construction when home prices are rising – there is more profit.

• Rising home prices add to income in the local economy as real estate brokers make more sales.  New construction adds to the incomes of construction workers and craftsmen such as cabinet makers and landscapers.

• Other industries are boosted by rising home prices.  As real estate sales and new construction increase, sales and production rise for home appliances and construction materials.

If home prices are declining, all of the above positives become negatives for economic growth.  The reversal of these effects is why the U.S. economy is sluggish and why a housing recovery is needed before growth returns to trend.

However, recent trends in mortgage lending and in home prices have been heavily responsible for the current credit crisis. 

But what about the effects on mortgage financing?

During the early and mid-part of this decade, there was an increased effort to boost home ownership in the modest income segment.  Without getting into the complex and value-laden issue of whether such was appropriate or not, some key facts about sub-prime lending appear to be well established.  First, many of the sub-prime loans had little or no down payment.  Many loans had adjustable rate mortgages with low teaser rates to help modest income borrowers qualify. 

Lenders and borrowers operated on the assumption (whether fully understood or not is another issue), that when the initial teaser rate eventually reached the date for conversion to a higher fixed rate, that the homeowner would have experienced enough appreciation to refinance the loan at a lower rate.  An important caveat apparently not understood by some was that if the homeowner did not have appreciation (resulting in homeowner equity), the homeowner would not qualify for refinancing.  And, certainly, if the home value had fallen, the homeowner could not get refinancing.

By 2006, the housing market began to slow and was in full recession by 2007 and remained so in 2008 thus far.  House prices actually declined in some local markets and stagnated in most other markets.  As a result, many subprime borrowers actually had negative equity in their home.  That is, the amount owed on the mortgage was greater than the market value of the house.  For many subprime borrowers, with no or negative equity, when the teaser rate expired and the new mortgage rate was not refinanced, this left the mortgage payment unaffordable.  For these subprime borrowers, the economically rational choice was to walk away, leaving the house in foreclosure.

• The near-term bottom line for homeowners is that the house price affects the homeowner’s ability to refinance.

Effects on broader credit markets

The broader credit markets have been severely affected by the decline in house prices, largely due to recent “innovations” in mortgage finance.

In years past, many lenders originated mortgages to retain them on their own balance sheets and for their own income.  But the recent trend has been for most mortgage originators to resell bundles of mortgages to others for their own investment.  These originators did not have the same incentives for maintaining mortgage quality as did originators retaining their own originations.  Most of the mortgages were bundled and purchased for Fannie Mae and Freddie Mac who then would sell these bundled securities with various maturities.  In the past, Moody’s has rated these mortgage backed securities with the highest investment grade and many financial institutions bought these MBSs for what was believed to be safe and healthy returns.  Many purchasers are overseas, including sovereign wealth funds.  A number of mutual funds are also holders.

When house prices declined, the value of these MBSs unexpectedly fell as many subprime borrowers were unable to refinance and then became delinquent at higher interest rates. Because of how they were bundled, it became difficult to determine the value of these assets and institutions were unwilling to buy these assets. But some firms were able to determine that losses were so great they were insolvent or in need of massive amounts of new capital.  That was the case for Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and Merrill Lynch, among others.  This is the basic story behind how the decline in house prices led to much of the gridlock in credit markets.

• The bottom line for the broad credit market is that the drop in house prices led to borrowers’ inability to refinance, increased delinquencies and foreclosures.  In turn, this resulted in a decline in value for MBSs, a huge increase in uncertainty over their value, and an unwillingness of sound lenders to take those assets as collateral.

What are the traditional, house price measures?

For many years, and even currently, the house price measures that most market watchers read about come from monthly economic reports on new home sales and on existing home sales.  The new home sales report is produced by the Census Bureau and the Department of Housing and Urban Development while the existing home sales report is produced by the National Association of Realtors.

The surveys used for the new and for the existing homes sales reports do not have the same sample each month and this plays some role in affecting price trends.  Typically (not always), when the economy is weak, the share of low end homes sold falls faster than for the high end.  This tends to add to sales prices even though sales are weakening overall. Both reports include average and median sales price. The median price is less volatile than the average price but still suffers from being impacted by shifts in sales between low and high end houses.  There is no direct comparison of prices for the same house being purchased and then resold later.

Newer house price indexes

But many economists complain that those home price series are not an accurate reflection of how home prices really change.  That is, the prices for existing home sales in the National Association of Realtor report and in the Census report for new home are affected by the share of sales according to price range.  What are better alternatives?

The Case-Shiller  and OFHEO house price indexes

Due to the depressed housing sector and the credit market woes tied to house prices, the Case-Shiller house price index has recently attracted market attention.  Named for its developers, this monthly index is a measure of resale price changes for existing single-family homes that compares changes for same houses. This repeat sales methodology captures the true appreciated value of each specific home sold. The Case-Shiller home price index report is a joint product of Standard & Poor’s and Fiserv, Inc. Within the report are 10-city and 20-city composites as well as data for each component city.  The baseline for this index is January 200 = 100.

The OFHEO (Office of Federal Housing Enterprise Oversight) House Price Index (HPI) is another series that has garnered market attention.  This index covers single-family housing, using data provided by Fannie Mae and Freddie Mac.  The House Price Index is derived from transactions involving conforming conventional mortgages purchased or securitized by Fannie Mae or Freddie Mac.  In contrast to other house price indexes, the sample is limited by the ceiling amount for conforming loans purchased by these GSEs.  The loan limit in 2007 was $417,000.  The limit was raised temporarily in February 2008 to as much as $729,750 in high cost areas of the country.  Mortgages insured by the FHA, VA, or other federal entities are excluded because they are not “conventional” loans.

The OFHEO HPI is a repeat transactions measure.  It compares prices or appraised values for same houses.  In contrast to the Case-Shiller index, the OFHEO HPI treats appraisals for refinancing as a transaction for the index.  Hence, the OFHEO HIP is not a pure sales price index.  But this index is a broad measure of house prices and also provides “stress test” information on the capital adequacy of Fannie Mae and Freddie Mac.

What are the house price indexes telling us?

By all of the measures, house prices have fallen notably over the past year.  Many economists believe the Case-Shiller price index is the most accurate in terms of determining changes in house value since it uses a true, resale methodology.   This index shows the sharpest year-ago decline and helps to explain why many financial firms holding mortgage backed securities have ended up with losses from nonperforming mortgages.

*Case-Shiller is for June 2008.

The story varies quite a bit regionally and the outcomes are similar for the various indexes.  The below chart compares existing home prices, median, by region.

The greatest house price declines generally have been in the West Census region.  Of course, that region had experienced some of the strongest price increases.

Separately, the Case-Shiller report has some of the sharpest year-ago decreases in: Las Vegas, -28.6%; Miami, -28.3%; Phoenix, -27.9%; Los Angeles, -25.3%; San Diego, -24.2%; and San Francisco, -23.7%, among others. These numbers are even more compelling in helping to explain many homeowners’ inability to refinance.

The bottom line

House prices have weakened substantially across the U.S. – falling sharply in some areas.  Declines in house prices have undermined the value of many mortgage backed securities and have played a role in causing credit markets to become illiquid, including for mortgage financing. Improvement in house prices is needed to stabilize credit markets and to boost consumer confidence.  Strengthening in the overall economy will be tracking improvement in house prices.