Home Price Declines: How Much Further Do We Have to Go?

By Dirk van Dijk

The best measure of housing prices -- the Case Schiller index -- was released yesterday, and it shows no let up in the pace of housing depreciation. The ten-city composite (C-10), which dates back to the start of 1987, peaked out in April of 2006 on a seasonally adjusted basis at 226.14, and is now down to 152.81. The 20-city composite (C-20) which only goes back to January 2000, peaked in May 2006 at 206.13 and is now down to 141.35. Thus, the C-10 index is 32.4% off its peak while the C-20 is down 31.4%, not a big difference.

One reason that the Case Schiller index is of interest is that it is one of the key factors in the bank stress tests (although on the not-seasonally-adjusted basis). Home prices are continuing to track much closer to the "more adverse" scenario than the baseline scenario (unadjusted actual of 151.41 vs. baseline of 154.42 and "adverse" of 149.96).

The good news is that it is not tracking below the more adverse, so if the banks can raise enough capital to handle the more adverse scenario (and so far they have made significant progress in doing so, even though it will result in very significant dilution to the initial shareholders) they should be able to make it through this downturn -- although not with a lot of room to spare.

The other two key factors in the stress tests were GDP growth and Unemployment. First quarter GDP was in line with the more adverse scenario, and unemployment appears to be tracking below the more adverse scenario.

Relative to a year ago, the C-10 index is off 18.6% while the C-20 is off 18.7%. For the month, prices were down 2.0% and 2.2%, respectively. Prices fell in all 20 cities in March, although the declines were very small (less than 0.3%) in Dallas, Charlotte and Denver. Interestingly, those are the cities that have declined the least since the peak, as shown in the first graph below (from here). Note that the graph shows the declines since the C-10 peaked out -- the numbers that follow are based on the individual city peaks, seasonally adjusted. The housing markets that have already been battered took it on the chin again in March.

Six cities saw prices decline by more than 3.0% in March alone. Phoenix was down 4.4% on the month to bring its total decline from its peak to 52.4%. It certainly has ashes to rise from. Las Vegas crapped out again, falling 3.7% on the month to bring its cumulative total decline to 49.9%. Miami was off 3.2% for the month bringing its cumulative decline to 46.9%. Thus the three cities that have fallen the most from their peaks are still getting hit hard, while those that have been relatively unscathed so far continue to avoid the brunt of the declines. The three other cities that fell the most in March were Minneapolis (-5.4%), Detroit (-4.6%) and Chicago (-3.0).



The massive declines we have seen nationwide raise the question of how much further we have to go. The declines in even the strongest cities are comparable in scope to what generally has happened historically in sharp regional declines -- for example the peak-to-trough decline in San Diego in the early 1990's was 16.7%. The declines in the weaker cities are probably comparable to the worst seen in the Great Depression.

The two best metrics for judging if houses are cheap or expensive are the ratios of price to income and price to rent. Anyone who claimed that they could not see a bubble forming in housing (I'm looking at you, Mr. Greenspan) was clearly not paying attention to these metrics.

The first graph below (both are from here) is set so that the level in the first quarter of 1987 is equal to 1.0, not the actual ratios, but they trace the movement of the ratios. They are based on the national numbers, but to be really relevant for someone looking to buy a home, numbers based on the local area would be much more relevant.

On a housing-price-to-median-income basis, we are almost back to the 1.0 level of early 1987, and within the 0.92 to 1.08 range that prevailed from then until 2001. This is very much a hopeful sign that the decline could soon come to an end, or at least that over the long term, a buyer could feel fairly confident that he was getting a decent price. On the other hand, we still have lots of excess inventory, most of which is distressed. This means it is likely that housing prices will undershoot what will prove to be the long-term equilibrium.



The price-to-rent history tells much the same story as the price to income graph. Note that the 1.0 level in this graph is set at 1997, not 1987. The pattern though is almost identical, ranging between 1.0 and 1.2 until 2001 and then soaring to absurd heights only to come crashing back.

We are right in the middle of that "fair value" range at 1.1. However, rents have started to fall at the major Apartment REITS such as Equity Residential (EQR), Mid-America Apartments (MAA) and Apartment Investors (AIV) and that usually presages declines in the rent component of the Consumer Price index (one more reason to be more worried right now about deflation than inflation, but longer-term inflation will be the bigger threat).

This also suggests that there are still more price declines to come, but that the worst of it is now behind us. While much depends on what city you are in, housing prices are now reasonable, but not exactly cheap. We will probably undershoot "fair value," so if you can hold off buying a new house for a few more months, your patience is likely to be rewarded. On the other hand, if you are planning on staying in the house for the next 20 years, it will not make that much difference at this point (unlike the past few years).

Comments

[Tricky:]

Thanks. Most of the articles today and yesterday on the recent housing data had been mere copy pastes of the Case Schiller graphs. I'm glad to see someone looked at where we stand on some of the key metrics of "are we priced right yet". The two you focused on are the two I watch the most (price to income, price to rent), which is why I thought we still had more room to fall.

Now that, on the surface, we seem to be getting there, it is certainly appropriate to revisit what is happening to income and rents. With the economy still not steady, there is probably a bit of room on the downside. Also, mortgages are harder to get? But rates are low. So on a net basis, I'm guessing we still have a little bit more down to go, so I wouldn't be a buyer just yet.

May 27 08:28 AM

[nathanredondo:]

I'm skeptical of those price to median income graphs- they can be misleading since they appear to look at the median at a national level rather than in the regions which are ground zero for the housing crisis. It is important to realize that in the higher end of the market (500K+), sales volume is next to zero.

If you look at housing prices in the hyperinflated counties of California, such as Los Angeles, San Francisco, Sacramento, Riverside, Orange San Diego and Santa Barbara counties, you would find that the more affluent areas (such as West Los Angeles or Russian Hill in San Francisco) are still hyperinflated due to price stickiness and delusional owners. In my neighborhood (90277, South Redondo Beach), we still are seeing sh&^ty 2 BR condos that are 40 years old in buildings that are falling apart holding out for 700K-1MM price tags.

Similarly, larger 3k sq ft newer townhomes are still trying to sell at 1.6-3MM (despite in one case a default on the construction loan). This generally results in a lot of lonely realtors sitting around on weekends, with the occasional client coming in to laugh at or taunt them. Many of these properties have been marked down multiple times already and have been on the market for two years or more. They will not move until the sellee's put down the crack pipe and face market reality- when this happens, due to either capitulation or financial necessity caused by the owners finally defaulting, it will not be pretty.

These prices are obviously out of equilibrium, so I see at least another 25-40% drop in prices before they are in line with median income-- with typical prices for the aforementioned properties coming in @ 350-450K and 900K-1.2MM respectively (which is more in line to 100-150K in the more affluent neighborhoods). Rising interest rates (4.69% to 4.81% this week alone) will only make this more painful.

The other shoe is yet to drop on pricing in more affluent areas- volume is next to zero because of delusional pricing- so far this has hidden the true magnitude of the bursting. Until it does, the market will continue to fall, only this time it will be the luxury properties, not the subprime ones, leading it.

May 27 11:47 AM

[Mad Hedge F...:]

More than people think. Anyone who thinks that we have hit bottom in real estate should start smoking something else. The S&P Case-Shiller National Home Price Index fell 19.1% in Q1, the sharpest drop in history. Charlotte, NC did best, rising 0.3% while Detroit, where prices have fallen to 1995 levels, did the worst at -4.9%. San Francisco came in at -2.2%. Most disturbing is that the disease is metastasizing from the West coast and the Sunbelt to infect the entire nation. Home prices are now back to the 2000 level, meaning that we have given back the century to date. Foreclosures are accounting for up to 70% in some local markets, and while they are boosting sales volumes, they are also accelerating the downward march in prices. Today’s data shows that the downward spiral is continuing, so most Americans are probably looking at another $100,000-$200,000 fall in home values. Not exactly a springboard for an economic recovery.

May 27 12:00 PM

[Jasper M:]

"This also suggests that there are still more price declines to come, but that the worst of it is now behind us."

Well, that's certainly true in Phoenix: If you are down >50%, by definition, the worst is behind you. SO comforting . . .

May 27 12:27 PM

[Fighting Yoda:]

Read Peter Schiff’s article from a few days ago: Housing's Big Picture Isn't Pretty
seekingalpha.com/artic...

“…Given that we are entering uncharted territory with price declines much sharper than those seen in the Great Depression, I would argue that the 100-year price trend would be the better projection to use. In such a scenario, the index would bottom out at around 108 if a 10% overshoot on the downside is seen. That leaves another 34% decline in home prices on the table…”

May 27 01:57 PM

[Donald Ingram:]

Agreed. The only fly in the ointment being how much inflation will impact prices going forward.


On May 27 01:57 PM Fighting Yoda wrote:

> Read Peter Schiff’s article from a few days ago: Housing's Big Picture
> Isn't Pretty
> seekingalpha.com/artic...
>
>
> “…Given that we are entering uncharted territory with price declines
> much sharper than those seen in the Great Depression, I would argue
> that the 100-year price trend would be the better projection to use.
> In such a scenario, the index would bottom out at around 108 if a
> 10% overshoot on the downside is seen. That leaves another 34% decline
> in home prices on the table…”

May 27 02:29 PM

[mr. mann:]

Dirk,
Kudos. Solid logic Well written.

I would like to get your take on where a logic bottom may occur if these assumptions are incorporated:
1) Inflation adjusted income decrease some percent (your estimate) over the next couple years,
2) Rents decrease some percent (your estimate) over the next couple years, and
3) Lack of buying confidence cause an over-shoot in the long-run ratios mentioned above.

Also, you make the assertion that: "The two best metrics for judging if houses are cheap or expensive are the ratios of price to income and price to rent."

This assertion doesn't seem to recognize the impact of interest rates. Is that correct? Can you add some elaboration to your assertion?

Thanks,
Mr. Mann

May 27 02:34 PM

[dcb:]

Are There Limits to Bank Arrogance?

* Dirk van Dijk, CFA
* On Wednesday May 27, 2009, 3:35 pm EDT

*
Buzz up!
* Print

Related:

* Bank of America Corporation
* , Citigroup, Inc.
* , JPMorgan Chase & Co.

Highlights include JP Morgan Chase & Co. (NYSE: JPM - News), Citigroup Inc. (NYSE: C - News) and Bank of America Corp. (NYSE: BAC - News).
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{"s" : "bac,c,jpm","k" : "c10,l10,p20,t10","o" : "","j" : ""}

Apparently there is no limit to the arrogance and sense of entitlement at the nation's largest banks. From today's Wall Street Journal we get this:

'Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves. Banking trade groups are lobbying the Federal Deposit Insurance Corp. (FDIC) for permission to bid on the same assets that the banks would put up for sale as part of the government's Public Private Investment Program (PPIP). PPIP was hatched by the Obama Administration as a way for banks to sell hard-to-value loans and securities to private investors, who would get financial aid as an enticement to help them unclog bank balance sheets.'

Let's recap a bit. Banks make a ton of bad loans and come to the brink of insolvency. The government has to guarantee their debt and injects billions and billions of dollars to shore up their capital base on extremely generous terms. Then the banks all whine and complain that the government might want some say about how much of that capital goes out the back door in the form of mega-sized bonuses to the very same people who lead the world to the edge of the economic abyss.

The ever-powerful Bank Lobby leans on Congress so that it will lean on the Financial Accounting Standards Board (FASB) to substantially ease the mark-to-market accounting rules, so they do not have to reflect the market value of the toxic assets on the balance sheet. The claim was that the bids in the market did not represent 'true value,' but were a fire-sale price.

It is true that there was not a lot of activity going on in the mortgage-backed securities market, especially the non-GSE backed paper that was created by the investment banks that held the worst loans. In an attempt to revive this market, Treasury Secretary Geithner came up with the PPIP program, where the government would invest side-by-side with private investors to buy up this bad paper.

Then, another arm of the government -- the FDIC -- would guarantee loans so the private/public investment partnership could leverage things way up. If the deal goes south, the private investor can then simply walk away from the deal.

The underlying assumption was that the reason there was no market for this stuff was that there were no buyers -- not that the sellers could not afford to sell at the 'true value' of the assets. The latter is far more likely to be the case. They have the real motive to try to pretend that the assets are worth more than they actually are.

Buyers, on the other hand, would be inclined to bid against each other until a rational price level was found. In any case, the idea was to get this paper off the books of the banks.

Now the banks want to be able to buy the stuff themselves, with the government (FDIC) backing. This is insane. Any bank that is selling this stuff should be absolutely prohibited from buying it -- not only the assets on their own books, but from any other institution as well. A shell game where J.P. Morgan (NYSE: JPM - News) buys the toxic assets from Citigroup (NYSE: C - News), which then buys the assets of Bank of America (NYSE: BAC - News), which in turn buys the assets of J.P. Morgan is not significantly different from the banks buying their own bad paper.

The PPIP program, if properly carried out, does have some advantages over the original ex-Secretary Paulson 'Cash for Trash' plan that was at the heart of TARP when it was first passed. On any individual deal, if the private investor makes money, then the government will also make money. However, given the leverage and the non-recourse nature of the debt, the private side will make out like a bandit and the government will make a modest return.

On an individual deal that goes south, the private side will lose what they put in, but that is a small fraction of the total loss, so the government will get kicked in the teeth. This structure does give an incentive to the private investor (who will make the investment decisions) to bid as low as possible on each asset to maximize their potential return. If the banks are allowed to bid on their own assets, or engage in wash-sale transactions with other banks, then there is no such incentive. Indeed the incentive is for them to overpay as much as possible. They get the cash up front from selling the asset, and then when the paper goes bad, the government takes most of the loss.

Incidentally, if the government were to truly follow the rule of law, they are required to fight this idea. The money for the public side of the public private partnership comes from the TARP program. The authorizing legislation for the TARP states:

(e) Preventing unjust enrichment. In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. 12 USCS § 5211(e).

This would seem to be a clear-cut case of unjust enrichment that Congress was trying to prevent when it put this language into the law. I know that the rule of law has become 'quaint' when it comes to the bailing out of the banks, but there has to be a limit somewhere. After all, if the banks participated in kidnapping for ransom, would we allow that to happen simply because the proceeds would help out their balance sheets?

FDIC Chair Shelia Bair needs to tell the bank lobbyists a resounding NO to this proposal, if not call security and have them thrown out of her office for being so arrogant as to suggest such a thing. Adding to the amount of toxic sludge on the balance sheet is not the way to unclog the balance sheets of the banks.

If the banks get their way, it will turn the potentially promising PPIP program into yet another rape of the American taxpayer by the banks. Enough with the Welfare Queens of Wall Street. It is time for someone in Washington to stand up against the bankers. That would be change we could believe in.

Zacks Investment Research
'

May 27 05:13 PM