How Low Will Housing Go?

That question may be the key to the future actions of the Federal Reserve. One estimate of "How Low Will Housing Go?" comes from Jan Hatzius, Chief Economist of Goldman Sachs:

Our working assumption has been that U.S. home prices are about 15% overvalued. This relies on a simple "affordability" measure which essentially adjusts the home price/income ratio by the level of (nominal) mortgage rates. Depending on one's assumption about income growth, the likelihood of overshooting on the downside, and the length of the adjustment process, this suggests cumulative nominal home price declines of 5-15% in the next few years.

However, affordability is becoming an increasingly problematic concept because it ignores changes in credit availability and changes in nonconforming mortgage rates. Hence, it may be better to look at simpler price/income or price/rent ratios to get a sense of house price valuation. These paint a more dire picture.

Even if we assume that the long-term trend for price/income and price/rent is higher now than the average of the 1975-2000 period (because interest rates are likely to stay lower), cumulative nominal price declines of 15%-30% are possible.

That's not so different from what HSBC HomePulse wrote back in January 2006:

We suggest that about half of the U.S. housing market is frothy and that this ‘bubble zone’ may be overvalued by as much as 35-40%, after taking into account low interest rates and tax advantages.

Current valuations imply a large permanent reduction in the risk premium and/or a sizable step up in future capital gains, not all of which, we think, is justified. The ‘bubble zone’ accounts for 50% of US GDP, or over USD, nearly the size of the German, French, and UK economies put together. In other words, it’s big. Therefore, when these housing bubbles begin to deflate, it is likely to have substantial macroeconomic consequences.

What’s troubling is that even a perfect ‘soft landing’ in the form of flat national house prices would be consistent with a 35-40% collapse in existing home sales. The gush of liquidity from mortgage equity withdrawal would dry up, resulting in a growth drag worth over 3% of GDP. If this adjustment can be managed over many years (and hopefully it will), the economy can avoid recession and get away with soft growth.

If the process is squeezed into a shorter time frame instead, then recession is probable, forcing the Fed to once again consider unconventional policy options – a probability that would only rise if the money supply were to decline at the same time the ‘bubble zone’ deflates.

Whenever I hear anyone suggest that these events were totally unforeseeable, I know that person is full of $%#*.

Source:
A Froth-Finding Mission: Detecting US housing bubbles
HSBC Macro US Economics, January 2006
http://neweconomist.blogs.com/new_economist/files/HSBC_frothfindingmission.pdf

Comments

[Malkiel:]

This credit/real estate puzzle seems to consist of several pieces hidden with the bowels of specialized industries that made "foreseeing" the whole something like blind men analyzing the elephant. The first is the extent to which credit standards had been hijacked by a new class of unregulated middlemen, the mortgage brokers, who were apparently working out in the field with their accomplices, the mostly untrained real estate agents, fudging numbers on a massive scale to produce massive fraud. The second is the lack of liquidity to the mortgage securities market, which only bond specialists would have known, but not had any reason to talk about if they weren't also real estate specialists. And another is the problem of what happens when free-range investors rather than banks tied to the Fed become the major buyers of mortgages. Every player trusted the process below them in the pipeline but nobody could see low enough to notice the damage from the mortgage broker termites...

2007 Aug 24 10:58 AM

[Rocktex:]

You are absolutely right from my experience as an agent working during 1989-1997.

Your estimate is somehow too generalized and conservative. Yes, the general trend may see 50 percent off the peak. But in so many distressed special cases, there are a lot opportunity for a patient investor.

I saw how low the housing market went down in Los Angeles around 1995-1997. We had at least 70 percent off the 1989 peak price. In 1995-97, there was a lot of condos, 3+2 with 1000-1200 sqft, asking 60K and selling for 50K. Some were even lower, there were a huge condo complex at the interscetion of San Gabriel Blvd. and I-60 asking only at lower of 30K. Interesting enough, I almost had to beg a buyer to buy them. Nobody wanted to buy. I had some buyers making up so many "stupid" excuses such as Califorinia has earthquake.
My investors and I bought 30 some units averaging around 55K and sold them for 325K in around 2003.
As I know, this mess created by "liar mortages" is even much bigger than that one of S & L crisis or RTC resolution.
We will see how many walk out their "no equity" homes that they purchased with no down payment and how the Fed handles the situation.

2007 Aug 24 12:05 PM

[tmmcnay:]

Affordability does not have the same effect over the whole range of home prices. I don't believe that a an 80,000 home overpriced in today's market to 100,000 is going to suffer the same decline in market value as a 500,000 home overpriced to 700,000.

2007 Aug 24 12:06 PM

[Rocktex:]

When housing is going down, the hardest hit area has been those poor areas. In Los Angeles area, it happen first in places such as El Monte, East LA, Pomona in San Gabriel Valley.
Simply enough, those people has very limited financial resources to deal with their housing difficulty. They gave up first and also interesting enough, nobody wants to get into their shoes because thsoe who can accept living in that area are not in a position to buy, particularily they don't have cool Cash to get the REO properties first and refinance them 3 months later to complete a "no money dow, cash out" play.
Your logics are right, but not to the facts of the situation.

2007 Aug 24 12:35 PM

[yolanda:]

First of all, I would like to say that I have been in the Mortgage industry for 25yrs. When I started in 1984, rates were running 13%. I remember the S & L scandal. What is happening now, is, I'm afraid much worse. I think the main reason, is because of GREED. Greed from the lenders, the Realtors, and also mortgage brokers, and Wall Street. Things are going to get worse before the get better. The worst part is, consumers, that had no part in this, are the scapegoats, and will be hurt the worst. From people losing their homes, to having to pay higher interest rates, to having to put more money down, the consumers will pay. On the other hand, I guess, the brokers, the mtg lenders and Real estate offices that are closing down are also paying. I hope to have a job in the coming months, but it sure doesn't look like it.

2007 Aug 24 01:06 PM

[Austrian Sc...:]

I'm not sure its so bad for the consumers. If he put no money down, is it really his house to lose? He's lost nothing except some credit for some period of time. Higher down payments mean lower prices and lower loan balances, so no problem there either. Credit does add value for most people.

2007 Aug 24 05:16 PM

[Still Renting:]

My brother is a securities broker. He put it this way: If there are four people on a river, three of which have 50% equity in their homes, and one that has no equity, and a flood wipes out all the homes, Which is the best off of the four?

He refinances his real estate as often as possible, but always with FIXED RATE mortgages. He then invests ALL of the extra cash. If real estate gets really bad, he walks away...and keeps the investments.

Yeah, I've over-simplified, but you get the idea.

2007 Aug 27 11:05 AM

[Still Renting:]

Enter your comment hereI live in the Seattle area, one of the few "still rising" markets. Yet, I pay $1625 rent for a home that is valued at $560k. You do the math.

After owning my own home for 18 years, I have now been renting for ten years. Rents have not only NOT gone up, but may have actually gone down. I have moved five times in those ten years and I actually pay less now than I did two years ago. And this house is nicer in every way than the last one.

My wife and I are now looking at maybe purchasing our primary residence but will be waiting AT LEAST 2 years. Unless you are married to the idea of being chained to your residence (home ownership) and are moving from one home to another, this is an INCREDIBLY ludicrous time to enter the ranks of home owners.

2007 Aug 27 11:02 AM