How Far Will House Prices Fall? Implications From the Latest WSJ Survey

About 5 months ago, I posted a figure depicting the impending resets on subprime mortgages, option adjustable rate and Alt-A ARMs. Responding to one comment, another reader made the following observation:

...a fall of 50% in [valuations on residential housing].

Nonsense.

I have to say that a 50% drop struck me as implausible as well. But, I thought I would re-examine this view in light of recent developments, and what the economists surveyed by the WSJ say.

First, consider the OFHEO House Price Index [HPI]. In Figure 1, I plot the historical (purchases-only) index (blue line), the average forecast as implied by the March WSJ survey (red line). I also include the high estimate and low estimates.

Figure 1: OFHEO seasonally adjusted HPI (purchases only) (blue line), mean forecast from WSJ March survey (red line), and "hi" and and "lo" foreasts (teal lines). NBER-defined recession highlighted gray. Sources: OFHEO, WSJ March survey, NBER, and author's calculations.

The two year high estimate is from James F. Smith of Western Carolina University and Parsec Financial Management, while the corresponding low estimate is from Maria Fiorini Ramirez and Joshua Shapiro of MFR, Inc. While the average forecast is for continued price decline, there is a wide dispersion of views. Figures 2 and 3 depict a histogram of percentage changes for 07Q4/08Q4 and 08Q4/09Q4, respectively.

Figure 2: Histogram of forecast 07Q4/08Q4 price changes, in percent. Source: WSJ March survey.

Figure 3: Histogram of forecast 08Q4/09Q4 price changes, in percent. Source: WSJ March survey.

The histograms indicate not only a lot of dispersion, but also considerable skewness in the 08Q4/09Q4 forecasts. These latter forecasts are not distributed Normally, according to the Jarque-Bera test statistic, using a 10% MSL.

In Figure 4, I plot a detail of the OFHEO index, in log terms, normalized to the peak equal to zero in 07Q2. This graph implies that house prices in 09Q4 will be 8.4% lower (in log terms) according to the average forecast. The worst case scenario depicts a 25% decline. For some perspective, the forecast of UCLA's Ed Leamer -- who accurately predicted the 2001 recession -- is also plotted (green line). Despite predicting a less than 45% chance of a recession, his forecasts imply a 17.3% decline in the OFHEO HPI. (Jan Hatzius, who has been prominent in the debate over the impact of bank losses and deleveraging (discussed here), did not provide a forecast.)

Figure 4: Log OFHEO seasonally adjusted HPI (purchases only) (blue line), mean forecast from WSJ March survey (red line), "lo" forecast (teal line), and Ed Leamer/UCLA Anderson School forecast (green line), all normalized to zero in 07Q2. Source: WSJ March survey, and author's calculations.

Now, even the worst-case price decline does not seem that disastrous. But, as has been discussed on a number of occasions, the OFHEO HPI (in this case the purchase-only index) has some characteristics which make interpretation difficult. More importantly, it measures the prices of houses that are financed with conforming loans.

It would be of interest to know what the forecasted decline in the OFHEO index implies for the Case-Shiller index of house prices, which could be construed as being more representative (for debate, see [1], [2], [3]). I'm going to take a particularly naive and a-theoretical approach, and use the linear relationship observed between log differenced prices, viz.:

dcsxr _t = -0.018 + 1.754(dhpi _t) + 0.610(dhpi _t-1) + 0.302(dhpi _t-2) + e _t

Adj. R ² = 0.72, SER = 0.0108, DW = 1.515, smpl = 1991Q4-07Q4.

Bold face coefficients indicate significance at the 10% level, using Newey-West HAC standard errors (lag truncation = 3). csxr is the log Case-Shiller 10-city index, hpi is the OFHEO log HPI (purchases only), and "d" prefix denotes a first differenced term.

The regression is not a perfect one, but CUSUM and CUSUMSQ tests fail to reject the null of no structural breaks. After the first year of residuals, the 1-step ahead and n-step ahead recursive residual tests fail to reject at the 1% MSL.

Using this relationship to project out the implied decline in the Case-Shiller index for the 2008-09 period yields the purple line in Figure 5.

Figure 5: Log OFHEO seasonally adjusted HPI (purchases only) (blue line), mean forecast from WSJ March survey (red line), log Case-Shiller house price index (green line) and implied Case-Shiller 10-city index based upon estimated relationship with OFHEO HPI. Case-Shiller index monthly data converted to quarterly by arithmetic averaging on unlogged data. NBER-defined recession highlighted gray. Sources: OFHEO, S&P, WSJ March survey, NBER, and author's calculations (see text).

The combination of the WSJ mean forecast and the observed correlation over the 1991Q4-07Q4 period leads to an implied 40% log decline in the Case-Shiller price index (34.7% in percentage terms). (If one uses a static-no lag specification, then the implied drop is 34.8% in log terms.)

(By the way, the above results pertain to the 10-city index. The 20-city index is only available from January 2000 onward. Estimating an analogous relationship (in log first differences, using 3 lags), yields an Adj. R² of 0.78. The implied decline from the 2006Q3 peak is 38.3% in log terms. Hence, while the 20-city index runup is less pronounced than the 10-city runup, the decline relative to peak is essentially the same.)

I certainly don't want to assert that house prices will decline by 40% in log terms. What is true is if (1) the mean forecast for the OFHEO HPI is realized, and (2) the historical correlation between the OFHEO and Case-Shiller indices continue to hold, then a 40% decline in 10-city prices is implied.

One corollary of this result is that only a slightly more pessimistic than average forecast implies a 50% decline in house prices as measured by Case-Shiller, relative to peak (the "Lo" estimate implies a 84% log decline).

In the same post I referenced above, I was admonished by one reader, to this effect:

...You must understand that when Menzie serves up one of his Dishes of Doom, the Doomsters dig in, adding their own special spices to the meal.

Never let it be said that I do not take into account readers' views. Hence, in order to present the upside scenario, let me observe that if the "hi" case (which in 07Q4/08Q4 is 2.2 standard deviations above the mean prediction) is realized, then the Case-Shiller 10-city index will be only 9.6% below peak (in log terms), and less than half a percent lower than what it was at 07Q4.

Comments

[nickgogerty]

affordability is what counts. look at average income growth. nickgogerty.typepad.co...

[Malkiel]

Let's see if those Wall Street guys who complain about academics can interpret THEIR graphs with that level of mathematical competence...

[BlueFire]

What he said!

[Growin$$]

Excellent work even if much of it is beyond my statistics study. From context, I judge the most optimistic at the end is the result of readers who say 'here are reasons it can't happen.' Looking purely at homes as a manufactured commodity, one starting with at least 9 months of excess inventory, one whose "marketing forces" face serious liquidity issues in early stages and perhaps more serious interest rate increases throughout and who also face a "saturated market" in many terms, it would be hard to believe that average deterioration would not be at least 35%. Put it another way, the market doesn't need it, there's lots of it around,cheap doesn't matter if monthly payments are driven up by rates,buyers are experiencing economic slowing of some depth and the entire financial bottleneck will not release uniformly leaving eager buyers unable to sell their homes (down payment source now required) or eager sellers anxious to relocate can't find qualified buyers (see above). The greater the granularity of the analysis, the more these mini-bottlenecks exacerbated by cautious tight money look very real. Ergo, 35% might be good news.

[User 171457]

An easier predicter is just draw a gently uptrending line from the beginning where the base and support is which tells me we'll see 4.6 on the chart.

[space_acer]

History has already logged a decline of 25-35% from the peak in 1988 to the bottom in early 90s.

The best rule of tumb would be prices appreciate by rate of inflation. As such a 40-50% decline to get back to long term mean is possible.

From the peak of 700K down to affordable mean price where prices are 2-3x local incomes we can see a 50% decline to $350K.

www.housingbubblebust....

[Stanley]

graphs are nice, but some hard data that points to a 50% drop in some areas, less in others would be:
- rents should be about the same as mortgage payments
- the median income should be able to afford the median priced home (without a crazy loan product)
- CAP rate or ROI on real estate should return to historical levels

[Yoski]

Prices will return to levels where people can afford to buy again. With exotic mortgages gone and wages increasing less than inflation, home prices will return to the long term mean of price/income ratio. Bailouts and other government intervention can stall this process and spread it out over a longer period, the end result will be the same in any case. Personally I would prefer a short but sharp decline rather than spreading it out over a decade or more, see Japan.

[Alec]

A very complicated way of doing something very simple. I am a mortgage lender. The loan programs we have left require full income verification and allow 1/3 of gross monthly earnings to be for housing. So, in a nutshell, take the median household income of any given area times 3 and you get a general idea of where median home prices need to be. They will actually be somewhat less because consumers have overspent in all areas, not just housing. Then consider the oversupply and that every day we have thousands of people who no longer qualify for financing at all because they have a foreclosure. Prices will be cut at least in half. Maybe as much as 2/3.

[MikeLA]

Stanley, rents must be higher than mortgage payments, you apparently have never been a landlord. There is 1. mortgage payment 2. PMI (maybe) 3. insurance 4. real estate taxes 5. HOA (most likely) 6. maintenance 7. profit
So you covered one out of 7. No one in his/her right mind would buy now for investing. Where I live (south OC), prices currently asked would have to come down 65% (YES THIS IS NOT A JOKE) for rent to break even with cost of carrying.
This is why a 'buying a real estate for cash flow' is non existent in Orange County at the moment.
Amazingly enough, this 65% fall is close enough to Income/Price ratio (which is about 55% drop here). I would say prices have to come down about 60% in the OC for market to move again.
I don't know about the rest of the country, I suspect it's not nearly as harsh as it is here.
In my neighborhood, I've seen a nice 2/2 with hardwood throughout, built loft and new everything go for 550K 2 years a go and now it goes for 350K. Still no buyers. I suspect that it will go down to under 200K before it moves.
Even some people who I consider 'crazy spenders' (and who accidentally are getting married now, so they are in 'emotional spending spree with optimistic outlook' kind of mood), have canceled their home purchases. In both cases, because they have no money for a meager 5-10% downpayment.
Not a scientific approach I know, but I know that I have the cash to buy but I think I would have to high on something to buy now. I would lose good chunk of it.

[cfish]

Agreed. Prices in Bay Area definitely need to fall more than half to make renting anywhere close to mortgage. Inflation is just about the only humane way to do it - sort of like killing a frog by slowing turning the heat up.

[filmrisk]

Housing prices will fall until they reach the price where most homebuyers can comfortably afford the down payment (remember those? they're baaack) and the monthly payments and can readily obtain the mortgage on those terms. Basically, the point where the average mortgage payment is 30% or less than median income in each area. By my calculations, that means at least another 15 to 50% drop in prices depending on the region of the country (southern Cal is in the 50% drop range, for example). Of course, you will also have to factor in the massive drying up of available funding for mortgages as no sane investor will ever again buy mortgages they way they did. And when lenders have to use their money (deposits or other internal capital, they certainly won't lend it out at 4, 5 6 or even 7%. Once risk premiums return to mortgages and other investments, you will see significant interest rates, Fed and other market manipulations be damned.

No chance of a bottom in the RE market for at least another two years, as stupid political posturing and grandstanding - such as Fannie and Freddie buying billions of bad mortgages, government sponsored guarantees on $720k mortgages, etc. prolongs the agonizing slide into the abyss.

If you are sitting on piles of cash and oil income, be patient. When we buy good assets to pennies to 40 cents on the dollar, wealth grows...

[filmrisk]

typo - meant to say ...payment is 30% or less of median income...

[Ming]

I have a question and some comment/questions :

1. The question : Given all reader's comments, in particular Alec's, are median home prices some function of 5 times of 1/3rd disposable monthly income currently?

2. The comment (with some questions too). This pertains to the equation. (It is only noted the Menzie's equation "predicts" how Case Shiller will move in relation to OFHEO data. The equation does not itself predict how house prices will move. Alec, please note : You and Menzie are not talking about exactly the same thing, hence your's and Menzie's methodologies are not substitutes for each other, even tho both methods apparently end up upon the same figure of around 40-50% )

(a) perhaps you could remove the negative intercept, which is although statistically significant @10% level, has a strange interpretation, namely that changes in case shiller are negative for 0 changes in OFHEO data.

A side effect of this is to bring up the estimates for Case Shiller.

b. With reference to the histograms, are expectations too *positive*? How accurate have these expectations proven to be?


c. Have the equation coefficients proven robust? What is the range of coefficients on a say 5 year (20 Q-s) rolling basis?

[Shiloh]

I thought fundamentally, home price is supposed to be 3x income. When it goes higher, other discretionary spending goes down. Then there are helocs..to finance other consumption --those are going to dry up after this credit mess. So either we have to return to fundamental ratios or one or another sector is not going to get paid. The middle class...is the backbone of capitalism, tax revenue, etc.

San Diego is having a price collapse in middle and low income neighborhoods and there is no major industry there to prop up prices -- where are all the 100K jobs? SD is overbuilt and there are plenty of bank-owned properties sitting, whilst they sit and deteriorate.

Common sense would indicate that prices have much further to fall.
But the historical graphs could indicate that the drop will continue through 2011 --stay flat for an additional 4 years.
It is possible from graphs that prices could fall back to 1998.

Keeping in mind that <b>wages</b&g... relative to prices have been stagnant. Now - we are in a so-called "deepening recession."

I think it all adds up to a major market correction and neighborhood blight.