Residential Housing Market: Mean Reversion Will Take Some Time

Includes: IYR, SPY
by: Mike Mezzadri

The following is an abstract from a Journal of Housing Economics paper:

House prices often exhibit serial correlation and mean reversion. Using two large panel datasets, this paper analyzes the price dynamics in two significantly different types of markets, cyclical (or volatile) and non-cyclical (or tame), by applying an autoregressive mean reversion (ARMR) model. Our results show that cyclical markets have larger AR coefficients than non-cyclical markets. As a result, house prices in cyclical markets tend to have larger price cycles. We also find that the upward periods have larger AR coefficients than the downward periods. This demonstrates that house prices are likely to overshoot the equilibrium in appreciating markets while experiencing downward rigidity during periods of decline.

It is my contention that housing prices will ultimately revert to more "normal" level but that there will not be time-symmetry, meaning that when we look back at this event in the future, the time it took for housing prices to rise will be shorter than the reversion process. This is just a speculation, but I think that economic policy, which attempts to reinflate deflating bubbles, while leaving the upside uncapped has something to do with this - the upside inflation inevitably occurs quicker than the downside reversion which is micro-managed. This ties into the greater contemporary theme of socializing losses and privatizing gains.

As to whether mean-reversion will take place, I think the only reason it wouldn't is if a "new normal" in prices is established. In an attempt to keep the consumer in the game, it's my belief that policy coming out of DC will attempt to artificially buoy housing prices. However, the evidence as to whether this will work is dubious, if it works at all. It's certainly not a long-term solution - that would be to allow deflation in asset prices to take place so that a real recovery can be established from equilibrium. (I'm not going to pretend I know what equilibrium is or should be, but I am positive it's not what current median housing prices are.) This administration will fight to prevent further home price deflation from happening, regardless of the long-term consequences.

Looking at the following chart, and assuming mean-reversion will take place, can't we say that mean housing prices will still fall significantly more? Just from eyeballing the chart, settling in between $100,000 - $120,000 on the index scale would seem to be "normal" (unless there is some sort of "new normal" forming) leaving a lot of downside room from our current range.

Our current situation looks a bit like this, with USA median prices fallling within the $165,000 - $185,000 range.

Taken together, it appears that median home prices would have to fall approximately another $65,000 in order to revert back to the "normal" range.

What sort of effects will come out of reversion, if it takes place? From Atif Mian and Amir Sufi of the University of Chicago Booth School of Business:

...from 2002 to 2006, homeowners borrowed $0.25 to $0.30 for every $1 increase in their home equity. Our microeconomic estimates suggest a large macroeconomic impact: withdrawals of home equity by households accounted for 2.3% of GDP each year from 2002 to 2006...

...Our results demonstrate that homeowners in high house price areas borrowed heavily against the rise in home equity from 2002 to 2006. We also provide evidence that real outlays were a likely use of borrowed funds. Money withdrawn from home equity was not used to buy new homes, buy investment properties, or invest in financial assets. In fact, homeowners did not even use home equity withdrawals to pay down expensive credit card debt! These facts suggest that consumption and home improvement were the most likely use of borrowed funds, which is consistent with Federal Reserve survey evidence suggesting home equity extraction is used for real outlays... should come as no surprise that these same homeowners have been the most likely to default on mortgage payments during the bust. The numbers are staggering. Homeowners with low credit scores in areas with high house price growth from 2002 to 2006 have seen mortgage default rates climb from 4% to almost 15% from 2006 to 2008. This increase is more than double the increase in defaults by low credit score homeowners living in steady house price growth cities...

..Our analysis of the microeconomic data has led us to the conclusion that the severity of this economic downturn is rooted in the household leverage crisis, which in turn is closely related to the housing market. If the housing market continues to deteriorate, then further de-leveraging of the household sector will likely keep a lid on any rebound in consumption. In other words, the future of consumption and house prices are closely linked.

Deutsche Bank says that:

  • $6 trillion in home equity has vanished already.
  • 25 million homeowners, or 48% of all mortgages, will eventually wind up being underwater.
  • "an absolute floor" of 7% (using a previous Fed study) of underwater borrowers will go on to default on their mortgages in the next three years.
  • Two-thirds of Alt-A and Subprime loans and almost 90% of Option ARM loans will be underwater in 2011.

The already-foreclosed-upon houses represent 9% of current underwater borrowers, showing that their estimates using the floor of 7% are probably too conservative. Financial Times says that 1.265 million homes were lost to foreclosure in '07 and '08, and using the most conservative figure given by Deutsche Bank, 1.75 million defaults will occur in total, meaning that a large majority have already happened (using the 7% assumption). The most conservative case seems unlikely to occur though, given that the already-foreclosed-upon houses represent 9% of current underwater borrowers.

7% seems like an accurate floor, but what is the ceiling? Other important variables are the assumptions that "48% of all mortgages, will eventually wind up being underwater" and that "about two-thirds of Alt-A and Subprime loans and almost 90% of Option ARM loans will be underwater in 2011." How accurate are these assumptions?

When looking at these assumptions, I am wondering whether firms are factoring in the possibility of persistently high unemployment rates (~10%) into their analyses, and what type of effect, in general, unemployment has on default rates.