Home Prices Still Falling

In October, home prices continued to slip, and the declines were very widespread. The Case-Schiller Composite 10 City index (C-10) fell 0.93% on a seasonally adjusted basis and is up just 0.20% from a year ago. The broader Composite 20 City index (which includes the cities in the C-10) fell by 0.99% on the month and is down 0.82% from a year ago. In September, the year-over-year gains were 1.52% for the C-10 and 0.55% for the C-20, so it looks like the year-over-year gains are rolling over.

Of the 20 cities, only two, Denver and Washington DC, saw prices rise, and only by 0.31% and 0.06%, respectively. Meanwhile, 18 saw prices fall. Year over year, four metro areas saw gains and 16 suffered losses. In September, there were also 19 down and just one up. Last month there were five areas up and 15 down year over year. It thus looks like a new downtrend in housing prices is under way.

There is a seasonal pattern to home prices, and thus it is better to look at the seasonally-adjusted numbers than the unadjusted numbers. Most of the press makes the mistake of focusing on the unadjusted numbers. From the April 2006 peak of the housing market, the C-10 is down 30.69% while the C-20 is off by 30.52%. The Case Schiller data is the gold standard for housing price information but it comes with a very significant lag. This is September data we are talking about after all, and it is actually a three month moving average, so it still includes data from July and August.

Existing home sales have been weak since the home buyer tax credit expired. The inventory to sales ratio has been extremely high at 9.5 months, although that is down from the June peak of 12.5 months. That is still as we saw during the implosion of housing prices that took place in 2007 or 2008. Housing prices are going to continue to fall in coming months. While the decline will probably not be as severe as the first leg down, it still has the potential to be extremely damaging.

It is hard to find much of a silver lining in the month-to-month data. Only Denver and Washington DC. posted increases, and they were anemic. Only three other cities kept the decline to less than 0.5%: Tampa (down 0.19%), L.A. (down 0.35%) and Charlotte (down 0.41%).

On the other hand there were five cities that posted month-to-month declines of over 1.5%. Atlanta was the hardest hit, plunging 2.13%, followed by Chicago with a 1.80% decline. The Twin Cities fell 1.76%, Phoenix dropped 1.55% and New York fell 1.53%. Those are similar in magnitude to the monthly declines we were seeing three years ago during the first wave of the housing price implosion.

With the exception of Washington DC (up 3.60%), the strongest cities on a year-over-year basis are in California, which was an early poster child for the housing bust. However, even there the year-over-year gains are starting to erode. L.A. is up by 3.32%, followed by San Diego (+2.97%) and San Francisco (+2.21% year over year). In September, San Francisco was up 5.43% year over year, followed by San Diego (+4.94%) and L.A. (+4.32% year over year). DC was in third place with a 4.40% gain. There was no other city with a year-over-year gain. As recently as July, the year-over-year gains in California were 11.06% in SF, 9.26% in SD and 7.5% in L.A.

There were six metropolitan areas where the year-over-year declines were more than 4.0%. Chicago fared the worst with a 6.54% decline, followed by a 6.22% drop in Atlanta. Portland is down 5.16%, and Detroit is off 5.51%. Charlotte, which early on seemed relatively immune from the housing bust, is down 4.20% year over year. Phoenix, showing no sign of rising from the ashes, is down 4.33% year over year. In other words, significant year-over-year declines are happening in just about every corner of the country, and regardless of how steep the early declines in the housing market were.

The homebuyer tax credit was propping up home prices, but prices are resuming their downtrend with that support gone. People had until June 30 to close on their houses, and they had to agree to the transaction by April 30. That pulled sales into those months that might otherwise have happened in July or August. The credit was up to $8,000, so almost nobody would want to close their deal in early July and simply leave that money on the table. The tax credit is a textbook example of a third party subsidizing a transaction. When that happens, both the buyer and the seller will get some of the benefit. The buyer gets his when he files his tax return next year; the seller gets hers in the form of a higher price for the house.

Since the tax credit is now over, that artificial prop to housing prices has been taken away. Sales of existing houses simply collapsed in July after the credit expired, and have remained depressed ever since. The extremely high ratio of homes for sale to the current selling pace is sure to put significant downward pressure on prices. There is still quite a bit of “shadow inventory” out there as well. That is homes where the owner is extremely delinquent in his mortgage payments and unlikely ever to make up the difference but the bank has not yet foreclosed on, or foreclosed houses that have not yet been listed for sale.

The tax credit was not a very effective means of stimulus, but it did help prop up prices, and that is a pretty important accomplishment, even if it proves to be ephemeral. The credit cost the government about $30 billion. A large part of that money went to people who would have bought anyways, but perhaps would have done so in July or August rather than May or June. To the extent it rewarded people for doing what they would have done anyways, it did nothing to stimulate the economy.

Also, turnover of existing houses really does not do a lot to improve the economy. It is the building of new houses that generates economic activity. It is not just about the profits of D.R. Horton (DHI). A used house being sold does not generate more sales of lumber by International Paper (IP) or any of the building products produced by Berkshire Hathaway (BRK.B) or Masco (MAS). It does not put carpenters and roofers to work. New homes do.

While housing prices are important to the economy, the level of turnover in used houses is not. Home equity is, or at least was, the most important store of wealth for the vast majority of families. Houses are generally a very leveraged asset, much more so than stocks. Using your full margin in the stock market still means you are putting 50% down. In housing, putting 20% down is considered conservative, and during the bubble was considered hopelessly old fashioned. As a result, as housing prices declined, wealth declined by a lot more.

For the most part we are not talking vast fortunes here, but rather the sort of wealth that was going to finance the kids’ college educations and a comfortable retirement. With that wealth gone, people have to put away more of their income to rebuild their savings if they still want to be able to send the kids to college or to retire. The decline in housing wealth is a very big reason why retail sales have been so weak. With everyone trying to save, aggregate demand from the private sector is way down. If customers are not going to spend and buy products, employers have no reason to invest to expand capacity. They have no reason to hire more workers.

Also, as housing prices fell, millions of homeowners found themselves owing more on their houses than the houses were worth. That greatly increases the risk of foreclosure. If the house is worth more than the mortgage, the rate of foreclosure should be zero. Regardless of how bad your cash flow situation is, due to job loss, divorce or health problems for example, you would always be better off selling the house and getting something, even if it is less than you paid for the house then letting the bank take it and get nothing. By propping up the price of houses, the tax credit did help slow the increase in the rate of foreclosures. Still, 23% of all houses with mortgages are worth less than the value of the mortgage today. Another 5% or so are worth less than 5% more than the value of the mortgage. If prices start to fall again, those folks well be pushed under water as well.

On the other hand, it is not obvious that propping up the prices of an asset class is really something that the government should be doing. After all it is hurting those who don’t have homes and would like to buy one. Support for housing goes far beyond just the tax credit. The biggest single support is the deductibility of mortgage interest from taxes. Since homeowners are generally wealthier and have higher incomes than those that rent, this is a case of the lower middle class subsidizing the upper middle class. Also, even if they are home owners, people with lower incomes are more likely to take the standard deduction rather than itemize their taxes. The mortgage interest deduction only applies if you itemize.

The real problem, though, is now that the tax credit is over, prices will find their more natural level. Fortunately, relative to the level of incomes and to the level of rents, housing prices are now in line with their long term historical averages, not way above them as they were last year. In other words, houses are fairly priced, not exactly cheap by historical standards, but not way overvalued either. That will probably limit price drops over the next six months to a year to the 5 to 10% range, rather than the 30% decline we saw from the top of the bubble. That however is more than enough of a decline to do some serious damage.

The Case Schiller report was weaker than the consensus expected. The second leg down in housing prices is underway, but fortunately will probably be a much shorter leg than the first one. Still, that is bad news for the economy. Used homes make very good substitutes for new homes, and with a massive glut of used homes on the market, there is little or no reason to build any new ones. Residential investment is normally the main locomotive that pulls the economy out of recessions. It is derailed this time around and there seems to be little the government can do to get it back on track.

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