How Much More Will Housing Prices Decline?

by Dirk van Dijk

Passing on a bit of wisdom from Dirk is a pleasure.

On Thursday, the National Association of Realtors announced that the median price of an existing home declined 12.4% in 2008 and now stands at $180,100 -- its lowest level since the second quarter of 2003. Median home prices are not the best measure of housing prices, since they can be skewed by changes in the mix of houses being sold. That appears to be happening with this data.

Low-end houses are selling better than high-end houses. This is because an increasing proportion of sales are of "distressed" houses, that is, either homes that have been foreclosed on or short sales where the owner is trying to sell for less than the value of the mortgage, with the bank forgiving the difference. These sales increased to 45% of all sales in the 4th quarter from 38% in the 3rd quarter.

A better measure of housing prices are repeat sales indexed, like the Case Shiller index. The 4th quarter data on that index will be out later in the month. Any way you measure it though, housing prices are down significantly from the peaks, including all the economic consequences of that fact.

It raises the question of how much lower will housing prices go? The nominal price of houses is not a very good gauge. A house is an asset, and as such its value is determined by the value of future cash flows. What are the cash flows you get from a house you own? It is not like you get a stream of checks in the mail each month just because you are a homeowner. The point is that you don’t have to write out checks each month to rent an equivalent house.

With this in mind, it is a good idea to look at previous housing bubbles and what happened. Since we don’t have that much recent experience with housing bubbles in the US (other than the current one), let's take a look at Sweden, which had a big bubble in the late 1980’s that burst in 1991, causing a financial meltdown. The graph below (bigger version available here) shows that home prices did not return to pre-bubble levels after they popped. However, the ratio of home-prices-to-rents did.

This is just what one would expect if one looks at housing as an asset, just the way if a stock gets pushed up to irrationally exuberant levels, it is best to look for it to return to its historic P/E levels, not to its original price level.

So what does this indicate for the US today? The second graph, also from Calculated Risk, shows the price-to-rent ratio here based on the Case Schiller index, and the owners’ equivalent rent component of the Consumer Price index. This is only through the 3rd quarter, and clearly the ratio came down further in the 4th quarter -- possibly to about the 1.2 level on the graph.

This would indicate that we are most of the way, but not completely done with the fall in housing prices. On a nationwide, Case Schiller basis, there is perhaps another 8-10% left to go. However, even this will continue to put a huge strain on the very weak balance sheets of the major banks like Citigroup (C), Wells Fargo (WFC) and Bank of America (BAC). Regional banks like Wilmington Trust (WL) and Key Corp (KEY) will also face severe stresses and might not pass the new government stress test without the need for new and very dilutive capital.

In case you had not noticed, Sweden today bears little resemblance to Somalia or the Sudan; they managed to survive their housing crisis. However, it took bold and dramatic action to solve the problem. They nationalized the banks -- cleaned them up. And then resold them after a few years. Eventually the US may have to go down that road, rather than trying to pussyfoot around with partial solutions like "bad banks" and "public-private partnerships." It is a much cleaner solution, and one that has been shown to work in the past, albeit on a much smaller scale

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"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." --Warren Buffett