Are House Prices in a Free Fall?

March 04, 2009

March 4, 2009 (Housing Market Monitor)

Are House Prices in a Free Fall?

By Dean Baker

March 4, 2009

Flow of tax payer dollars to Fannie and Freddie will continue for some time.

The latest data indicate that the house price decline is continuing to accelerate. The Case-Shiller 20-City index showed prices falling at a 2.0 percent rate from November to December. The median house price in the National Association of Realtors Existing Home Sales series fell 3.1 percent from December to January. It has fallen by 18.9 percent over the last six months.

However the sharpest decline was in the Commerce Department’s data on new home sales. These data showed the median price of a new home fell by 9.9 percent from December to January. This series is especially erratic, but even if the actual price decline was only half this large, a 5.0 percent decline would still be an extraordinary one month drop.

It is also worth noting that this series provides the most current information about the state of the housing market since it is based on contracts signed in January rather than closings. Since there are typically 6-8 weeks between when a contract is signed and a closing, the other price series, which are based on closings, are reflecting contracts that were signed close to two months earlier. For this reason, price movements should be expected to show up in the new home data before the other series.  

Given other economic data it is certainly plausible that the rate of house price decline is accelerating. The unemployment rate has risen by more than 3 percentage points from its low in 2007, with involuntary part-time rising by another 2 percentage points. If there are twice as many people who fear unemployment or short hours as who actually end up unemployed or working short hours, then the weak economy would have reduced the number of potential homebuyers by 15 percent.

In addition, the plunge in house prices will also reduce demand, since it has destroyed home equity. By some estimates, close to 20 percent of mortgage holders are underwater. After deducting realtor fees and other closing costs, tens of millions of current homeowners would not have enough equity left to make the down payment on a new home. In this respect, many long-time homeowners will face the same difficulty as first-time homebuyers in raising the money needed for a down payment. With the sharp drop in the stock market destroying savings, few of these homeowners will have enough financial wealth to make a down payment.

The danger in this situation is that house prices will go into a downward spiral, with declining house prices destroying equity. The loss of equity reduces the number of potential buyers in the market, putting further downward pressure on prices. This sort of downward spiral will have further negative effects on the economy. As homeowners lose more equity, they will feel the need to cut back further on consumption. In addition, with more homes underwater, default rates will rise with the losses on each foreclosure increasing.

Unfortunately, there has been little real discussion to date of measures that could arrest this sort of price decline. A serious effort would focus on sustaining prices in markets where the bubble has already deflated. Efforts to sustain house prices in markets where the bubble is still deflating will almost certainly fail, and will result in the government wasting money on a failed effort.

However, in the markets where sale prices are in line with rents, it would be desirable for the government to try to prevent prices from overshooting. It can do this by directly intervening in the market, buying up foreclosed properties. This could be an effective policy that carries little downside risk. In fact, this policy certainly carries less risk than continuing to allow Fannie Mae and Freddie Mac to guarantee mortgages in markets where the bubble is still deflating.

The country is paying an enormous price as a result of the failure by policymakers to recognize an $8 trillion housing bubble. The insistence of policymakers on designing housing policy as though the bubble did not exist will lead to more losses of tax dollars in the future. As a result, the flow of taxpayer dollars to Fannie and Freddie will continue for some time.


Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR’s Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.

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