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Housing Decline Continues To Rock Real Estate

Posted Monday, June 30, 2008

The April Case-Shiller index showed that house prices are still plunging in most of the 20 cities covered, although there are more markets showing gains this month than last. The data show that real house prices in the 20-city index were falling at close to a 26 percent annual rate over the months from January to April. Since their peak in the summer of 2006, real house prices have dropped by more than 23 percent.

Prices are dropping most rapidly in Miami, where the annual rate of nominal price decline has been 37.5 percent over the last quarter. Following closely behind are Las Vegas, with a 36.8 percent rate of price decline and San Francisco and Phoenix, both with 35.6 percent rates of price decline. Prices were falling at a 33.7 percent annual rate in Los Angeles.

While prices were plummeting in these cities, there was somewhat of a turnaround in other cities. Nominal prices rose in 9 of the 20 cities this month. By comparison, they only rose in two of the twenty cities (Charlotte and Dallas) last month. The monthly rate of price decline slowed in every city except Phoenix and New York, where it increased modestly and San Diego, where it was unchanged at 2.6 percent in April.

While house prices are still plunging in many cities, the slower rate of decline can be seen as a positive sign. The price plunge will not just stop all at once, clearly it must slow first.

In this respect, the data from Cleveland are encouraging. Prices in Cleveland rose by 2.9 percent in April, while prices in the bottom third of the housing market rose by 5.9 percent. By comparison, prices in the bottom third of the market in Cleveland had been reported as dropping at a 62.9 percent annual rate December to March period. It is possible that the prior months' declines were simply driven by sampling error ? the sample size in Cleveland is far smaller than for any other metropolitan area ? but it may also be the case that the Cleveland market has hit bottom. There have been anecdotal accounts of investors taking advantage of the plunge to buy up large blocks of housing in depressed cities like Cleveland. Such speculative purchases can help to put a floor in the market. 

The Dodd housing bill passed a key test vote and advanced in the Senate yesterday. The bill has two important flaws as a measure to help homeowners facing foreclosure. First, the lenders get to decide which loans get into the program. This raises a serious adverse selection problem. While lenders will have to take a substantial write-down compared with the initial value of the mortgage, they presumably will not bring in loans unless they expect to do better under the program than if they had to go through a foreclosure. In other words, look for the lenders to bring their worst loans into the system.

The other problem is that there is no restriction on the guaranteed price for a newly issued mortgage. While the bubble is deflating, there are many markets where homes are still hugely over-valued. In these markets, even if the guaranteed price on a new mortgage is below the value of the initial mortgage, it is still likely to be well above the price at which home values will eventually settle.

In such cases, the homeowner is likely to be paying far more in ownership costs than they would pay to rent a comparable unit, severely straining their budget. For example, if the ratio of sale price to annual rent is 20 to 1, and the homeowner gets a 6.5 percent mortgage, after adding on 2 percentage points for taxes, maintenance, and insurance, a homeowner will be paying 70 percent more to own than to rent a comparable unit, even before including principle payments.

Furthermore, since prices are dropping, homeowners are unlikely to accumulate any equity. And, since the home is likely to be sold for less than the guarantee price, the government is likely to have to make good on the guarantee.
By Dean Baker