Five years from U.S. housing peak, still no bottom

April 15, 2011

By Martin Hutchinson
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

WASHINGTON — Five years on from their peak, there’s still no bottom in sight for America’s house prices. After rising from a trough in 2009, prices are falling again and market activity is very thin. It’s another complexity for monetary policymakers with an eye on inflation: hiking interest rates could further squash housing.

The housing bubble that inflated in the run-up to 2006 owed much to the Federal Reserve’s policy. During and after the 2001 recession, the Fed under Chairman Alan Greenspan held interest rates very low, and well below inflation. That coincided with a political environment and tax benefits — like the mortgage interest deduction — that encouraged home ownership, and was capped by financial technology that allowed mortgages to be repackaged and resold so that the original lenders retained no risk.

Yet thanks to low interest rates, the National Association of Realtors’ affordability index remained above its long-term average even as the ratio of the typical house price to income soared to unprecedented levels above five times, compared with a long-term average around three times.

Helped by a dose of bubble-induced fraud that stretched some mortgage borrowers even further, lower-quality subprime borrowers began getting into difficulty even as house prices were peaking. That was the beginning of the collapse that eventually swept through the mortgage securitization market and put the banking system in difficulty, causing a financial crunch and a sharp economic downturn.

The average house price tumbled 32 percent in the three years after the 2006 peak, by the seasonally adjusted S&P/Case-Shiller 20-city index. Initially, prices then rebounded remarkably quickly, turning up in June 2009 — around the time the recession bottomed and well before the peak in unemployment — and climbing 5 percent in the following 12 months.

But that turns out to have been a false dawn. Even cheaper money, extra tax incentives and higher loan limits at the now government-owned Fannie Mae and Freddie Mac and at the Federal Housing Administration helped produce the rebound, but it fizzled out in the months after the tax breaks were withdrawn in April 2010.

A renewed house price decline has set in, with the January reading of the Case-Shiller index 4 percent down from its mini-peak seven months earlier — although the index remains just above the post-crisis trough level.

Meanwhile, U.S. new home sales in February fell 28 percent from the previous year to a record low pace. The inventory of new homes rose to 8.9 months’ sales, although this is an improvement on the 12 months’ worth of stock two years ago. Existing home sales also declined slightly in February from a year earlier.

U.S. employment trends have turned positive in recent months, which will help prices. So will mild inflation, which increases housing affordability. But there are factors that point to a significant further decline. First, interest rates remain artificially low, and with inflation beginning to accelerate, they are declining in real terms. This has brought the NAR’s affordability index to an all-time peak of 192.3 in February. That suggests even the current level of house prices may be flattered by low mortgage costs.

Second, the already high level of reported housing inventories may not tell the whole story. Homes going through the foreclosure process and those that cannot currently be sold because the owners are underwater on their mortgages represent an additional, invisible overhang.

Looked at against history, American house prices are still well over 30 percent above the cyclical low in September 1993 in real terms, adjusting the long-running Case-Shiller 10-city index for inflation. On a more thorough analysis, economist Gary Shilling believes house prices have a further 20 percent to fall. That may be too pessimistic, but prices surely face headwinds from the foreclosure pipeline and high levels of inventories.

And that’s the difficulty for the Fed. With house prices in January down 31 percent from their peak by the Case-Shiller 20-city index and declining again, more loans that appeared perfectly sound when written are dipping under water. Yet with Friday’s release showing consumer prices rose 0.5 percent in March, the same increase as in February, it looks as if inflationary pressures are slowly building. That means policymakers may soon have to consider raising interest rates, which will force mortgage costs higher and knock housing prices down further. Five years on, U.S. homeowners don’t yet have much cause for optimism.

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Housing prices in most markets still have a long way to fall. Measuring change against the peak prices may show the depth of the pain, but it is otherwise irrelevant.

What policymakers need to focus on is solutions that will help home-borrowers out of the deep end, and into the shallows. Affordable shallows that will either allow them to pay an existing mortgage, or move on to a new one, at reasonable price.

While home buyers incentives may be perceived as an economic stimulus, we are too far gone for that; incentives just delay the inevitable, the leveling of the playing field in a free-market economy.

Fast, swift, and painful aid to get us out of this mess is the solution. Nothing will change until housing bottoms and prices are affordable to middle-class America.

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