Source: I-Beam Design, Pallet House - Kosovo.

The government “aggregator bank” is a distraction. It will not halt our economic descent until it determines what price to pay for “toxic” structured mortgage assets filled with credit, prepayment, and extension risk. Before that can happen, it must develop a realistic home price view, to be used in the valuation process.

That’s why two economists’ recent thoughts on the magnitude and timing of future home price declines are so disturbing. Last week:

• Professor Carmen Reinhart of the University of Maryland observed that real (inflation adjusted) home prices decline an average of 35% from their peak following a severe banking crisis, such as the one that faces us today; and
• Professor Robert Shiller of Yale separately suggested that the current housing downturn could last for ten more years.

This piece will assume that both economists are correct. I will apply their metrics to a well-known housing price index and then derive a simplified future home price path consistent with their statements. I will show that if both economists are correct, then real home price returns may be zero in the long-term and negative for the foreseeable future. I close by considering what this could mean for the aggregator bank.

HISTORICAL HOME PRICE PATH

For our analysis, we will use the deflated, or CPI-inflation adjusted, OFHEO Home Price Index (“real HPI”). It is graphed, below, in Figure 1.

The real HPI peaked in 2006. Figure 2 (below), summarizes the ascent:

As indicated, the real HPI peaked in June 2006, following a five-year rise of 33%, or roughly 6% a year, with compounding.

MAGNITUDE OF FUTURE HOME PRICE DECLINE

Professor Carmen Reinhart just completed a thorough examination of international banking crises with Professor Kenneth Rogoff of Harvard. Writing last week in Vox, she summarized their findings:

• Financial crises are protracted affairs;
• Asset market collapses are deep and prolonged; and
• Real housing price declines average 35%.

Source: C. Reinhart, Vox – The economic and fiscal consequences of financial crises, 26 Jan 2009.

If the current crisis produces a 35% decline in real US home prices from their peak, what does that suggest for their future level of real home prices? As indicated by Figure 3 (below), they must still fall by 25%. Since the current (i.e., last available) value of the real HPI was 134, a 25% percent (or 34 point) decline in the index results in a real HPI figure of 100.

TIMING OF FUTURE HOME PRICE DECLINE

Professor Robert Shiller spoke last week with the German newspaper Handelsblatt. Professor Shiller warned that home buyers’ fear and the disappearance of easy credit could produce a housing downturn more severe than that of the Great Depression:

• We are still experiencing a record price decline.
• It is quite possible that house prices fall more strongly than they did during the global economic crisis of 80 years ago. The real estate crisis could last 10 more years.

Source: R. Shiller, quoted in MoneyNews/Handelsblatt – Shiller: A Decade of Housing Pain, 30 Jan 2009.

If the US real home price decline lasts ten more years, as Professor Shiller warns, and the magnitude of the decline simply mirrors the average real home price decline following international financial crises, what does this imply for the future rate of change in real home prices?

As indicated by Figure 4 (below), the real HPI would need to fall at a rate of almost 3% per year, for the next 10 years.

Note: This does not necessarily mean that nominal home prices would be falling. Rather, nominal home prices – if they increased – would be increasing at a rate that would be less than that of the general inflation rate. If this path is realized in the future, then home ownership would not generate the real wealth, and opportunity for equity extraction, that occurred during the 2001 – 2006 runup at a rate of about $250 billion per year.

POSSIBLE FUTURE HOME PRICE PATH

We can combine the above suggestions for the timing and magnitude of future real home price declines to produce the chart in Figure 5, below.

The historical path of real HPI is in blue and is the same as that appearing in Figure 1, above. The red line indicates the possible future path that real home prices would follow if they declined at a constant annual rate of –2.9%/year, for 10 years.

As Figure 5 indicates, this sort of sustained decline would:

• Represent, more-or-less, a complete “reversal” of the increase that occurred between 1997 and 2006;
• Return real home prices to the level of 100, which last occurred in 1997 and which initially occurred in 1987.

Figure 6, below, summarizes the impact of a possible complete home price reversion, if home prices decline for 10 additional years, at the rate calculated above.

LONG TERM PROSPECTS FOR REAL HOME PRICES

As indicated, real home prices might reach a level in 2018 that last occurred in 1997, and this full reversion period – up and down – would last 21 years.

If the above scenario occurs, it would support the view that the long term (or at least from 1987 – 2018) real increase in home prices is zero. If so, it would confirm Professor Shiller’s belief. Writing in the spring of 2006, before the peak, Professor Shiller observed:

• Until the recent explosion in home prices, real home prices in the United States were virtually unchanged from 1890 to the late 1990s…
• It is perhaps more accurate to say the real price of housing has been flat since 1913 except for two episodes: the home price boom that followed World War II (which essentially restored home prices to their 1913 level) and the current home price boom…
• The magnitude of the current boom is much greater than past booms, and so the way the boom ends, may be more unpredictable and dramatic.

Source: R. Shiller, The Economists’ Voice - Long-Term Perspectives on the Current Boom in Home Prices, Mar 2006.

AGGREGATOR BANK IMPLICATIONS

So what should the “aggregator bank” pay for distressed mortgage assets?

In the unlikely case that home prices resume the post-1997 surge that began when today’s mega-banks were formed - see Now and Then - perhaps something like their original value.

If however, real home prices returns are:

1. Negative for the foreseeable future; and
2. Close to zero in the long term

It may be difficult to assign any value to leveraged and structured assets originated when real home price returns were extraordinarily strong.

- - - - - - - - - - -

I used to work with numbers for a living. I wonder where the bottom is as I search for a new job or at least my next idea. Till next time.

REFERENCES

I Artman, Sterling Slivers – Now And Then: Bank Nationalization, Mergers and Regulation, 29 Jan 2009.

H-J Knipper & T Rieck, Handelsblatt - Interview with Robert J. Shiller/The crisis may last another ten years, 29 Jan 2009 [translated from the German].

C Reinhart, University of Maryland/Vox – The economic and fiscal consequences of financial crises, 26 Jan 2009.

R Shiller, quoted in MoneyNews/Handelsblatt – Shiller: A Decade of Housing Pain, 30 Jan 2009.

R Shiller, BEPress/The Economists’ Voice - Long-Term Perspectives on the Current Boom in Home Prices, Mar 2006.