Friday, February 11, 2005

FDIC says bust in home prices not likely soon

Biz New Orleans
WASHINGTON — Average home prices rose 13 percent in the year ending September 2004, and are up almost 50 percent over the last five years. In December, the Office of Federal Housing Enterprise Oversight noted, "The growth in home prices over the past year surpasses any increase in 25 years."

Because of this rapid growth, some have become concerned about the possibility of a home price collapse, either nationwide or in a number of major cities.

A white paper released yesterday by the Federal Deposit Insurance Corp., addressed the question, “Must a bust always follow a boom?” The following are excerpts from the report:

Must a bust always follow a boom? Based on our look at history, our answer must be "no." Only infrequently do home price booms lead to busts, at least by our criteria.

If it is relatively rare for housing booms to result in a price bust, how do booms usually end? Our look at history suggests that stagnation in home prices is often the most likely outcome. Of the 54 boom episodes prior to 1998, 45 did not see a subsequent bust. In these cases, nominal home prices rose by an average of 2 percent per year during the five years after the boom ended. The equivalent figure for real home prices was a modest 2 percent per year decline. So for 83 percent of our post-boom cities, nominal prices continued to inch up and any declines after inflation were very modest. Home prices in these markets simply stagnated, or stalled out, following their booms rather than going bust.

Why do home prices bust? Two case studies are useful: the Oil Patch and the 1990s bi-coastal collapse.

If a home price boom is not a sufficient condition to cause a home price bust, as our look at history suggests, what is? Clearly one suspect is the overall economic health of these cities during their home price busts. In fact, the two major regional episodes of U.S. home price busts since 1978 were associated with rather severe, localized economic shocks that tended to affect major employers.6

This association between localized economic stress and a home price bust is best illustrated in the case of the oil patch cities during the mid-1980s. When oil prices surged in the late 1970s, the oil-producing areas of Texas, Oklahoma, Louisiana, Colorado, Wyoming, and Alaska began experiencing an economic boom and population inflows. As the economies in these cities accelerated and their populations surged, demand for housing naturally boomed.

The local economic booms in the oil patch cities began to unwind, however, as oil prices started to weaken. After surging 250 percent between 1978 and 1980, crude oil prices began a six-year decline that culminated with a 46 percent price drop in 1986. The economic stress resulting from the decline in oil prices is evident in the intermittent job loss and population outflows that characterized the oil patch cities until 1989. This economic stress in turn weighed heavily on the housing markets in these cities. In the worst cases, nominal home prices fell by 40 percent and 33 percent in Lafayette, Louisiana, and Casper, Wyoming, respectively, between 1983 and 1988.

Population outflows were perhaps the most detrimental factor weighing on housing in these cities. Not long after population growth slowed sharply in these markets, and even for several years after their average populations started growing again, home prices were in decline. One of the worst years of population loss for these cities was 1987, when Anchorage lost 2 percent of its residents, Odessa-Midland's population dropped 5.4 percent, and Casper saw a net outflow of nearly 7 percent of its residents. Population outflows are extremely harmful to housing markets, because they both depress demand for homes and raise the number of homes on the market.

What does history suggest about the current situation? First, home price booms do not last forever. Second, we have seen that most booms usually do not go bust but instead tend to result in a period of price stagnation. Finally, busts do sometimes follow booms. In those instances, severe economic shocks—often including a net outflow of population — appear to be a key factor in pushing nominal home prices sharply lower. Home price declines do not occur simply because home prices have boomed, and they do not occur independently of local economic conditions.

Although relatively few metro area housing booms have ended in busts, there are reasons to think that history might be an imperfect guide to the present situation. Foremost among these are changes in credit markets that are pushing homeowners — and housing markets — into uncharted territory. A major financial development in the 1990s was the emergence and rapid growth of subprime mortgage lending. Subprime mortgage loan originations surged by a whopping 25 percent per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years. While the growth in subprime lending has made home ownership an option for millions of households who could not qualify for conventional loans, it has also been associated with higher levels of delinquency and foreclosure.

Home buyers are also increasingly availing themselves of higher-leverage mortgage products. The effect of this structure is to raise the total loan amount to a level very near the value of the home, which may make borrowers more likely to default in the event of a housing market downturn. An increased incidence of default and foreclosure could, in turn, contribute to downward pressure on home prices as distressed properties are liquidated by lenders. However, little is known as yet about the effects these credit-market changes might have on the dynamics of boom-bust cycles, making them promising areas for future research.