The central role of home prices in the current financial crisis: how will the market clear?

This paper begins by describing some patterns in home price movements over recent decades. It then discusses some distinguishing characteristics of housing markets that will contribute to determining prices going forward: Housing is heterogeneous, making prices hard to measure. Home prices are subject to inertia and are sticky downward. Housing markets have traditionally been quantity clearing markets, with excess inventories absorbed only as new households are formed. And housing markets depend critically on credit market conditions and monetary policy. Two opposite scenarios for future home prices are both plausible: The first, noting among other things the many "underwater" mortgages and unsold inventories and the likelihood of a severe recession, foresees a slow recovery. The second observes that the market clearing process has been orderly so far and that deep regional housing busts in the past have sometimes been followed by quick recoveries, suggesting that a more rapid turnaround is possible.

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The housing market today lies at the heart of a potentially catastrophic collapse of the banking and financial system. By some measures, housing prices are down by more than even the most pessimistic forecasters were predicting a year ago. The collapse in value of the collateral behind the nation's $12 trillion portfolio of home mortgages has led to unprecedented rates of delinquency and foreclosure. The decline in home prices has also led investors to unwind the layers of risk created by and traded in new, complex contracts, which now threaten the foundation of the payment system.

This paper begins with an overview of changes in the value of residential capital and land over the last four decades. It then lays out some salient facts about how the housing market has operated in the past, with a focus on alternative market clearing mechanisms. Finally, while stopping short of a specific forecast, the paper presents both the case for a continuing severe decline, with prices falling well into 2010, and an argument that the market may begin to stabilize as early as 2009Q1.

Home Prices and Land Values in the United States, 1975-2007

One national index of home prices suggests that nominal prices never fell over any full quarter between 1975 and 2005. The national quarterly repeat sales index of the Office of Federal Housing Enterprise Oversight (OFHEO; top panel of figure 1) rose 532.4 percent, or more than sixfold, in nominal terms between 1975Q1 and 2007QI. The bottom panel of figure 1 plots the S&P/Case-Shiller National Index, available back to 1987. Nominal home prices by this measure fell in a number of quarters, but the overall pattern is the same: prices were either rising or flat between 1987 and 2005. Nominal prices rose at an average annual rate of 6.0 percent over the whole period but began accelerating rapidly in 2000.

Table 1 compares increases in home prices with income growth and inflation. Between January 1975 and December 2006, the consumer price index (CPI) rose nearly fourfold, implying an average annual rate of increase of about 4.3 percent over the 32 years. Personal income per capita grew at the same rate as home prices, although median household income did not keep pace.