Aftershock: Housing in the Wake of the Mortgage Meltdown

A special study incorporating Case-Shiller® Home Price Indexes

SUMMARY
Aftershock: Housing in the Wake of the Mortgage Meltdown analyzes the house-price outlook for the
nation and the nation's 381 metropolitan areas using Fiserv Lending Solutions' Case-Shiller Home Price
Indexes—widely regarded as the most accurate measure of house price appreciation available.
Key questions addressed in this special study include:
• What is the outlook for national, regional and metro house prices?
• When will housing markets hit bottom and what will the shape of their recoveries look like?
• What are the key weights on housing markets? How and why do they differ by region?
• Which regions are likely to suffer more severe and/or protracted house price declines?
• What are the spillover effects of declining house prices on the broader economy?
• Can policymakers mitigate the severity of the coming house price declines?
Forecast Summary
The current housing recession is expected to run through early 2009 and will ultimately be severe enough
to be characterized as a housing crash. Home sales are expected to hit bottom in early 2008, declining by
over 40% from their peak, housing starts will reach their nadir in mid-2008, falling by 55%, and house
prices are expected to decline by 12% through early 2009. After accounting for the plethora of non-price
discounts home sellers are offering to buyers, effective house-price declines peak to trough will total well
over 15%.
Awash in Inventory
The housing market’s most fundamental problem is it is awash in unsold inventory. According to the
Census Bureau, as of the third quarter of 2007 there was close to 2.1 million vacant unsold homes that
were for sale, equal to 2.6% of the stock of owner-occupied homes. Even a well-functioning housing
market has a substantial amount of inventory. But in the quarter-century between the early 1980s and
mid-2000s, the vacancy rate was an unwavering near 1.7%. The difference between the current over
2.6% vacancy rate and the 1.7% rate that consistently prevailed prior to the recent boom provides a good
estimate of the amount of excess inventory in the market—it currently totals nearly 750,000 homes (see
Chart 1-4). This is far and away the highest level of excess inventory in the post-World War II period. 2
Subprime Financial Shock
Subprime financial shock. Inventories of unsold homes will rise substantially further in coming quarters as
the ongoing subprime financial shock results in a collapse in home sales and surging mortgage loan
defaults and foreclosures. The global financial turmoil ignited this past summer by the rising credit
problems on U.S. residential mortgage loans has significantly disrupted the flows of credit into the
mortgage market. The issuance of bonds backed by subprime, Alt-A, and jumbo loans has fallen
dramatically in recent months. At the peak of activity between 2005 through the first half of 2007,
issuance of these bonds totaled close to $1 trillion annualized. During the third quarter—the shock began
in late July and August—issuance plummeted to only $300 billion (see Chart 1-5). 5 So far in the fourth
quarter, issuance has not measurably revived.
Where's the Bottom
Where’s the bottom? The outlook for the housing market thus appears very daunting. The mountain of
housing inventory will only clear sufficiently for the market to find a bottom if homebuilders significantly
further curtail construction, and thus new supply, and for home sellers to slash their prices to restore
affordability and stimulate housing demand. To gauge just how much lower construction and house prices
must decline for this to occur, the Moody’s Economy.com macroeconometric model of the U.S. economy
was simulated under a number of different assumptions. Under the baseline (most likely) set of
assumptions, the economy avoids recession but experiences slow job growth, the entire Treasury yield
curve remains well below 5%, and loan modification efforts soon gain momentum. In this scenario, the
housing market finds a bottom by early 2009 with average annual housing starts of approximately one
million units over the entire period and a peak-to-trough decline in national house prices of 12% (see
Chart 1-12). Housing starts in September were running at a 1.2 million unit pace and house prices are
down 5% so far.
Financial Threat
Financial threat. The risks to this disconcerting near-term housing outlook seem skewed decidedly to the
downside. Of most concern is that sliding house prices and eroding mortgage quality will reignite another
wave of global financial turmoil. The ramifications of this for the economy, and thus housing, would be
overwhelming. Behind this worry is the financial system’s substantial exposure to hundreds of billions in
mortgage losses that are set to come. While financial institutions have begun to recognize these losses,
as is evident from the recent string of billion dollar writedowns, they have fallen well-short of what they
ultimately will have to realize.
Circumspect Consumers
Another negative risk to the outlook is posed by the intensifying negative housing wealth effects resulting
from the severe and persistent decline in house prices and homeowners’ equity. As consumers turn more
cautious in response to their eroding wealth, the economic expansion will surely waver, but if it falters
significantly it will ignite a further devolution of the already reeling housing market. The wealth effect
postulates that changes in household wealth measurably impact household spending. If household wealth
is rising (falling), then households will spend more (less) out of their current income, and thus save less
(more). The idea behind the wealth effect is simply that as households become wealthier they do not
need to save as much today to be prepared for their future financial needs. It is no longer as necessary to
save for such things as their children’s college education or their own retirement.
Engaged Policymakers
The most significant upside risk to the housing outlook is that policymakers appear fully engaged in
stanching the financial turmoil and ensuring that the economy avoids recession. The Federal Reserve has
aggressively lowered interest rates in recent weeks and Congress and the administration are working to
aid the hard-pressed mortgage market. More help will be needed, but policymakers appear ready to
provide whatever is necessary.