As we discussed in prior posts, low interest rates and high overseas savings led to a credit-and-debt bubble, which fed the mortgage markets and, in turn, real estate prices.
Robert Shiller, author of "Irrational Exuberance," developed the now widely used Case-Shiller home price index. Looking at his numbers, the ridiculous heights the bubble reached become obvious. (They're available at standardandpoors.com, at the somewhat ridiculous URL http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html.)
Here are some charts based on his indexes (now owned and published by Standard and Poor's.)
The chart above show home prices from 1987 to September 2008 (ten city index). As you can see, home prices from 2000 onward (after Greenspan lowered rates to fight the 2000-2001 recession), were way out of line from the historical trend. That just sounds too depressing though...let's take the (very) optimistic assumption that the 1990s were a bad time for home prices, and that the 2000 level was the "right level." Here's the chart below.
What does this chart tell us? Well, for one thing, home prices were still way out of whack recently. The National Association of Realtors tells us that U.S. median sales price of existing single-family homes peaked at about $220,000 in 2006. (Data available here: http://www.realtor.org/research/research/ehsdata). Remember the guideline that home prices should be about 3 times a family's income? Well, the median household income was about $50,000 in the 2006-2007 time period (Data available from the U.S. Census Bureau at http://www.census.gov/hhes/www/income/incomestats.html.) So, home prices were over 4 times the average household's income - no wonder homes were unaffordable!
The big question now of course is, where are home prices going? Well, to reach the 3x level of affordability, home prices would have to drop to $150,000, a further 18% drop from the $183,000 level calculated by the National Association of Realtors for October 2008. Using the Case-Shiller indexes, it depends on your interpretation. I personally don't expect home prices to drop all the way to their historical averages - it would be too painful (and, we should build in a "natural" rate of home appreciation that includes inflation). Rather, I'd expect them to bottom out somewhere slightly above the historical average, and then inflation would eat away the remaining ~10% of home values. So, given an index value of 173 (10-city index) in September 2007, a fall to index values of 130-150 would imply anywhere from a 15%-25% further decline in home prices.
So in a nutshell, the news is really bad. #1: Home prices are not done dropping. #2: Even when they bottom out, they're likely to be above the historical average. #3: They're unlikely to bounce back once they've bottomed out. And as a corollary, all the talk of stabilizing home prices buy having Treasury but mortgage-backed securities doesn't make any senese - home prices need to be lower, and trying to prop them up is only delaying the inevitable. Yes, we should try to make mortgages available once again; yes, we should try to help consumers at risk of foreclosure re-negotiate loan terms; and yes, we should try to bail out banks with bad mortgages so our financial system doesn't melt down.
But, we should be aware that home prices have to fall further to reach a sensible point (i.e. historical affordability ratios), and that the road ahead will be very, very painful.
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