For the last few years, housing prices have soared. A lack of supply has pushed prices up further.
But what happens if prices begin to fall? Homebuyers have cause to be nervous: during the last housing downturn in 2008 and 2009, home prices fell by 60 percent in some place like Las Vegas and Phoenix. But slowing prices, weak new construction data, and jitters about a possible interest rate increase suggest that prices might drop, as they did seven years ago.
How far can home prices go?
A new study by Federal Housing Finance Agency (FHFA) presents a new technique for evaluating how far house prices could fall in a market downturn. The authors — Alexander N. Bogin, senior economist at FHFA, Stephen D. Bruestle, a lecturer at Pennsylvania State University, Erie, Pa., and William M. Doerner, senior economist at FHFA — have developed a tool that they call a conservative lower bound (CLB) for housing prices. The tool could be used as part of stress test for banks.
“We develop a theoretically-based statistical technique to identify a conservative lower bound (CLB) for house prices,” the authors write. “Leveraging a model based upon consumer and investor incentives, we are able to explain the depth of housing market downturns at both the national and state level over a variety of market environments. This approach performs well in several historical back tests and has strong out-of-sample predictive ability. When back-tested, our estimation approach does not understate house price declines in any state over the 1987 to 2001 housing cycle and only understates declines in three states during the most recent financial crisis. This latter result is particularly noteworthy given that the post-2001 estimates are performed out-of-sample. Our measure of a conservative lower bound is attractive because it (1) provides a leading indicator of the severity of future downturns and (2) allows trough estimates to dynamically adjust as markets conditions change. This estimation technique could prove particularly helpful in measuring the credit risk associated with portfolios of mortgage assets as part of evaluating static stress tests or designing dynamic stress tests.”
The Federal Housing Finance Agency, which regulates the mortgage giants Fannie Mae and Freddie Mac, has acted as the conservator for Fannie and Freddie since the government took them over in 2008. Fannie Mae and Freddie Mac don’t make loans. They buy them from lenders, wrap them into securities and provide guarantees to make investors whole if the loans default.
The paper — titled “How Low Can House Prices Go? Estimating a Conservative Lower Bound” — reveals how low home prices can go.
“Since the recent financial crisis, there has been an increasing focus on improving stress testing,” the authors conclude. “Thus far, the stressed housing paths have been largely static in nature, essentially ignoring current market conditions. This area of work is particularly important for evaluating the reasonableness of static stress tests or developing dynamic stress tests that could help prepare financial institutions for low probability but high impact events such as the recent financial crisis.”