In March, home prices continued to slip, and the declines were still widespread. The Case-Schiller Composite 10 City index (C-10) fell 0.10% on a seasonally adjusted basis, and is down 2.84% from a year ago. The broader Composite 20 City index (which includes the cities in the C-10) fell by 0.23% on the month and is down 3.53% from a year ago. The second down leg of housing prices continues.

Of the 20 cities, seven were up on a month-to-month basis, and 13 were down. Year over year, though, just Washington DC saw a gain and the 19 others suffered losses. Washington DC was the strongest by far, with prices up 1.20% on the month and up 4.38% from a year ago. This is the 9th straight month-to-month decline in the composites, and the fifth straight month that both of the composites were negative on a year-over-year basis.

The overall indexes are down 31.78% (C-10) and 31.63% (C-20) from the (4/06) bubble peaks. They set an interim low in May 2009 and rallied into the summer of 2010 before turning down again. The bounce has mostly faded, and the C-20 index is just 0.16% away from setting a new post-bubble low. The C-10 has only a little bit more breathing space before setting a new low, up just 1.64% since that interim bottom.

Check the Seasonally Adjusted Numbers

There is a seasonal pattern to home prices, and thus it is better to look at the seasonally adjusted numbers than the unadjusted numbers. Most of the press makes the mistake of focusing on the unadjusted numbers. Thus the numbers you read in this post might be slightly different than the ones you read about elsewhere.

The Case Schiller data is the gold standard for housing price information, but it comes with a very significant lag. This is March data we are talking about, after all, and it is actually a three-month moving average, so it still includes data from January and February.

Home sales, both new and used, have been improving, but from very weak levels in recent months. Based on pending sales, it looks like existing home sales are going to be very weak in the months to come. In short, the spring selling season has been a bust. While the inventory to sales ratio for used homes is down from the June peak of 12.5 months, it is still elevated at 9.2 months.

Housing prices are going to fall again in coming months. The first graph (from this source) tracks the history of the C-10 and C-20 indexes. Note that on both indexes we are almost back to the post-crash lows. It seems likely to me that we will set new lows before the second leg down is over. On a seasonally unadjusted basis we did so this month, so that is not the world’s boldest predication.

Results by Region

Of the seven cities that posted month-to-month gains, DC led the way with a 1.20% rise. San Fransisco was also strong with a rise of 0.54%. Miami bounced by 0.27%, but none of the gainers (Seattle, LA, Phoenix and Tampa) were up by more than 0.2%.

On the downside, four cities fell by more than 1% on the month. Charlotte was the hardest hit, falling 2.63% for the month. The Twin Cities were down almost as hard, dropping 2.49% for the month. Cleveland was down by 1.32% for the month while Atlanta was down by 1.21%.

On a year-over-year basis, DC was the strongest city by far with a 4.38% rise. Every other city has lower priced housing than a year ago, and only two have managed to hold the losses to less than 2%. Detroit is down 0.79% and L.A. is off 1.65% year over year.

There were five metropolitan areas where the year-over-year declines were more than 7%. Worst hit were the Twin Cities (Minneapolis/St. Paul), off 9.83% from a year ago. Phoenix fared the next worst with a 8.40% decline, and shows no sign of rising from its ashes. Seattle is down 7.42% year over year. Portland is down 7.56%, while Chicago is off 7.48%. Tampa is down 6.80%. In other words, significant year-over-year declines are happening in just about every corner of the country.

The graph (also from this source) below tracks the cumulative declines for each city over time. If the red bar is shorter to the downside than the yellow bar for a city, it indicates that prices in that city have risen since the start of this year.

In every city, prices are below where they were in April 2006, but there is a huge variation. Las Vegas is the hardest hit, with prices down 58.29% from the peak, followed by Phoenix down 55.11%. Miami has joined the “half-off club,” down 50.01%. Tampa (down 45.49%) and Detroit (down 45.34%) are not far away from joining that rather dubious group.

At the other end of the spectrum, there is just one city that has managed to avoid a double-digit decline: Dallas, where prices are down only 5.87% since April 2006. Charlotte is off 12.19%. Denver is off 10.61% from the national peak. (Note: the percentage declines I am quoting are from when the national peak was hit; the numbers in the graph are relative to that city’s individual peak, so there is a little bit of difference).

Also keep in mind that these are nominal prices. While inflation has been low over the past few years, it does add up, so in real terms the declines are much greater.

Artificial Support Now Long Gone

The homebuyer tax credit was propping up home prices a year ago, but now with that support gone, prices are resuming their downtrend. However, the artificial support is still being felt in the year-over-year numbers. People had until June 30 to close on their houses, and they had to agree to the transaction by April 30. The credit was up to $8,000, so almost nobody would want to close their deal in early July and simply leave that money on the table.

The tax credit is a textbook example of a third party subsidizing a transaction. When that happens, both the buyer and the seller will get some of the benefit. The buyer gets his now when he files his tax return, the seller gets hers a year ago in the form of a higher price for the house.

Since the tax credit is now over, that artificial prop to housing prices has been taken away. Sales of existing houses simply collapsed in July, after the credit expired, and have remained depressed ever since. The extremely high ratio of homes for sale to the current selling pace is sure to put significant downward pressure on prices.

There is still quite a bit of “shadow inventory” out there as well. That is, homes where the owner is extremely delinquent in his mortgage payments and unlikely ever to make up the difference, but that the bank has not yet foreclosed on or foreclosed houses that have not yet been listed for sale. It also includes all those people who think that the decline in housing prices is just temporary, and are waiting for a better time to sell. As they do, it seems if they will be in the roles of Vladimir and Estragon — waiting for Godot.

Prices Will Only Fall So Far

While it seems clear to me that the downward trend in home prices is likely to continue, we are unlikely to have a decline anything like the first downdraft in housing prices. The reason is in the next graph (also from this source).

People need a place to live, but they do not have to own a house. They have the option of renting. A house is a capital asset, and the cashflow from owning that asset is in the form of rent you do not have to pay. One of the clearest signs that we were in a housing bubble was that the prices of houses got way out for line with rental prices.

While on this basis, houses are not yet “cheap” on a national basis, neither are they absurdly expensive the way they were a few years ago. If prices fall too far from here, it will become cheaper to own than rent, and lots of people who are now in apartments will start to buy. This graph also includes the CoreLogic housing price data which is similar to the C-20, but if anything a bit weaker in recent months.

New Home Construction Key to Stronger Economy

It is existing home prices — not the volume of turnover — that is important. The level of existing home sales is only significant relative to the level of inventories, since that provides a clue as to the future direction of home prices. If there is an excess inventory of existing homes, then it makes very little sense to build a lot of new homes.

It is the building of new houses that generates economic activity. It is not just about the profits of D.R. Horton (DHI). A used house being sold does not generate more sales of any of the building products produced by Berkshire Hathaway (BRK.B) or Masco (MAS). Turnover of used homes does not put carpenters and roofers to work. New homes do.

Existing home prices, on the other hand, are vital. Home equity is — or at least was — the most important store of wealth for the vast majority of families. Houses are generally a very leveraged asset, much more so than stocks. Using your full margin in the stock market still means you are putting 50% down. In housing, putting 20% down is considered conservative, and during the bubble was considered hopelessly old fashioned.

As a result, as housing prices declined, wealth declined by a lot more. For the most part we are not talking vast fortunes here, but rather the sort of wealth that was going to finance the kids’ college educations and a comfortable retirement. With that wealth gone, people have to put away more of their income to rebuild their savings if they still want to be able to send the kids to college or to retire.

Housing Wealth and Retail Sales

The decline in housing wealth is a very big reason why retail sales have been so weak. With everyone trying to save, aggregate demand from the private sector is way down. If customers are not going to spend and buy products, employers have no reason to invest to expand capacity. They have no reason to hire more workers.

People pulling money out of their houses was a big force behind what growth we had during the previous expansion. Mortgage equity withdrawal, also known as the housing ATM, often accounted for more than 5% of Disposable Personal Income during the bubble, thus greatly lifting consumer spending. Since the bubble popped, people have been on balance paying off their homes (or defaulting on them through foreclosures).

The comparison of the next two charts shows how important housing wealth is to the middle class. The first graph includes home equity wealth, the second looks only at financial assets like stocks. The upper middle class (50 to 90% income brackets) had 26% of the total wealth in the country in 2007, and just 9.3% of the wealth in the form of financial assets. The value of non-financial assets, mostly home equity, has declined significantly since 2007, and with it the wealth of the middle class.

Also as housing prices fell, millions of homeowners found themselves owing more on their houses than the houses were worth. That greatly increases the risk of foreclosure. If the house is worth more than the mortgage, the rate of foreclosure should be zero. Regardless of how bad your cash flow situation is — due to job loss, divorce or health problems, for example — you would always be better off selling the house and getting something, even if it is less than you paid for the house, then letting the bank take it and get nothing.

By propping up the price of houses, the tax credit did help slow the increase in the rate of foreclosures. Still, more than a quarter of all houses with mortgages are worth less than the value of the mortgage today. Another five percent or so are worth less than five percent more than the value of the mortgage. If prices start to fall again, those folks well be pushed under water as well.

On the other hand, it is not obvious that propping up the prices of an asset class is really something that the government should be doing. After all, it is hurting those who don’t have homes and would like to buy one.

Mortgage Interest Deduction

Support for housing goes far beyond just the tax credit. The biggest single support is the deductibility of mortgage interest from taxes. Since homeowners are generally wealthier and have higher incomes than those that rent, this is a case of the lower middle class subsidizing the upper middle class. If you are in the 35% bracket, then effectively the government is paying 35% of your mortgage interest; if you are in the 10% bracket, the government is effectively picking up only 10% of the tab.

(The same, incidentally, holds true for other tax deductions, such as charitable contributions. Also, even if they are home owners, people with lower incomes are more likely to take the standard deduction rather than itemize their taxes. The mortgage interest deduction only applies if you itemize.)

There has been much discussion of trying to rationalize the tax system and bringing down tax rates, but to do so the base would have to be broadened through the elimination of deductions. The mortgage interest deduction is one of the biggest of these. An attempt that leaves the mortgage interest deduction in place would have to be mere tinkering around the edges.

While the concept of lower rates and fewer deductions is a good one, transitioning from here to there in the current weak housing market is going to be difficult to say the least.

Housing Prices at Historically Fair Value

Fortunately, relative to the level of incomes and to the level of rents, housing prices are now in line with their long-term historical averages, not way above them as they were last year. In other words, houses are fairly priced — not exactly cheap by historical standards, but not way overvalued either.

That will probably limit how much price fall over the next six months to a year to about 5% more from here, rather than the 30% decline we saw from the top of the bubble. That, however, is more than enough of a decline to do some serious damage.

The second leg down in housing prices is underway, but fortunately this will probably be a much shorter leg than the first one. Still, that is bad news for the economy. Used homes make very good substitutes for new homes, and with a massive glut of used homes on the market, there is little or no reason to build any new ones.

With used home prices falling, they undercut the prices of new homes. A homebuilder simply cannot compete with a bank that just wants to get a bad asset, a foreclosed home, off of its balance sheet.

Residential investment is normally the main locomotive that pulls the economy out of recessions. It is derailed this time around and there seems to be little the government can do to get it back on track. Eventually, a growing population and higher household formation will absorb the excess inventory.

The key to higher household formation (“economist speak” for getting the kids to move out of Mom and Dad’s basement and into a place of their own) will be more jobs. Unfortunately, residential investment is normally a key source of jobs when the economy is coming out of recessions. Sort of a tough “chicken and the egg” problem.
 
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