In January, home prices continued to slip, although the declines were less widespread than in recent months. The Case-Schiller Composite 10 City index (C-10) fell 0.22% on a seasonally adjusted basis, and is down 2.03% from a year ago. The broader Composite 20 City index (which includes the cities in the C-10) also fell by 0.22% on the month and is down 3.03% from a year ago. The second down leg of housing prices continues.

Of the 20 cities, eight were up on a month-to-month basis, and 12 were down. Year over year, though, just two metro areas saw gains and 18 suffered losses. Washington DC was the strongest by far, with prices up 3.59% from a year ago. San Diego managed to squeeze out a 0.08% rise.

This is the 7th straight month-to-month decline in the composites, and the third straight month that both of the composites were negative on a year-over-year basis. Seven cities hit new post bubble lows in their home prices.

Look at 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. The small rebound in housing prices we saw from the spring of 2009 to the summer of 2010 has now mostly evaporated. The C-20 index is just 0.67% above its interim low in April 2009. The C-10 is holding up somewhat better and is now 2.16% above April 2009 levels.

Longer term, though, the declines between the two indexes are very similar. From the April 2006 peak of the housing market, the C-10 is down 31.44% while the C-20 is off by 31.30%. The Case-Schiller data is the gold standard for housing price information, but it comes with a very significant lag. This is January data we are talking about, after all, and it is actually a three month moving average, so it still includes data from November and December.

Existing home sales have been weak relatively weak in recent months (see “Used Home Sales Plunge”). While the inventory-to-sales ratio is down from the June peak of 12.5 months, it is still elevated at 8.6 months.

The second leg in the housing price downturn is not over. 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 down leg is over.

The Best and the Worst

Of the eight cities that posted month-to-month gains, Washington DC led the way with a 0.85% rise, Atlanta (up 0.73% and Dallas (up 0.52%) were also strong, at least for the month. On the downside, the Twin Cities were hit hard, with prices tumbling 1.49% on the month. Seattle was the only other city with a decline of more than 1.0%, falling 1.05% from December. Miami (down 0.79), New York (-0.71%) and Charlotte (-0.65%) were also very soft.

On a year-over-year basis, DC was the strongest city by far with a 3.59% rise. San Diego has managed to cling to a 0.08% increase, but that does not mean things are going well there. As recently as July, the year-over-year gain was 9.26% in SD.

There were eight metropolitan areas where the year-over-year declines were more than 6%. Phoenix fared the worst with a 9.15% decline, and shows no sign yet of rising from its ashes. Detroit has been hit almost as hard, down 8.08%. Portland is down 7.80% year over year. The Twin Cities are down 7.54% while Chicago is off 7.40%. 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 57.87% from the peak, followed by Phoenix, down 55.31%. Three more cities are down more than 45%, Miami, down 49.40%, Detroit off 47.50% and Tampa, with a 45.71% decline.

At the other end of the spectrum, there are just three cities that have managed to avoid a double-digit decline. Dallas, where prices are down only 5.45% since April 2006, Charlotte off 6.98% and Denver where they are down 9.67%. (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.)

Post-Tax Credit Housing Market

The homebuyer tax credit was propping up home prices a year ago, but now with that support gone, prices are resuming their downtrend.  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 play the parts of Vladimir and Estragon, waiting for Godot.

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 (unfortunately not yet updated for the current data). 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 cash flow 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.

Existing Home Prices Crucial

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 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 lumber by International Paper (IP) or 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, a 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.

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.

Millions with Underwater Mortgages

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, do 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, 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 underwater 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.

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. Incidentally, the same holds true for other tax deductions, such as charitable contributions. Also, even if they are homeowners, 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.

Eliminate Mortgage Deductions?

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.

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.

2nd Down Leg to Be Shorter

The second leg down in housing prices is underway, but fortunately 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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