Are Home Prices Still too High?

The Wall Street Journal “Home Prices Declined at Record Pace in October” reports that the Standard & Poor’s/Case-Shiller home price index fell 2.2% month over month and 18% year over year for October. Some of the metropolitan areas fell more than 30% year over year. Prices peaked in mid 2006, but are still 58% above early 2000.

The value of homes to a large extent depends on where consumers are anchored. Those that bought during the bubble endear the Federal Reserve’s view that we are in a deflationary spiral. Those that were priced out or too cautious during the bubble still see inflated prices. Funny, how the Fed only sees the danger of asset price deflation, and never recognizes the inflation in asset prices. Anchoring plays a large role in a person’s view of economic value.

It’s old news that the Fed and Treasury are trying to prop up housing prices by every free market means possible. Most of their methods are truly bizarre. After socializing Fannie Mae (FNM) and Freddie Mac (FRE), the Fed wants to purchase up to $500B of their MBS in the free market. At the same time the Treasury won’t explicitly guarantee the GSE debt. Wouldn’t it be cheaper and more effective for the Fed to buy directly from the GSEs? All this to create a shortage of guaranteed high quality agency MBS theoretically pushing conforming mortgage rates to the mid 4% range. The Fed apparently believes that low mortgage rates are the answer to everything. History warns us that the Fed never believes that consumers consider the long-term value in asset purchasing decisions.

All of the Treasury’s previous attempts at free market mortgage modification have failed. I believe this is because mortgage investors are viewing the long-term economic value of housing based on more than temporary measures by the Fed. “Lite” modifications have failed because mortgage investors, banks and servicers have not matched payments with borrowers’ ability to pay. And investors only want to take true write downs if they can completely exit the transactions through foreclosures or short sales.

The purposeful failure of free market mortgage modifications will lead to the feared “cram-downs” by bankruptcy judges if enabling legislation is passed during the next Administration. Judges will determine the comparative economics of the NPV (net present value) of foreclose versus modifications. This fear should rightfully strengthen the mortgage underwriting process.

Let’s look at a few general methods of measuring the economic value of residential real estate. The first is affordability. The mortgage payments and operating expenses should not exceed the 30% to 40% range of the buyer’s gross income. Operating expenses include real estate taxes, insurance, utilities and any condo or HOA dues. The range should also consider other debt and credit score. The old rule of thumb was the purchasers should not consider homes costing more than three times their annual income. This means a couple earning $60,000 should not pay more than $180,000 for a home. With operating costs greatly inflated, the Fed’s interest rate lever is much less a factor on affordability.

The second general valuation factor is rental return on the property. The Fed considers owners’ equivalent rent rather asset value in calculating housing inflation. But, the Fed did not consider negative rental returns an indication of a housing bubble. The last general valuation factor is appraisals. I consider appraisals to be the least dependable indication of economic residential housing values. In many instances, prior sales are more of an indication of emotional values rather than economic values. The rent verses buy calculation provides a much stronger support level.

The Fed and Treasury believe that they can create equilibrium of supply and demand by freeing up mortgage credit and lowering rates. If they can tempt enough buyers to enter the market based on artificially low rates, they believe a floor in housing prices will be maintained. I say they’re wrong. Housing prices will have to fall to their economic value based on expected longer term interest rates and inflated operating expenses. The free market was tempted by artificially low interest and got burned not too long ago.

What good is it to buy a house because you can afford the mortgage payments, only to find out that you will have to sell it at a loss later?

Disclosure: Author is long FNM and FRE.

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