The Truth About Housing Prices

Separating economic fact from economic myth


Editor's Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: In order for the economy to recover, housing prices have to reach pre-recession levels. They cannot decline further. Therefore the government must continue to prop up housing prices or provide incentives to encourage people to buy homes.

Fact 1: Pre-recession housing prices were a historic anomaly based on easy credit caused in part by misguided government policy. Lower housing prices are not bad for everyone. They are also the only way to get rid of our bloated housing inventory.

The idea that economic recovery can't happen unless our housing prices return to pre-recession levels makes no sense.

First, as the chart below shows, for most of American history housing prices grew at a relatively slow rate. It was only in the last 15 years that prices exploded. The factors behind this sudden change are a mixed bag of government policies that encouraged homeownership and cheap interest rates and a willingness by banks to lend to people who could only realistically afford to pay if housing prices doubled every two years. George Mason University economist Russ Roberts has a very good blog post explaining why housing prices went up so fast.

Second, low prices are not bad for everyone. Yes, low prices are bad for homeowners who are trying to sell and for banks that have lots of bad loans on their books. But low prices are very good for people who want to buy houses. They are also very good for low-income buyers who were priced out of the market in recent years. Finally, low prices are good for people who build homes.

But most importantly, only lower prices can address one of the major problems of the real estate market: a bloated inventory of unsold homes.

The inventory of existing homes stood at 3.71 million in November 2010, about where it was four years ago, according to the National Association of Realtors. Add to that the 197,000 new homes for sale and you can see just how bloated the inventory of unsold homes has become.

As Bloomberg's Caroline Baum wrote in January: "The demand curve is downward sloping. What that means is demand for any good or service isn't fixed. It depends on the price. A $1,000 cashmere sweater will find a lot more takers when it's marked down to $500 in a post-Christmas sale. In general, the lower the price, the greater the quantity demanded. Hence, a reduction in prices could address this glut."

We need a reduction, not an increase in prices. A return to the historical norm, not to the recent anomaly. This means that state and federal policies which prop up housing prices are discouraging the market from taking the steps necessary to get back on track.

Myth 2: We need a foreclosure moratorium to help those people drowning in debt who have had to default on their mortgages.

Fact 2: Defaulting on a mortgage does not necessarily reflect an inability to pay. The current crisis has produced a new phenomenon: homeowners who default by choice. A moratorium would eliminate the current penalty and thereby encourage more people who are still able to pay to walk away from their obligations.

While some foreclosures are driven by homeowners' economic hardship, there is much evidence to suggest that many other foreclosures are driven by the homeowners' rational economic calculus.

Economists at the Federal Reserve Bank of Boston conducted research on the borrower's choice to default on a mortgage. Their findings, presented at the 2009 Annual Macroeconomic Conference of the National Bureau of Economic Research, revealed "that 'unaffordable' loans, defined as those with high mortgage payments relative to income at origination, are unlikely to be the main reason that borrowers decide to default." This finding begs further inquiry into the more nuanced homeowner motivations behind the decision to default.

Bankers also created incentives for homeowners to strategically default during the housing boom. Popular lending products—such as low or no-down payment loans and interest-only loans—reduced homeowners' equity investments in their loans. These products allowed consumers to accumulate no equity through their monthly payments. While housing prices were rising, these loans performed exceedingly well, as borrowers could either sell or refinance if they were unable or unwilling to make payments. However, when housing prices turned down, high-LTV loans quickly went underwater, leaving homeowners with strong incentives to permit foreclosure.

Furthermore, there is a very close relationship between the timing of the nationwide drop in housing prices and the rise in the foreclosure rate. The chart below comes from a paper on this topic by George Mason University's Todd Zywicki and Gabriel Okloski called "The Housing Market Crash." On this chart we see the striking relationship between the decline in housing prices and the increase in foreclosure rates. It supports the idea of voluntary homeowner default.

The strong correlation between falling prices (which represent a decrease in homeowners' future return on their investment) and foreclosures suggests that homeowners' anticipated future payoffs, and not simply their current ability to pay, is informing the decision to default.  

As Zywicki explains, while we don't know how many foreclosures are being driven by bad economic fortunes and how many are driven by economic opportunism, we do know that basing policy on the idea that everyone is in the former category creates major moral hazard issues for dealing with those in the latter category.

Myth 3: There is a national foreclosure crisis.

Fact 3: It is a national problem, not a national crisis. It is a crisis in only a handful of states.

Right now there are 2,139,672 foreclosure homes for sale in the United States.

Although home prices have fallen precipitously in many areas of the country and foreclosures have risen to all-time highs, the foreclosure problem in the United States affects states disparately.  

Using data from RealtyTrac, the above heat map compares the foreclosure rates across states in January 2011; the darker the state the more foreclosed properties per housing unit. As you can see, foreclosures are clearly concentrated in certain states. To look at this fact differently, the chart below compares those states with the greatest number of new homes entering foreclosure in January with those with the least number. Once again, there is clearly a large amount of variation in the foreclosure problem facing each state.

As  George Mason's Zywicki wrote to me recently, "one reason that the 'crisis' is concentrated in some states but not others is because of local laws and procedures that make borrower default a relatively more attractive option—such as antideficiency laws that act like a get out of jail free card or long, drawn-out foreclosure proceedings that enable a homeowner to live in their house rent-free for a very long period of time without paying. Think of it this way to illustrate—if defaulting on your mortgage meant that you would have your right hand cut off, then I'd guess you'd see a lot fewer defaults. Easy foreclosure rules increase the option value of default and so more borrowers at the margin do it."

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.