Wednesday, February 22, 2012

Why Wasn't the Risk of a Housing Price Decline Taken Into Account? ERP #2

This is the second of four posts based on figures from the 2012 Economic Report of the President. For an overview and the first post, start here.

When I give talks about the causes of the recession, people often shake their heads in disbelief at the thought that few investors were taking the risk of a housing price decline into account. I think this disbelief is a case of 20:20 hindsight. Investors didn't take the risk of a national housing price decline into account  because they hadn't seen anything like it before. Here's a figure showing comparing the housing price declines nationwide during the Great Depression,  and then comparisons with more local housing price declines in Boston in 1989 and in California in 1990. Sure, investors knew that housing prices could nosedive in a local market, and some were even braced for the possibility of a modest housing price decline nationwide. But for the country as a whole, predicting in 2005 or 2006 that national housing prices would drop much farther and faster than during the Great Depression would have been a prediction outside all historical experience. I admire the clairvoyance of the few who truly saw it coming, but I can't reasonably blame those who didn't.

The evidence does offer some hints that the decline in U.S. housing prices may be just about over. For example, one measure of a price bubble is to look at the ratio of housing prices to rents. When this ratio rises sharply, then it may be a signal that prices are getting out of line. But that ratio has now fallen back to pre-crisis levels. Similarly, the ratio of mortgage value per home-owning household has trended up over time, as the economy has grown. During the housing price bubble, that trend launched like a rocket, but now it has been flat for a few years, and is not too far out of line with the longer-term trend.

At the most basic level, the national average of actual housing prices does seem to have levelled out since early 2009. Indeed, futures markets that were predicting a continued drop in housing prices as of January 2009 have seen housing prices hold up better than expected at that time.