Dueling Home-Price Indexes Illustrate Debate over Home Prices

WASHINGTON, JUNE 26, 2008--In the first quarter of 2008, almost 2.5 percent of all mortgages were in foreclosure--the highest level on record. In introducing a June 17 conference at AEI, Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the Institute, noted that many concerns are associated with rising foreclosure rates, chief among them the worry that vacant homes will drag down the value of nearby properties and will have a significant negative impact on housing prices. A decline in housing values might cause consumer spending to fall and depress economic growth nationally. Wallison explained that proposed legislation would address these policy issues by assisting homeowners who are having difficulty meeting their mortgage obligations.

Yet, few studies have evaluated the empirical relationship between foreclosure rates and housing prices, leading to uncertainty about whether or not the fears of house price depreciation and reduced consumer spending are rational. At the June 17 event, visiting scholar Charles W. Calomiris presented a paper--coauthored by Stanley D. Longhofer and William Miles of Wichita State University--that used state-level data to evaluate the impact of foreclosures on house prices. He presented three main conclusions:

• The Case-Shiller Index is not the best source for house-price data for purposes of assessing the macroeconomic consequences of foreclosure-induced house-price declines. The Case-Shiller index is a popular house-price index among economic forecasters and the media, but Calomiris said that its house prices are too negatively skewed. He explained that the index does not give enough weight to young, middle-income homeowners, whose consumption is most responsive to changes in housing wealth since they usually have a significant percentage of their assets invested in their home and are thus most vulnerable to changes in house prices. Furthermore, the index has "poor and biased regional coverage" and does not have comprehensive state-level data. Calomiris recommended using the OFHEO index instead.
• Any wealth effects from falling house prices will be minimal. Calomiris explained that consumers theoretically have two separate bank accounts: "one that finances your housing consumption--that's called your house--the other that finances your other consumption--that's all your other wealth." There is no general consumption effect from housing wealth; rather, housing wealth only affects consumption for borrowers that need to use their house to be able to borrow against the future, and in theory, these effects should be smaller than the effects of other wealth on consumption.
• Foreclosures will have a minimal impact on housing prices. After careful analysis of the data, Calomiris forecasted that "the OFHEO price index [will] not decline by more than 4.5 percent from its peak in the second quarter of 2007 to the end of 2009. . . . Over a two and a half year period, [that is] not a large overall cumulative decline."

Jay Brinkmann of the Mortgage Bankers Association endorsed the results of Calomiris's study. In particular, he praised the authors' decision to cull their data from OFHEO rather than Case-Shiller, which allowed for the use of state-level data. Arguing for analysis of state-by-state variation, Brinkmann noted that a quarter of all loans outstanding are in four states--California, Florida, Nevada, and Arizona--which "represented 42 percent of all the foreclosures starting in the first quarter, and, in addition, they represented 78 percent of the increase in foreclosures." He said that Case-Shiller suffers from "a disproportionate counting of problem markets" and that "markets where we're seeing more stable price behavior simply aren't represented."

Mark Zandi of Moody's Economy.com sharply disagreed, contending that the Case-Shiller index is a better measure of house prices. He pointed out that the Case-Shiller index has a greater negative correlation with mortgage default data over the past several years than the OFHEO index does. Moreover, Zandi reminded Calomiris that the choice between the two indexes is not merely an "academic argument": small banks and thrifts gauge their reserve requirements based on price projections from various indexes. Institutions using the OFHEO index will "reserve a lot less than a bank that's reserving against the Case-Shiller index," which Zandi cited as a cause for significant concern.

Zandi also took issue with Calomiris's mild forecast of future house-price declines. He estimated, based on the large decline measured by the Case-Shiller index, that in the first quarter of 2008, about 8.5 million homeowners were in negative equity positions, which means that 16–17 percent of all homeowners were "underwater." As housing prices decline in coming months--Zandi predicted a 25 percent decrease based on Case-Shiller data--the percentage of troubled homeowners will rise dramatically. Zandi concluded that "the foreclosure problem is in full swing. It's nationwide. I don't believe it's five states--it's coast-to-coast. I think it's a mistake to believe that this isn't going to be a serious macroeconomic issue."

--KAREN DUBAS

For video, audio, and more information about this report, visit www.aei.org/event1741/.

AEI has sponsored extensive research on the housing crisis. Two recent conferences covered the deflating housing and mortgage bubble and the credit crisis. A recent article by Desmond Lachman offers a more pessimistic view on the housing market than Calomiris's.

For media inquiries, contact Véronique Rodman at 202.862.4870 or vrodman@aei.org. 

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