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Housing's Second Leg Down

Home prices have fallen 34% from their peak in the middle of 2006, according to Standard & Poor's HPI data -- but is that enough? Or is there further to go? How much further could we fall? It's worth noting that the question of what happens next with home prices isn't merely an academic exercise. With CoreLogic estimating that more than 11.2 million U.S. borrowers were underwater on their mortgages at the end of the first quarter, the direction of U.S. home price trends over the next few years will have a direct impact on bank and related financial balance sheets the world over. With that in mind, take a look at chart 1, below. It shows data from the Standard & Poor's/Case-Shiller monthly housing price index, using the 10-city index (unadjusted) from July 2006 until today. HPI shorter You can see the downward leg in housing prices, followed by an apparent stabilization starting in April of last year. This chart largely captures the frame of reference used by most in the financial press. And if this is your window frame, you'd think housing has stabilized as of late -- which is precisely what much of the current administration and the financial press has been suggesting. But there's a problem here. The frame is too narrow to give proper context. So let's take the frame all the way out to 1987, and see what we get (in chart 2, below). HPI longer The world here starts to look very different, indeed, and shows a run-up in housing prices that began in mid to late-1997, and ran all the way through the middle of 2006 -- which is, of course, precisely what took place. Between 1997 and 2006, U.S. home prices averaged growth of 11.35% annually. The same chart also shows that for the decade prior to 1997, housing gains were typically far more modest -- an average of 2.4% per year, in fact, using the same S&P data. And the so-called housing recovery that looked so great earlier? From this vantage point, it appears more like what it really is: a ledge. Home prices could continue to float along sideways for years from this point, as some of my colleagues have suggested earlier. But I tend to think we have another 8-10% to fall. Here's why. Across the entire S&P/Case-Shiller dataset, more than 23 years worth of data, average home price appreciation is 4.5% per year--and that average includes the gonzo 1997-2006 years, which effectively skew the long-term trend upward. Nonetheless, if you apply the generous 4.5% trend across the data you find that home prices still sit well above what the trend would project. For example, applying 4.5% trend growth starting in 1999 (when the growth rate began to transition towards parabolic) suggests that current home price levels through May 2010 are still 8.5% above where they would otherwise be expected to be. Apply it all the way back to 1997, and home prices are still 4.3% too rich versus the trend. I get the feeling that few truly understand that despite the severe crash in home prices observed thus far, we yet remain above the long-term trend. That's how severe the price bubble really was. We could realistically have further than 8% to fall, as well. Apply a more realistic trend value of 3.5% per year (countering the disproportionate effects of the boom years), for example, and U.S. home prices could be considered 15.6% to nearly 19% too rich. CoreLogic's negative equity report estimates that roughly 2.4 million households were nearly underwater by the end of the first quarter (defined as within 5% of being in a negative equity position). Even if home prices simply revert to a 4.5% growth trend dating back to 1997, most of these households would join the ranks of the underwater. While it's been discussed very little thus far -- because, let's face it, how gloomy do we really want things after being beat sideways for three years now? -- there is even some possibility that housing prices could over correct and head below the trend, thanks to the effect of stimulus demand hangover and a burgeoning supply of distressed real estate still waiting to enter the re-sale market. In other words, U.S. housing could be setting itself up to get really cheap (and at that point, you'll see me transform into a huge housing bull, BTW). Through the end of July, 2.6 million mortgage loans were 90+ days delinquent and not yet in foreclosure, according to Lender Processing Services; do you honestly believe that these problem loans and the houses tied to them are simply going to go away without affecting the overall market? Of course not. Right now, housing isn't particularly demand driven; it's supply driven. And as I wrote in March, right now we face a supply problem of epic proportion. It's a problem we have yet to address, and home prices eventually must reflect that. Paul Jackson is the editor of HousingWire Magazine and HousingWire.com. Follow him on Twitter: @pjackson

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