A new working paper from the Federal Housing Finance Agency published today proposes a new way to measure how far home prices could fall in a worst-case scenario.

So what's a worst-case scenerio? By way of comparison, the new FHFA measurement would envision a scenerio similiar to the repeat of the 2008 housing crash, which is when the Case-Shiller index dropped to an all-time low.

The paper, authored by two current and one former FHFA economists, offers a theoretically based statistical technique to identify that conservative "lower bound" for house prices that could be used as an indicator for the severity of future downturns.

 “Leveraging a model based upon consumer and investor incentives, we are able to explain the depth of housing market downturns at both the national and state level over a variety of market environments,” they state. “This approach performs well in several historical back tests and has strong out-of-sample predictive ability. When back-tested, our estimation approach does not understate house price declines in any state over the 1987 to 2001 housing cycle and only understates declines in three states during the most recent financial crisis.”

The credit risk and required capital associated with mortgage assets is often estimated through stress testing where the house price path is an important determinant of the severity of the stress test, the authors state in their summary. Specifically, some important factors in the extent of credit-related losses are how far house prices are above long-term trend and the extent to which they can fall below trend.

“Leveraging a model based upon consumer and investor incentives, we are able to explain the depth of housing market downturns at both the national and state level over a variety of market environments,” they write. “In brief, as house prices fall below trend, housing becomes an increasingly attractive investment—its empirically documented, mean-reverting nature may engender higher expected returns. Investors and consumers are incented to enter the market, slowly reaching a critical mass of additional demand sufficient to cause house prices to rebound.”

Alex Bogin and William Doerner, both senior economists with FHFA, and Stephen Bruestle, a lecturer and former FHFA employee, say that the approach they propose performs well in several historical back tests and has strong out-of-sample predictive ability.

“In an in-sample back-test using data from 1987 to 2001, our estimation approach does not understate any state-level house price declines. In an out-of-sample back test using data from the most recent financial crisis, our estimation approach only understates actual severity in three states,” they write.

The paper has been presented at the Federal Reserve Bank of Richmond and at the American Real Estate Society annual meeting.

It will also be presented soon at the American Real Estate and Urban Economics Association national conference.

The paper can be read here.