Rising Mortgage Defaults Put Continuing Pressure on Home Prices

Banks don’t like to own real estate, especially not when they’re fighting for survival. So when they acquire homes through the foreclosure process, they usually sell them fast.

The key to a quick sale is to set a low asking price, which is why foreclosed homes are usually the cheapest ones on the market. There is only so much demand for homes, so when banks are sitting on a large stock of foreclosed homes, they quickly come to dominate the supply side of the market.

That’s a pretty good description of what’s going on in the Bay Area right now. While fewer than 1% of Bay Area homeowners defaulted on their loans during the first quarter of 2009, more than half of the homes that were resold during the same period had been foreclosed on during the previous year.

Take a look at the chart, below, which shows the recent history of mortgage defaults in the Bay Area.

A default is said to occur when a borrower misses a scheduled loan payment. When that happens, the lender may issue a Notice of Default, which is the first step in the foreclosure process. According to Dataquick (which provided the data for the chart), 80% of borrowers who default on their loans ultimately lose their homes to foreclosure.

After falling for six months (due to changes in California law and a temporary moratorium on foreclosures), default activity resumed its upward trend in the first quarter of 2009. Lenders issued a record 19,438 default notices to Bay Area homeowners.

There is anecdotal evidence that housing demand is recovering in the Bay Area, perhaps due to the recent performance of the stock market. On the other hand, unemployment is still rising sharply, so I wouldn't be surprised if the recent surge of optimism turns out to be a flash in the pan. In that event, prices will be mainly driven by supply-side factors. Considering the recent trend in mortgage defaults, Bay Are home prices are likely to be under pressure for some time to come.

(In case you're curious, default notices were issued on roughly 0.2% of San Francisco homes during the first quarter. Meanwhile, previously foreclosed homes accounted for roughly 12% of resale activity.)

Apartment Rents Trending Down in Bay Area

Bay Area apartment rents have been falling for the last six months, and are now about 4% below their Q3 2008 peak. That's according to Novato apartment research firm Real Facts, via the San Francisco Chronicle. Real Facts surveys apartment complexes with 50 or more units, and includes everything from studios to four-bedroom apartments in their numbers. Their estimate for the average rent in the nine-county Bay Area was $1,556 for the first quarter of 2009. That's 1.4% lower than their estimate for the first quarter of 2008, and represents the first year-on-year rent decrease in the last four years. Rents in the City were essentially flat on a year-on-year basis -- Real Facts estimates that they fell 0.1%.

My guess is that apartment rents will continue falling for the next several months. The Bay Area is still losing jobs at a rapid pace, and increasing numbers of foreclosed homes are being bought by investors and converted to rentals.

Inventory of Unsold Homes Suggests that San Francisco Market Will Remain Weak

The inventory of unsold homes has historically been a good predicter of near term housing market performance. I addressed this topic in an earlier blog posting. For California as a whole, the historical relationship seems to have broken down recently. The breakdown probably resulted from banks dumping foreclosed homes onto the market. (I'll address this shortly, in another blog posting.) San Francisco has had relatively few foreclosures, however, so the historical relationship has held up pretty well.

Take a look at the chart, below, which compares the beginning-of-year inventory of unsold homes in San Francisco to the change in median price during that same year.

Inventory is stated as the number of months required to sell the current stock of for-sale housing, assuming that selling activity remains at current levels. I plotted it using an inverted scale in order to highlight the correlation with price changes.

Real estate practitioners often assert that the housing market is "in balance" when there is six months worth of inventory. The chart suggests, however, that the equilibrium level of inventory for San Francisco may be less than six months. Since 1997 (the beginning of my data series), the average inventory in San Francisco has been only 3.6 months, compared to 5.0 months for California as a whole. And although San Francisco began 2008 with just over six months worth of inventory, prices fell almost 20% during the year.

The San Francisco market had 5.8 months worth of inventory at the beginning 2009. That represents only a modest improvement over 2008. If I had to make a prediction based on this indicator alone, I'd say that 2009 is shaping up to be another weak year for the San Francisco housing market.

Unemployment Still Increasing Sharply

The national unemployment rate reached 8.5% in March. That's almost a full percentage point higher than the January reading of 7.6%. Ben Bernanke said at the time that unemployment would climb to 8.0% "for sure." Presumably, he felt that a higher figure would have sounded outlandish. In retrospect, he was being overly cautious.

The Bay Area unemployment rate has been climbing rapidly as well. It hit 9.9% in March, compared to 8.8% in January and only 5.1% in March of 2008.

It's hard to see home prices stabilizing when the job market is deteriorating so rapidly.

Some Perspective on Housing Vacancy Rates

The cover story of last weekend's edition of USA Today was entitled, Open House Anyone? One in Nine Homes Sit Empty. The nation does indeed have a lot of vacant homes, but it's not as bad as the title suggests. Even in 'normal' years, there are plenty of vacant homes. Take a look at the chart, below, which shows historical vacancy rates for the United States and the western region.

The blue line shows the vacancy rate for the US, and the purple line shows the vacancy rate for the western region. The numbers (and the definition of 'western region') come from the Census Bureau. The figures in the USA Today article excluded vacant homes that are used seasonally (such as beach houses) but the chart includes all vacant homes.

As the article suggests, the current vacancy rate is unusually large, at around 14.5% (which is actually closer to 1 in 7). But even in normal years, plenty of homes sit empty. From 1987 to 2000, the vacancy rate was fairly stable at around 11.5%. That's equivalent to 1 in 8.7, which is still higher than the ratio that USA Today was hyping in its article.

Setting hype aside, a three percentage-point increase in the vacancy rate means that almost 4 million units were added to the pool of vacant homes between 2000 and 2008. To put that in perspective, the national housing stock increased by roughly 11 million units over the same eight-year period. In other words, roughly 1/3 of the new homes that were built since 2000 are essentially superfluous.

Another way to get a handle on the vacancy rate is to consider the rate of new household formation. Lately, it's been running at around 1.5 million per year. Not all of the 4 million additional vacant homes are available for new households (roughly half of them are second homes or vacation homes), but there still appears to be more than a year's supply of excess vacant homes in the nation. Home prices will remain under pressure (at a national level) until those excess units have been absorbed.

While we're on the topic, I thought it would be interesting to plot the national vacancy rate on the same chart as the Case Shiller composite home price index.

It's no coincidence that the vacancy rate started rising at the same time as the housing bubble began inflating. Rapid price increases contributed directly to increasing demand for homes -- that's more or less the definition of a bubble. If the price increases had been driven by true demand for housing, we wouldn't have so many empty homes now.

Credit Spread Model Predicts Massive Job Losses

I find a lot of interesting ideas in the Wall Street Journal's "Heard on the Street" column, which is published daily on the back of the Money & Investing section. Today's lead article, Giving Corporate Credit Its Due, describes an economic model from a forthcoming research article by Simon Gilchrist, Vladimir Yankov, and Egon Zakrajsek. The model uses corporate credit spreads to forecast job market activity. Take a look at the chart, below, which compares nationwide hiring activity with the results of the authors' model.

The shaded green line shows the year-over-year percentage change in nonfarm payrolls. The blue line shows the corresponding prediction from the authors' model. Evidently, the model fits the historical data rather well.

There's a big difference between explaining the past and predicting the future. In other words, there's no guarantee that the model's predictions will be accurate. So much for the disclaimers. The current prediction is bleak. It calls for nonfarm payrolls to fall by 7.5% during calendar year 2009. Even if you assume that some of those job losses have already turned up in the official statistics, that would still take the unemployment rate well into double digits by the end of the year.

Reflecting on one of my earlier blog postings about jobs and home prices, this new model suggests that home prices will remain soft at least through the end of the year.

(By the way, a 'credit spread' is the difference between two interest rates, i.e., the rate that a corporate borrower pays and the rate that the government pays. Government debt is assumed to be free of default risk, while corporate debt exposes the holder to the possibility of not being repaid. The difference between the two interest rates encapsulates the bond market's estimation of the likelihood that the corporate borrower will default.)

Benchmarking the Financial Crisis - Part 2

In December of last year, Carmen Reinhart and Kenneth Rogoff published an article comparing the current financial crisis to historical financial crises from around the world. I summarized their findings in a previous blog entry. Yesterday, Barry Eichengreen and Kevin O'Rourke published a similar article comparing the current crisis to the Great Depression. Such comparisons have become commonplace. They've generally found that the current crisis has been mild compared to the Great Depression...in the United States. Eichengreen and O'Rourke depart from the usual analysis by comparing the two crises at a global level. Their findings are sobering.

Using the peak in global industrial production (i.e., April 2008) as a starting point, Eichengreen and O'Rourke found that:

• Global industrial production has fallen by over 10%. Thus far, it has more or less followed the same trajectory as in the Great Depression.
• Global stock prices have fallen by 50%. In contrast, stock prices had fallen by only about 10% in the first twelve months following the 1929 peak in industrial production.
• Global trade has fallen by over 15%. Again, the rate of contraction is much greater than in the first twelve months of the Great Depression, when trade fell by only about 5%.

The authors point out that global policy responses have thus far been much more aggressive (and appropriate) than in the Great Depression. Evidently policy makers have learned from past mistakes. Let's hope that we get better results than the last time.