A note: The Mortgage Market Meltdown and House Prices 1

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1 A note: The Mortgage Market Meltdown and House Prices 1 By Chris Mayer, Paul Milstein Professor of Real Estate and Senior Vice Dean, Columbia Business School As of August 8, 2008 This note examines the impact of the recent mortgage market meltdown on the relative cost of owning a home (versus renting) for single family houses in 19 metropolitan areas around the US. I compute this ratio today and compare it to the average ratio over the last 28 years for each metropolitan area separately. The primary analysis uses data from Case Shiller/S&P through May, 2008, the most recently available house price data. The first computation assumes there is a normally functioning mortgage market that is, that mortgage rates are 1.6% above the 10 year Treasury rate as is the average spread over the last 20 years. The second computation shows the impact of the current distressed mortgage market on house prices, where mortgage rates exceed the 10 year Treasury rate by more than 2.4%. This note is preliminary and will be part of a more complete study with the same title that will be available soon. There are several key takeaways: 1) With interest rates so low, house prices are very sensitive to changes in mortgage rates. The increase in mortgage rates over the last year and a half has almost surely had a significant negative effect on house prices. This analysis suggests that the cost of owning a home has increased between and 10 and 20 percent relative to what it would be if the mortgage market was normally functioning (see Table 1). Figure 1 shows that the spread between mortgage rates and the 10 year treasury rate is near its high over the last 20 years and has risen further in early August. This analysis still underestimates the impact of the credit crunch on house prices, as many buyers who would have previously been able to purchase a home are now unable to qualify for a mortgage at any price. 2) The problems in the mortgage market have put the nation s housing in a downward spiral that will be hard to break. Lenders facing losses on their existing mortgage portfolios and the prospect of further deterioration in the housing market have either exited the mortgage market or sharply reduced lending and increased mortgage rates. The rise in mortgage rates, of course, makes it more difficult for existing homeowners with subprime loans to refinance into a lower rate and makes it more expensive for potential new homebuyers to enter the housing market. The resulting foreclosures and falling demand from first time homebuyers puts further downward pressure on house prices, leading to a vicious cycle. 3) While house prices have come down a lot, prices in bubble markets like Miami, Tampa, and Phoenix still have at least percent more to go. The model does not consider Las Vegas 1 Mayer acknowledges the excellent research assistance of Rembrand Koning and Ira Yeung, as well as helpful comments from Charlie Himmelberg and Todd Sinai. 1

2 due to the lack of historical rent data, but house prices in Las Vegas are also likely to continue to fall as well. 4) In this model, house prices have already corrected to where they should based on fundamentals in coastal markets like San Francisco, Boston, and New York. However, deteriorating mortgage markets and economic fundamentals will likely continue to hit these markets hard, leading house prices to keep falling. 5) House prices in hard luck Midwestern markets like Detroit and Cleveland appear inexpensive, but these cities face continued negative economic shocks and extremely high levels of foreclosures and are unlikely to recover anytime soon. 6) Markets in a few places (Texas and the Carolinas) were not hit with the subprime crisis or deteriorating economic fundamentals as much as the rest of the country, but house prices in these markets will likely fall due to increasing mortgage costs. 7) The study does not include condominiums, which are almost surely in worse shape in most parts of the country. Overbuilding of condominiums is a severe problem in many places and in some markets, condo projects are still being finished. As well, the NY market data is not representative of what is happening in the Manhattan market. The analysis The numerical calculations are based on the methodology in the paper: Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions (2005) by Charles Himmelberg, Christopher Mayer, and Todd Sinai and published in the Journal of Economic Perspectives. The paper, data links, and programs are available at I construct a measure for evaluating the cost of home owning that is standard for economists the imputed annual rental cost of owning a home, a variant of the user cost of housing and apply it to 28 years of history across a wide variety of housing markets. This calculation enables me to estimate the time pattern of housing costs within a market. Given the relatively short time series, it is hard to say just how costly a market must become before it is unsustainably expensive or cheap. However, I can determine how expensive a market is currently relative to its own history. The analysis uses the following variables: house prices, rents, property tax rates, personal income tax rates, government interest rates, mortgage rates, expected inflation, loan to value ratio, and a risk adjustment for homeowners as described in that article and summarized below. It is important to understand that these estimates ARE NOT A FORECAST OF WHAT HOUSE PRICES WILL DO, only a rough calculation of what house prices might be if housing and mortgage markets were functioning normally as they have the last 28 years. As noted below, I expect house prices to continue to fall across the country. The following explanations might help interpret what I am doing, in addition to the basic calculations described in the earlier paper. The appendix describes these calculations in more detail. 2

3 a) The analysis uses Case and Shiller/S&P data for house prices that is available through May, These data likely reflect larger house price declines than many homeowners might experience if they were to sell their own house as many of the sales in Case and Shiller are sales by institutions (banks, servicers) of previously foreclosed properties. These foreclosed properties may be of poor quality and this is not captured in the C&S index. As well, institutional sellers may be less patient and willing to sell at lower prices than individual sellers would. b) I assume that borrowers use an 80% Loan to Value ratio to purchase their home and use a socalled conforming mortgage financed by a lender like Fannie Mae or Freddie Mac. c) I also assume that homebuyers would have a normal risk premium for buying a house (that is, that home buyers face the average risk level for housing over the last 28 years). d) I have made two calculations for comparison: i. The first calculation shows how expensive house prices would be (relative to renting) if we had a normally functioning mortgage market. In the last 20 years, 30 year fixed rate mortgages averaged 1.6% above the 10 year treasury rate. With 10 year Treasury rates at about 4% today, this means that mortgage rates would normally be about 5.6% today. Figure 1 reports this mortgage spread over the last 20 years. ii. The second calculation shows how expensive house prices are based on actual mortgage spreads today, which are about 2.4% above the 10 year Treasury rate. As a comparison, a 250,000 mortgage would have monthly payments of $1,435/month using a 5.6% mortgage rate, but those monthly payments would rise to $1,580 using a 6.5% mortgage rate, a 10% rise. This effect alone substantially reduces the demand for housing, even without considering other fundamentals. Table 1 at the back of this note reports the results of my analysis. It reports the ratio of the annual cost of owning with the rental cost. The ratio represents how expensive owner occupied housing is (relative to renting) as of May, 2008 compared to the average cost since Thus a ratio number of 1.1 suggests that housing is 10 percent more expensive relative to its average cost from Similarly, the ratio of 0.9 suggests that owner occupied housing is 10% cheaper than its 28 year average. For comparison with other estimates, Table 2 reports the same analysis using OFHEO data as of the end of Quarter 1, The exclusion of data from April and May in the OFHEO data makes house prices look much more overvalued than in Case and Shiller. However, Case and Shiller reported substantial price declines in April and May. What is missing from this analysis? I think most of the risks are to the downside; that is, house prices are likely to fall further than these calculations suggest. Here are my caveats: 3

4 1) The analysis is missing other problems that many borrowers might face getting a loan today, which all result in further downward pressure on house prices. These non price terms are nearly impossible to include in such a numerical analysis: a. Required downpayments are much higher than in years past. If a borrower does not make a 20% downpayment, fees are much higher than normal. Without at least 20% down it is very hard and expensive to borrow money. b. Borrowers with anything but excellent credit are unlikely to get a mortgage at all, obviously a huge change from years past. This does not just affect subprime borrowers, but also borrowers with any perceived problem in their past credit or just borrowers who live in cities where house prices are falling more rapidly. 2) Homeowners almost surely perceive the risk of owning a home as much higher than in years past (as do investors), suggesting that prices will fall further until deteriorating confidence and the perception of greater risk reverse themselves. 3) House prices exhibit clear momentum and lag changes in economic fundamentals. So continued declines in economic fundamentals and the downward pressure on house prices will not show up in data for several months. (If you agreed to buy a house from me today, we would not close for several months, so the price shows up in the data with a 2 month lag.) 4) Most critically, the recent large losses at Fannie Mae and Freddie Mac could well lead to even larger increases in mortgage rates. This is a serious problem and leads to a vicious cycle. Lenders facing losses on their existing mortgage portfolios and the prospect of further deterioration in the housing market have either exited the mortgage market or sharply reduced lending and increased mortgage rates. The rise in mortgage rates, of course, makes it more difficult for existing homeowners with subprime loans to refinance into a lower rate and makes it more expensive for potential new homebuyers to enter the housing market. The resulting foreclosures and falling demand from first time homebuyers puts further downward pressure on house prices. Government intervention beyond the recent housing bill might well be required to break this cycle. 5) Most forecasts are for continued declines in economic fundamentals and higher unemployment rates, which will surely lead to further declines in demand, at least in the short term. The news is not all bad. Here are a few silver linings: 1) As house prices fall, new buyers start to come into the market. This will eventually help stop the decline. 2) Buyers who purchase today may be getting a good deal in a couple of years. As mortgage markets recover, as they inevitably will, buyers can refinance with a lower rate. This will make their existing home more affordable, but also make housing more affordable for new buyers as well. This will likely lead to a reversal in declines. It is just hard to know when this will happen. 3) These cycles always reverse themselves with enough time. 4

5 Figure 1 Data are current through July, 2008 and are obtained from the Federal Reserve Board. The spread in early August 2008 appears to have widened further with the financial difficulties reported by Fannie Mae and Freddie Mac. 5

6 Table 1 Cost of owning relative to renting using Case&Shiller/S&P house price data as of May, 2008 "Normally" functioning mortgage market Current Mortgage Market ATLANTA BOSTON CHARLOTTE CHICAGO CLEVELAND DC DENVER DETROIT LOS ANGELES MIAMI MINNEAPOLIS NEW YORK PHOENIX SAN DIEGO SAN FRANCISCO TAMPA Note: the fundamentals are updated as of July, 2008, except house prices which are as of May,

7 Table 2 Cost of owning relative to renting using OFHEO house price data as of 1 st Quarter, 2008 "Normally" functioning mortgage market Current Mortgage Market ATLANTA BOSTON CHARLOTTE CHICAGO CLEVELAND DC DENVER DETROIT LOS ANGELES MIAMI MINNEAPOLIS NEW YORK PHOENIX SAN DIEGO SAN FRANCISCO TAMPA

8 Appendix: I have re rerun the user cost model in Himmelberg et. al. (2005) to compute the imputed rent/rent ratio using recent data (OFHEO 2008:Q1, Case and Shiller: 2008: May). I did it two ways. The first approach is exactly the same as in the earlier paper. The second approach uses a higher risk premium as computed below. The UCC= riskfreerate + proptax taxrate*(mortgrate + proptax) + deprec + riskprem expapprec Method 1) For this calculation, the riskprem= 2% as in the previous paper. Method 2) For the new cost of capital model (the model that considers the impact of the recent credit crunch), I did the following: Assume buyers finance their purchase with 80% debt and 20% equity. Using Modigliani and Miller, Riskfreerate + 2% = 80%*mrgrate + 20%*costofequity = 80%*(riskfreerate + mrgspread) + 20%*(riskfreerate + equityspread) Next I solve for the average cost of equity over the last 20 years by using the average mrgrate spread, the 10 year treasury, and the financing assumption. The average mortgage spread over the last 20 years is 160 bp over the 10 year Treasury. Thus the equity spread is 3.59% over treasuries when buying a house with 80% debt. Given Todd Sinai s work on the extent to which owning a house provides a hedge against rent risk, this makes a lot of sense to me. Finally, I re compute the imputed rent/rent index using the new/higher mortgage spread. At the end of the first quarter of 2008 (March 31), that mortgage spread was 2.46%, 86bp above the historical average. Today it is 2.42%. The increase in the mortgage spread without a commensurate increase in the equity spread, causes the overall risk premium of owning to rise from 2.0 to Tables 1 and 2 report the results of this analysis. The first set of columns shows the current user cost using the old method (#1) and second column reports the new method (#2). Table 1 reports results using Case and Shiller/S&P indexes, which are available through May, Table 2 instead uses the OFHEO data thru Q1. The data in Table 2 show the likelihood of much steeper price declines in bubble cities like Miami and Phoenix. However, the Case and Shiller data are more current and reflect large reported price declines in these bubble cities in April and May. In both tables, the cost of housing rises by about 13 28% when we account for the recent mortgage market crisis and the resulting higher mortgage spreads. The largest increases in the annual cost of housing is in the highest historical appreciation markets like New York, San Francisco, and Boston. As noted in the earlier paper, house prices in these markets trade at a large premium to rents and are especially sensitive to economic shocks to mortgage rates. 8