Relationship between Foreclosures and House Prices

BusinessWeek Online (Pallavi Gogoi 11/28/2007) reports that traders dealing real estate futures contracts on the Chicago Mercantile Exchange are betting on double-digit declines in nine out of the 10 biggest housing markets in the U. S.

The only exception is Chicago, where prices are still expected to fall by 5.6 percent over the next year.

Robert Shiller, chief economist at MacroMarkets and developer of the Standard & Poor’s/Case-Shiller home price index, said he thinks ordinary homeowners should consider hedging their housing bets.

In theory, a homeowner could buy a futures contract for his city, and then sell it short. If the value of that person’s home fell, he would get an offsetting financial gain from the futures contract.

In practice, housing futures are thinly traded. Some days they don’t sell at all, a spokesman for S&P said.

Meanwhile Shiller is pessimistic about the current housing market. He told analysts that 50 percent declines in home prices were certainly feasible. "I'm not going to forecast that, but I think it's a real possibility," he says.

Empirical evidence has consistently shown that homeowners are hesitant to sell their homes for losses, often leaving their homes on the market for long periods awaiting the “right” price.

According to The Office of Federal Housing Enterprise Oversight (OFHEO) there is a direct relationship between foreclosure activity and changes in home prices. During the housing market boom, foreclosure rates were at very low levels, in large part because financially strapped homeowners could easily sell their homes or refinance their mortgages.

With the significant market deceleration and the more recent tightening of lending policies, those options have become harder to exercise in recent quarters. OFHEO House Price Index (HPI) shows a strong positive correlation between foreclosure filings and price declines is shown across the 50 states and the largest 100 metropolitan areas in the U.S. Using zip-code level foreclosure data, the analysis then looks within several high-foreclosure cities to determine whether prices in neighborhoods with particularly high foreclosure activity show greater price weakness. Although one might expect such neighborhood-level effects to be present, the limited empirical review suggests that price declines have been quite similar for high-foreclosure neighborhoods as compared to other areas.

The causal relationship between home prices and foreclosures is two-directional: high foreclosure activity can both cause and be caused by home price declines. Home price declines can cause foreclosures by decreasing the equity homeowners have in their properties. Mortgagors are much more likely to default on their loans if the current value of their property falls below the outstanding loan balance (i.e., their equity is zero or less). Declines in home prices will increase the frequency with which homeowners find themselves with no equity and thus may be motivated to “walk away” from the property and the mortgage.

Home foreclosures contribute to weakening prices by introducing additional supply to the inventory of unsold homes. Compounding this influence is the fact that the sellers of foreclosed homes, frequently creditors, may be strongly averse to holding onto the property for an extended period of time. As a result, they may be willing to sell for lower prices than resident homeowners.

The upshot of the interrelatedness of foreclosures and house price changes is that the empirical evidence should reveal sharp differences in measured appreciation for states and cities with higher foreclosure rates. Figures 1 and 2 in fact show such differences.

Figure 1 plots recent appreciation rates and foreclosure filings by state since the third quarter of 2006. The bars reflect the relative intensity of foreclosure activity for states, where intensity is defined as the ratio of statewide foreclosure filings to the number of households.(The total number of foreclosure filings includes data from five quarters: 2006 Quarter 3 – 2007 Quarter 3.) The blue squares show house price appreciation between the third quarters of 2006 and 2007. OFHEO’s “purchase-only” price index, which is constructed exclusively with sales price data, is used to estimate price changes.

The graph clearly depicts the negative correlation over the latest year. With few exceptions, states with the lowest appreciation (i.e., greatest depreciation) tended to have the most foreclosure filings. For instance, Nevada had by far the greatest relative foreclosure activity and, at the same time, showed the third largest price decline. By contrast, states with relatively few foreclosure filings, including the Dakotas and Vermont, had relatively strong price growth of between 5 and 6 percent.

Figure 2 plots the same statistics as Figure 1, but does so for the 100 largest cities in the country.As might be expected, the cities with the greatest relative foreclosure activity are largely clustered in California, Nevada, Florida, and the Midwest, where price declines have been substantial. The twelve cities with the lowest foreclosure activity all evidenced four-quarter price increases, the lowest of which was 2.5 percent (i.e., nearly three-quarters of a percentage point above the national average).

Because home price trends can diverge significantly across different neighborhoods in a given metropolitan area, one might expect that the same foreclosure-price association observed in Figures 1 and 2 would be evident for smaller geographic aggregations. The analysis uses zipcode level foreclosure data to determine whether high foreclosure neighborhoods have shown greater price weakness than other areas in the same city. The five metropolitan areas with the greatest relative foreclosure activity since the third quarter of 2007, Detroit, Stockton, Las Vegas, Riverside (California), and Fort Lauderdale, are the focus of the analysis.

RealtyTrac, a private supplier of detailed foreclosure data, provided OFHEO with time series data reporting the number foreclosure filings by zip code since early 2006. These data are used to identify the five zip codes in each metropolitan area with the greatest foreclosure intensity since the third quarter of 2006. The intensity of foreclosures is defined as the ratio of total foreclosure listings to the number of sales in the zip code between 2001 and 2005 This “normalizes” the foreclosure information so that highest foreclosure areas are not simply zip codes with the greatest number of homes. Two indexes are then constructed and compared for each city: one calibrated with the “high foreclosure” zip codes and the other computed using all other zip codes in the metropolitan area.

According to RealtyTrac U.S. foreclosure filings were up 94 percent in October compared with the same month the previous year. The U.S. had one foreclosure filing for every 555 households in October. Foreclosure filings were up in 45 states, year over year, but the filings have declined slightly since they hit a high in August.

The states with the highest foreclosure filing rates in the country last month were in order from the highest: Nevada, California, Florida, Ohio, Georgia, Michigan, Colorado, Arizona, Indiana and Illinois.

The economies of the nation’s largest cities will be hard hit by rising foreclosures and slowing home sales, according to a study by forecasting firm Global Insight Inc., prepared for a coalition of mayors meeting in Detroit.

Another study predicts that the foreclosure crisis will reduce home values by $519 billion in 2008, bringing the total forecast of lost equity for the nation's homeowners to $1.2 trillion. As a result, 524,000 fewer jobs will be created next year with a potential loss of $6.6 billion in tax revenues in 10 key states alone.

Global Inight says the economy will grow at a rate of 1.9 percent in 2008, a full point less than it would have without the foreclosure crisis.

The study also predicts:

Housing starts will continue to decline until the second quarter of 2008, when the annual rate housing starts will be just 800,000, a drop of almost 20 percent from current levels.

Sales of existing homes also will continue to fall by another 10 percent in 2008.