House Prices Must Return to Trend Levels to Stabilize Market

RISMEDIA, Dec. 4, 2008-With new data coming out each week lamenting plummeting house prices and some policy makers advocating price supports in the housing market, a new report from the Center for Economic and Policy Research (CEPR) offers a straightforward solution to the turmoil in the housing market: let the prices fall.

The report, “The Key to Stabilizing House Prices: Bring Them Down,” notes that prices are still hugely out of line with trend levels in bubble markets and calls for Fannie Mae and Freddie Mac to restrict the buying of mortgages in these areas. This would lead to fewer loans being issued in these markets and prices would quickly adjust to normal levels.

“Most policy analysts failed the public by missing the housing bubble,” said report author and CEPR Co-Director Dean Baker. “By simply limiting the flow of capital into bubble-inflated markets, the GSEs have the opportunity to bring stability back to the housing market by helping prices return to trend levels.”

The report, which draws on data from the Case- Shiller Index, emphasizes that house prices used in mortgage appraisals should be based on rental values to avoid over-valuation. The fact that real house prices exploded by 80% from 1996 to 2006 while rents increased by only 4% over the same time period points to a degree of speculation and the fact that prices still have further to fall before the bubble deflates.

If Fannie and Freddie no longer supported the purchases of homes at bubble-inflated prices, there would be a quick price decline of 20 to 30% in the most over-valued markets. After this drop, homebuyers would be less fearful of further price declines, both boosting demand and reducing vacancy rates. At the same time, the consequent flow of loans into non-bubble markets would help prevent a downward price spiral in these areas and avert the risk of overshooting on the negative side.

“A rapid return to trend levels is significant for homeowners in that it gives them a sense of how their home equity figures into their real wealth and how they have to adjust their consumption and saving decisions,” said Baker. “This is even more important for the huge cohort of baby boomers rapidly approaching retirement who may find that they have little or no wealth to support them in retirement beyond Social Security.”

For those faced with foreclosure due in part to falling home prices, the best solution is one that amends the rules on foreclose to give homeowners the right to rent their home at the market rate. This would have the dual effect of keeping families in their houses and give bankers an incentive to renegotiate terms by making foreclosure an even less attractive option.

The full report can be found on the CEPR website by clicking here.