It’s now been two years since Wisconsin and the rest of the United States slipped into the recession. The past year saw inflation-adjusted seasonally adjusted GDP decline by almost 2 percent in the difficult first quarter, start climbing back towards zero in the second quarter, but bounce back into positive growth, up about 0.7 percent during the third quarter of 2009. Official unemployment hit a high of about 10.2 percent, and has declined slightly to 10 as of this writing (although the newer “broad” measures of unemployment that include involuntary part-timers and discouraged workers is currently at 17 percent). But unemployment usually lags GDP in the recovery, and a number of observers, not least Federal Reserve Chairman Ben Bernanke and White House advisor Larry Summers, believe the recession is over.
But the consensus view at the Graaskamp Center for Real Estate is that it’s too soon to be confident we’re in recovery.
Overview
The housing market led us into the “Great Recession” and it will lead us out. In addition to declines in GDP and rising unemployment, our annus horribilis saw a postwar low in housing starts, serious declines in housing prices in Wisconsin and savage falls in some of the coastal markets, rising mortgage defaults and housing foreclosures, falling transactions volume, and sales inventories of new and existing homes larger than any we’ve seen since the second oil price shock of thirty years ago.
But housing prices have started to creep back up, and inventory divided by transaction volume is approaching normal levels. National Association of REALTORS® data on house prices, adjusted for inflation, peaked nationwide in 2005 at about $250,000, saw some of the steepest declines early last year, and as of this writing are bumping along at around $180,000. That bumping is in some sense a good thing, for the last thing we would want to see in the next six months would be house prices shooting back up to their 2005 or 2006 levels. House prices had to come down.
For most of the 1970s and 1980s, as well as the early 1990s, housing prices grew on average about half a percentage point per year over background inflation. But from roughly 1996 to 2006, depending on the data series, house prices grew at 5 percent to 7 percent per year faster than background inflation, which is clearly unsustainable.
House prices are now roughly in line with fundamentals like incomes, interest rates, and rents. A good starting point is income. As Figure 1 shows, for much of the 80s and early 90s house prices were about 3 to 3½ times median household income. During the bubble the ratio peaked at about five, but now we are back in range with historic norms. Other data, not shown, demonstrate that we’re almost back in line with historic norms of price/rent ratios.
But we are concerned that just as house prices overshot going up, they could overshoot going down. The big risk in the housing market now comes from foreclosures, about which more below. But first, let’s take a quick look at some of our local markets.
How’s Wisconsin doing?
Wisconsin’s economy and housing markets have not escaped the pain, but as we noted last year so far we’ve done somewhat better than the nation as a whole. The next figure shows you that most of our markets had smaller percentage declines over the past two years than we’ve seen in the national averages. When the U.S. market dove in 2007-2008, Madison took a much smaller hit and now we have our first metropolitan area where median house prices exceed the national. Milwaukee, our biggest metro area, followed a profile very much like the national average with a steep decline but (so far) a better bounce back. Other data, not shown, indicate that it was Milwaukee County that had the steepest decline and the biggest snap back; Washington, Ozaukee and Waukesha counties saw slower declines and less of a recovery, so far. Some of our smaller metro areas like Eau Claire and Green Bay, while not unaffected, have seen less of a boom and bust cycle than the rest of the country, much less the highly volatile markets in states like California and Florida.
Will we hit the target, or will we overshoot?
We’ve already noted the “green shoots” of stabilizing prices with so far some modest increases; and declining inventory. But mortgage delinquencies, defaults and foreclosures are still high. For example, nationally almost 4 percent of outstanding mortgages are 90 days past due, according to our friends at the Mortgage Bankers Association; almost a percent and a half of outstanding mortgages enter foreclosure each quarter. Why are defaults and foreclosures so stubborn this time around?
There are two theories about why people default on mortgages. Pure “finance theory” says that when the value of the mortgage exceeds the value of the house, people will default. Empirical research tells us these theories are not mutually exclusive. Both present values, and debt service burdens matter. Some borrowers will default even when house values exceed mortgage values, if their cash flow is sufficiently impaired. But if the house is valuable they will often take extraordinary measures to make payments. Some will default when they go under water, even if they can readily make payments. But many won’t. Default probabilities rise a lot when both conditions are met. And, we’re there. We’ve had 10 percent unemployment before. We’ve had mortgages underwater before. But we’ve never had 25 percent of mortgages underwater (50 to 60 percent in the worst hit states) with 10 percent unemployment before. That’s why we’ve shifted from a subprime crisis to a crisis in prime mortgages that are underwater with unemployed or underemployed mortgagors.
Current government programs, like the Home Affordable Modification Program (HAMP) or the earlier Hope for Homeowners are ineffective. There are many problems with HAMP’s design and execution, but there’s no way an improved HAMP can solve this problem. Why? Because the philosophy behind HAMP is to get employed people out of “stupid mortgages” (bad subprime designs) into a “better” mortgage; and many of the UU “unemployed, underwater” defaults are taking place with perfectly fine plain vanilla mortgages in place. Furthermore, unemployed are effectively excluded from HAMP because of the income tests. What can be done? Some housing economists across academia and government are coalescing around plans to provide temporary mortgage support to the unemployed. We’ve offered the Wisconsin Foreclosure and Unemployment Relief Plan (WI-FUR); and colleagues at the Boston Fed have offered a complementary plan. WI-FUR focuses on a voucher; the Boston Fed plans focus on a loan.
About 36 percent of the unemployed currently receive unemployment insurance. For about half the mortgagees in the country an unemployment check would be more or less completely eaten up by a mortgage payment. WI-FUR recommends a temporary supplement or housing voucher to unemployment insurance to help cover mortgage payments.
There are many variations on the theme, and some decisions are more political than economic. Should WI-FUR vouchers be given only to unemployed mortgagees, or to all unemployed households? After all, renters are under stress too. Should we cover only those receiving unemployment insurance, or seek out those who’ve lost their job in the past year but aren’t collecting? How big should the payment be? When should it be “sunset?” The costs vary with design parameters, but can range $10 to 40 billion/year, depending on breadth of coverage, details of payment, and so on. WI-FUR could be fully funded by taking money from HAMP (currently $75 billion), or other ineffective programs.
How is it going? Through spring and summer 2009, we received little response. This fall some momentum has built, as politicians and bureaucrats begin to realize the shifting nature of the foreclosure problem, how strong housing’s spillovers to the rest of the economy can be, and the fact that HAMP is not working.
Finally, as of this writing there is some movement; several legislators are talking to us seriously and legislation is being drafted. But the nation’s economy is still behind the curve. Time is of the essence; if we see a winter spike in foreclosures, we fear an overshoot that drives house prices down further, pulling consumption, employment, and commercial real estate along with it.
What’s the outlook for 2010 and beyond?
The good news is that housing prices in Wisconsin, as elsewhere, have stopped their decline and appear to have stabilized. House prices are back in line with fundamentals, broadly speaking. We have done better than most states, though we’ve certainly had pockets of pain. The bad news is that a significant risk remains of downward overshooting, if foreclosures indeed continue to spike given the toxic pairing of high unemployment and large fractions of mortgages under water. There are policy prescriptions out there, but the politics can be difficult.
The worst may be yet to come for commercial real estate, in Wisconsin as well as the rest of the country. Nationally we expect to see continued weakness in the commercial real estate markets, following the downturn in housing and our current weak retail and consumer durables markets. Once again our generally conservative approach to development and real estate lending is paying off with more modest losses in this area than national averages, but we aren’t immune from the pain.
We have a lot on our plate for the long run. We still have no long run plan for Fannie and Freddie. Will continued low mortgage rates and firmer prices attract more buyers back into the market, in a sustainable way? Most importantly, will we honestly rethink and rectify the moral hazard and incentive issues that are now rife throughout our system? As of this writing we face some real battles over issues like the Fed’s role in broader financial regulation, and whether we will restrict the menu of mortgage offerings on offer to typical buyers. Whatever the details, we need to find some ways to give all participants in the modern unbundled real estate transaction some skin in the game.
I’m still bullish on the American economy and real estate markets in the long run. Maybe a good place to end this outlook is with a reading recommendation. Pick up a copy of Carmen Reinhart and Ken Rogoff’s masterful This Time is Different: Eight Centuries of Financial Folly. Read it. Know it. Live it. We’ll get through this crisis, as we have the others. We’ll have crises in the future, as we have before. But there’s no reason we can’t do a much better job next time around!
Stephen Malpezzi is the Academic Director of the James A. Graaskamp Center for Real Estate at the Wisconsin School of Business.