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What Happens To Banks When House Prices Fall?

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The recent rapid appreciation of house prices in many U.S. markets has prompted concern over

the possible effects of a sharp decline in prices, especially for commercial banks and other real

estate lenders. This article examines regional real estate booms and busts in the 1980s and 1990s:

Only about half of state house price booms were followed by a severe decline in prices, but large

declines occurred in several states that did not have a prior boom. Banks in states that had large

house price declines experienced high loan default rates and, thus, low profit and high failure rates.

Although U.S. banks may have become more exposed to residential real estate recently, they appear

less vulnerable to a decline in house prices than banks in states with large price declines in the

earlier period. (JEL G210, R110, R310)

Federal Reserve Bank of St. Louis Review, September/October 2006, 88(5), pp. 413-29.

.................

CONCLUSION

The rapid increase in U.S. house prices since2000 has prompted concerns about the possible effects of a sharp decline in house prices on financial institutions and macroeconomic activity. Evidence from other countries suggests that declining house prices, especially when pre-ceded by a period of rapid house price appreciation, can have a marked contractionary impacton macroeconomic activity. This article looks to the experiences of U.S. states for evidence about house price booms and busts. This review finds that house price booms have not always led to busts and that busts do not always follow booms. Sharp declines in nominal house prices in farm and manufacturing states in the early 1980s, and in energy-producing states in the mid-1980s,were not generally preceded by periods of rapid house price appreciation. The large declines in house prices experienced in New England states, California, and Hawaii in the late 1980s and early1990s, however, were preceded by extended periods of rapid growth in house prices relative to personal income.

Banking conditions deteriorated markedly in all states that experienced a large decline in nominal house prices during the 1980s or 1990s.Within a few quarters of the start of a decline, banks experienced increased loan defaults and falling income. Several states that had large declines in real estate prices also witnessed increases in bank failures, as well as more severe declines in economic activity than did the United States as a whole. Additional research is required, however, to determine whether either the decline in real estate prices or the deterioration of banking conditions caused state income growth to lag the national average.

U.S. banks, as a whole, have become increasingly exposed to residential real estate since 2000,as reflected in increases in their holding of real estate loans and securities and in the amount of available home equity lines of credit as a percent-age of total bank assets. Bank capital has also increased, however, which makes the increase in residential real estate exposure less worrisome than it would otherwise be. Further, a portion of the residential real estate loans and securities held by banks are guaranteed by third parties, and many banks purchase only highly rated securities that have little credit risk.

Although they have become more exposed to residential real estate since 2000, U.S. banks as a whole appear considerably less vulnerable to a decline in residential real estate prices than were banks located in states that experienced large house price declines in the late 1980s and early 1990s. Further, the proliferation of interstate branching that has occurred since 1997 suggests that, today, banks in general are probably less vulnerable to local real estate shocks than in the late 1980s and early 1990s.

In sum, U.S. banks seem well positioned to withstand a modest decline in house prices, especially a localized decline. Still, empirical evidence from the United States and other countries indicates that declines in housing wealth can have severe macroeconomic repercussions, especially if banking system capital does become impaired.

An interesting report just before it all started.

Even the people in charge of the system seem to be deluded that the banks only bought "highly rated securities"......

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http://www.fdic.gov/bank/analytical/fyi/2005/050205fyi.html

May 2, 2005

Summary

In February 2005, the FDIC released an FYI report entitled "U.S. Home Prices: Does Bust Always Follow Boom?" The article examined the historical pattern of home price booms and busts for U.S. metropolitan areas. This issue of FYI updates the home price analysis from the previous article, using recently released 2004 data for the house price index (HPI) published by the Office of Federal Housing Enterprise Oversight (OFHEO). Based on this index, U.S. average home prices rose by almost 11 percent in 2004, up from 7 percent in 2002 and 2003. Moreover, the number of boom markets according to our definitions increased by 72 percent last year, and now includes some 55 metropolitan areas.

The broadening of the U.S. housing boom during 2004 may imply a growing role for national factors–including the availability, price, and terms of mortgage credit–in explaining home price trends. To the extent that credit conditions are in fact driving home price trends, the implication would be that a reversal in mortgage market conditions could contribute to an end of the housing boom. While history clearly shows that housing booms don’t last forever, the manner in which they end matters for mortgage lenders and borrowers alike.

Background

Our February 2005 FYI report examined the historical pattern of home price booms and busts for U.S. metropolitan areas from 1978 through 2003. It defined a “boom” market as one in which inflation-adjusted prices rose by at least 30 percent in a three-year period. Based on this definition, some 63 cities had experienced a boom at some point in the last 30 years, and 33 cities were experiencing a boom as of the end of 2003. The report also defined metro-area housing “busts” as markets in which home prices had declined by at least 15 percent (in nominal terms) over a five-year span. While 21 housing busts have occurred since 1978 under this definition, only nine of them have occurred on the heels of a housing boom.

One conclusion of this study was that a housing boom does not necessarily lead to a housing bust. In fact, boom was found to lead to bust in only 17 percent of all cases prior to 1998. Moreover, when busts occurred they were typically preceded by significant distress in the local economy. The most common way for a housing boom to resolve itself was through a period of price stagnation that allowed local economic fundamentals to catch up with high home prices.In the end, however, the paper suggested the applicability of this historical experience to the current housing boom remains uncertain. The expansion of subprime and high loan-to-value mortgages, along with growing use of home equity lines of credit, could change the dynamics of home prices in future cycles.

This issue of FYI updates the home price analysis from the previous article, using recently released 2004 data for the HPI published by OFHEO.

Home Price Developments in 2004

Based on the OFHEO house price index, U.S. average home prices rose by almost 11 percent in 2004. This was the most pronounced gain in nominal home prices since 1979 and was a substantially higher rate of appreciation than the 7 percent gains in both 2002 and 2003. Adjusted for inflation, the price of the average home in the OFHEO sample increased by 8 percent–the fastest pace recorded in 30 years.

The acceleration in home prices last year appears to have been greater than the improvement in underlying economic fundamentals would have suggested. Fundamental economic factors, such as rental rates and personal income, typically help to determine home price trends. Last year, home prices rose 11 percent, but rents only increased by 2.7 percent nationwide. In 2003, the 7 percent gain in home prices also outstripped a 2.4 percent gain in rents.1

As for personal income, it grew 5.8 percent in 2004 and 4.2 percent in 2003. While stronger than the pace of rent growth, this was still far less than the pace of home price gains during the past two years. This gap between growth in home prices and incomes has been widening since the decade began. Moreover, the price-income gap has become especially pronounced in high-cost metro areas.

The housing affordability index for first-time homebuyers of the National Association of Realtors, which takes into account home prices, incomes and interest rates, slipped 3.8 points in 2004 to 77.7.2 This marks the second-lowest annual level for the affordability index since the recession year of 1991. The lowest reading during this interval was 75.9 in 2000, when 30-year mortgage rates were over 8 percent. If this decline in affordability continues, it might eventually weigh on home sales and price appreciation as first-time buyers are priced out of the market.

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Conclusions

Our analysis of the OFHEO historical home price data shows that metro-area housing booms don’t last forever. But what matters to lenders and borrowers alike is the manner in which housing booms end. In over 80 percent of the metro-area price booms we examined between 1978 and 1998, the boom ended in a period of stagnation that allowed household incomes to catch up with local home prices. While neither lenders nor current homeowners particularly like stagnation in home prices, such an outcome represents a necessary adjustment in market conditions that helps bring home prices within the reach of new homebuyers.

Mortgage lenders and borrowers encountered a great deal more distress in the 21 episodes of U.S. metro-area housing busts identified between 1978 and 1998. Fortunately, based on the criteria we use to define a housing bust, such an outcome can be characterized as relatively rare. In fact, only 17 percent of the housing booms identified during this period led to a subsequent bust, and where busts occurred they were typically preceded by significant distress in the local economy. To the extent that local factors continue to determine home price trends, the expectation would be that metro-area home price busts will continue to be relatively rare.

However, the broadening of the U.S. housing boom during 2004 may imply a growing role for national factors–including mortgage credit conditions–in explaining recent home price trends. More research is needed to establish exactly what role, if any, changes in the cost and availability of mortgage credit played in the expansion of the U.S. housing boom in 2004. But to the extent that credit conditions are driving home price trends, the implication would be that a reversal in mortgage market conditions–where interest rates rise and lenders tighten their standards–could contribute to an end of the housing boom. While our analysis shows that boom does not necessarily lead to bust, it remains to be seen to what degree the current situation might differ from our previous experience in U.S. housing markets.

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  • 401 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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