Why Home Prices Won't Stabilize in 2008

Many economists are calling for home prices to stabilize in 2008. I think that this belief results from little more than wishful thinking. There is nothing in the fundamentals that supports the belief that home prices will reach a meaningful bottom this year. Inventory is still far too high, foreclosures don't appear to be slowing down and economic indicators are pointing towards a general economic slowdown and perhaps a recession.

The boom in home prices at the turn of the century was dramatic. From January 2000 to November 2005 the Case Shiller national home price index doubled and home prices in San Diego increased 2.5 times. Much of this increase was due to loose lending standards that resulted from global liquidity and low real interest rates. The ongoing liquidity crisis has led to a curtailment of many of the loose lending practices that defined the home price boom - 100% financing, negative amortization, no doc, "liar loans" etc. The lending led home price bubble will take a long time to unwind. I fear the unwind may end up being just as dramatic as the run up in prices. Below are the Case-Shiller home price index numbers from 1987-2007 for several cities and the 20-city composite. I am tempted to label this graph "The Anatomy of a Bubble":


At current levels all San Diego home buyers who purchased homes with no money down since April 2004 are underwater. Those who put 10% down are underwater if they bought between July 2004-December 2006. Those who put 20% down are probably not underwater unless they bought a condo downtown. Why does this type of analysis matter? Put simply, home buyers who are underwater are far more likely to walk away from their mortgage when it resets to a higher payment. Unfortunately every 1% decline in home prices pushes 1,000's more homeowners underwater and increases the probability that we will see higher foreclosure rates and more "must-sell inventory" to work off before we can establish a meaningful bottom in home prices.

If the real estate market throws the economy into a recession all the analysis gets much worse. Higher unemployment and slower wage growth along with general economic malaise will only exaggerate the correction in home prices. Until we see a stabilization in foreclosure rates, a fall in inventory, an increase in sales and an improved general economic picture our prediction remains that home prices will not stabilize in 2008.

If you bought a home in San Diego at the peak of the last cycle in July of 1990 it took a full 8 years before your home price returned to its original purchase price. This time around home prices may take even longer to return to their November 2005 price level. Since the average homeowner only stays in their home for 7 years, a lot of homeowners will be literally "trapped" in their home and, unable or unwilling to buy their way out, they will likely just walk away.

I don't like making long-term predictions about home price trends, but I'm thinking another 7-8% drop in in the Case Shiller home price index in 2008 is in order. We'll look at 2009 when it comes, but something tells me we won't be much more optimistic then.