- The housing correction will take a little longer than had been expected.
- Resolution of processing issues should be reached by the fall.
- House prices should hit bottom in 2012.
Foreclosures are weighing on the outlook for U.S. house prices, and the slow resolution of issues surrounding the so-called robo-signing scandal is keeping distressed homes off the market. As a result, the housing correction will take a little longer to complete than previously expected, although the outlook has changed very little. House prices will founder until early next year and start rising in earnest at the end of 2012.
Share of distress sales is key
The key to the near-term outlook is the change in the share of sales of distressed homes, known as REO sales. As this share increases, the proportion of discounted home sales will also increase, causing house prices to fall. This relationship was particularly evident in the first quarter of this year. Robo-signing slowed the number of REO sales to third parties by 11% in the first quarter compared with the fourth quarter of 2010, according to RealtyTrac. But weakness in nondistress sales caused the share of foreclosure sales to increase from 17% to 19%. These homes were sold at an average discount of 35%. Concurrently, the Case-Shiller price index declined by 2%.
Since late last summer, we have called for a 34% peak-to-trough decline in U.S. house prices as measured by the Case-Shiller index, with the bottom occurring in the third quarter of this year. Loan processing problems that emerged at the end of last year did not alter this earlier forecast, although they did pose a number of risks to the timing of the bottom. We had expected that servicers and regulators would resolve the processing issues by this spring. However, judging from the absence of agreement between the servicers and the 50 state attorneys general, as well as from the sustained reduction in foreclosure filings, resolution is taking longer and is likely to occur by this fall.
The slow disposition of homes likely to turn into distress sales has a near-term positive effect on house prices, as fewer distress sales?all else equal?mean fewer discounted home sales. Conversely, the prolonged disposition of potential foreclosures also prolongs the length of time house prices will take to complete the correction. Consequently, while the peak-to-trough decline remains unchanged at about 34%, we expect the house price index to take longer to reach a bottom, with it occurring in the first quarter of 2012 rather than in the third quarter of 2011. Even with the bottom delayed, the remaining decline will be a modest 2% between the first quarter of this year and the first quarter of next.
Prices could pick up this year
It is quite possible that house prices will pick up slightly in the second or third quarter of this year, as foreclosure sales remain depressed while nondistress sales pick up. Job gains will improve, albeit slowly, as the year progresses, and the increase in jobs, combined with high affordability with respect to household incomes and quickly improving affordability with respect to renting, will help boost sales of nondistressed homes. By the fourth quarter of this year, however, the distress share will rise, sending the house price index back down. Servicers will be working through the backlog of nearly four million potential distress sales, and the increase in distress sales will outpace the increase in nondistress sales.
Progress is being made on the foreclosure-processing front that supports expectations of a resolution by the fall. Although the state attorneys general are still working on settlement, the Federal Reserve, along with a couple of other regulators, has issued orders to the largest servicers to revamp their foreclosure processing systems; the servicers should implement these operational changes by the end of October. Additionally, the GSEs have just put out new, more stringent guidelines for servicer foreclosure timelines that are effective immediately. These guidelines will motivate servicers to push foreclosures through as efficiently as possible
There remain many uncertainties around the timing of foreclosures that could easily delay the end of the price correction even further. Legal issues surrounding the foreclosure process could take longer to resolve than expected. Moreover, with the courts clogged with filings, even once the servicers start up, it may take longer than expected to work through all the foreclosures.
Changing seasonal factors
Foreclosures are changing the seasonal factors used to adjust the Case-Shiller home price index. Not only does this change cause confusion in choosing the appropriate measure of house prices to gauge the turning point in the housing cycle, but it also complicates forecasting the bottom. The seasonal factors, however, are fairly small and do not change the basic direction of home prices or the timing of the bottom in our forecast. Further, volatility and measurement error endemic to all data are more significant sources of uncertainty in determining turning points than seasonal factors.
Seasonality in house prices is related to the highly seasonal nature of home sales. Most sales occur in the spring and summer, and the stronger demand helps elevate prices. Sales are weakest in the first quarter. However, the seasonal impact is much smaller on prices than on sales. The adjustment in prices is less than 3% in either direction, while the adjustment in home sales is on the order of 15% to 25%.
Foreclosure sales have little discernible seasonal pattern but have a large negative impact on house prices. Thus, as distress sales have increased over the past several years, they represent a disproportionately large share of the not seasonally adjusted sales in the first and fourth quarters, when normal home sales are the weakest. The large share of distress sales in turn causes house prices to be weaker than normal in the first and second quarters. The seasonal adjustment factor has increased in recent years to account for the rise in foreclosures.
For this reason, the S&P/Case-Shiller index committee describes the seasonally adjusted indices as “less reliable” than the not seasonally adjusted index and recommends using the not seasonally adjusted price index when making sequential comparisons. However, to the extent that foreclosures still constitute a significant share of home sales?and they will for at least the next year?the more recently calculated seasonal adjustment factors make sense. When foreclosures no longer represent a large share of sales, the seasonal factors?which heavily weight the last several years of seasonal patterns?will no longer be applicable.
Finally, the seasonal factors for house prices are small enough that the trends in the seasonally adjusted data and the not seasonally adjusted data are similar and the turning point in the forecast is the same: a house price bottom in the first quarter of 2012. Comparing the quarterly growth rates of the seasonally and not seasonally adjusted indices with a seasonally adjusted index that uses factors calculated from data through 2004?well before foreclosures became an issue?and a seasonally adjusted index that uses factors calculated from data between the first quarter of 2005 and the first quarter of 2011?when foreclosures are a big issue?the basic direction of house prices is the same. Regardless of which seasonal factors are used, the bottom is still the first quarter of 2012.
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