Friday, June 26, 2009

Distressed Sales and House Prices

In my last entry I argued that a shock was causing existing home sales to rise relative to new home sales, and that this same shock was causing house prices to fall more than would be suggested by the level of existing home sales. This `shock' is more than likely a supply side shock: quantity up, prices down, Econ 101 at work. A question is how much of this is being driven by distressed sales where the house is being sold because the current owner has stopped paying the mortgage.

Andrew Leventis, a researcher at the Federal Housing Finance Agency has attemped to answer this question is a recent working paper: "The Impact of Distressed Sales on Repeat-Transactions House Price Indexes".

In the paper, Leventis uses transactions data from California and breaks down transactions into distressed and non-distressed. A transaction is distressed if a Notice of Default was filed on the property up to a year before the transaction occurred and no other transactions occurred for the same property between the transaction and the Notice of Default. He performs the analysis for two different groupings of data. The first grouping he calls `Enterprise' data, and this consists of the transactions that would be included for calculating the FHFA House Price Index (HPI). The second grouping is `Recorder' data, which consists of the data that would be used to calculate the Case-Shiller index. His figure one shows that the share of distressed sales has increased from less than 5% before the fourth quarter of 2006, and has been rising steadily ever since, now over 45% for the first quarter of 2009. The rise in distressed sales is very similar to the gap that has appeared between new and existing home sales.

The main question of the paper is "How much are these distressed sales driving down house prices?" To paraphrase Leventis, we can breakdown the effect of distressed sales on house prices into two categories:
  1. Direct Effect: distressed houses sell at a discount, therefore, as the share of distressed sales in the sample increases, then the reported house price index will fall.
  2. Indirect Effects: the more distressed sales there are, the harder it is for a non-distressed seller to sell a house, lowering the prices for all houses.
In his paper, Leventis can only get at the direct effect. His figure 4 shows the discount for distressed sales. We can see that before 2006, that distressed sales sold at about a 4% discount. At the peak of the bubble in 2006, the discount almost went completely away--it didn't matter if a seller was distressed, seemed that buyers were willing to buy everything and anything in sight. However, after 2006, the discount gets significant, approaching almost 20% for the `Enterprise' data, and 15% for the `Recorder' data (there is an interesting divergence between the two types of data in the last couple of quarters).
Therefore, by the end of 2008, distressed sales were selling at a 20% discount and made up roughly 45% of sales. Relative to the peak in the housing bubble in 2006 (when the discount was essentially zero), if this sales pattern would maintain itself for a year, it would imply that the house price index is being pushed down an extra 9% due to the direct effect from distressed sales. However, the total effect so far has been smaller. His figure 2 shows the effect of the distressed sales on year-over-year price growth for the `Enterprise' data. The figure contains two plots: one showing price growth for the entire sample, another with the distressed sales removed. The effects are fairly small. The cumulative effect of the distressed sales is estimated to drive down prices an extra 5.3% from the peak, for a fall of 41.3% relative to only 36.0% when the distressed sales are excluded. The effect on the `Recorder' data is smaller, implying an extra house price fall of 1.9% from 44.8% to 46.7% (see his figure 3, not shown here).

To summarize, the divergence between new and existing homes seems related to the surge in distressed sales. The work by Leventis suggests that the direct effect of the distressed sales on the reported house price indexes is most likely small relative to the total decline we've seen in house prices. What we do not know is whether the distressed sales are directly responsible for the fall in house prices and the increase in existing sales relative to new sales, or if the distressed sales are simply the result of the large supply of housing, which is then responsible for distressed sales, housing price falls, and an increase in existing relative to new sales. My viewpoint is that we are just seeing the effects of supply at work.

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