California Housing Still Over Priced: Examining Case Shiller Data and Seasonal Distortions. The Impact of Shadow Inventory on Price.

One simple rule that every student of introductory economics understands is that a product that has more demand than supply will typically push the price up.  The recent stabilization in housing prices has given the impression that the housing market is correcting on its own.  Nothing can be further from the truth.  There are three primary reasons why housing seems to be stabilizing in the current market:

1.  The $8,000 tax credit

2.  Federal Reserve buying mortgage securities and keeping the overall interest rate artificially low

3.  Shadow inventory being held off market giving the appearance of a smaller inventory

Combine these three powerful forces and you can understand why there has been a slight stabilization in the housing market.  Yet this is extremely deceiving especially in a state like California. First, let us look at some data from the Case-Shiller report put out on Tuesday:

What you will notice is that yes, prices have seemed to tick up according to this chart.  Yet overall, prices are still falling.  So what gives?  You need to understand how the Case Shiller operates.  This index looks at repeat home sales.  So let us run a hypothetical example.

-Homeowner buys home in California for $200,000 in 1999.

-At one point in 2005, home is valued at $500,000

-Homeowner needs to move and sells home in 2009 for $300,000

Did the homeowner make money?  Of course.  Does the actual chart reflect this change?  It doesn’t.  The Case Shiller is the best indicator of market trends but it does have its flaws.  The recent uptick reflects the convergence of the three forces of tax credits, shadow inventory, and low mortgage rates.  All of these are artificial injections into the market and can’t be held together forever.

Consider the overall mortgage rate.  In many cases people can get mortgages for 5 to 5.25 percent.  This is much below the historical trend.  In fact, looking at 40 years of data the overall 30 year rate is closer to 9 percent:

The problem with setting up the current precedent is that it front loads the market to the short term.  Say you buy a home with a 5 percent mortgage rate.  But what happens if mortgage rates go to 8 percent in a few years?  Unless fundamentals in the actual economy change the future buyer of your home just lost a massive amount of purchasing power.  The difference between a 5 percent mortgage and an 8 percent mortgage is gigantic.  Look at the principal and interest difference between these two for a $400,000 mortgage:

$400,000 @ 5% 30 year fixed PI:                 $2,147

$400,000 @ 8% 30 year fixed PI:                 $2,935

This is a significant difference especially when many mortgages are being backed by government loans that adhere to strict debt to income ratios.  What is being missed in all this discussion of housing prices is one pivotal point regarding jobs and income.  The current increase in price is due to government subsidies and not an improvement in the economy.  What this tells us is the general move of prices is temporary and not long lasting.

If you have any doubt of this temporary move, then why would those in the real estate industry keep pushing so hard on an extension on the tax credit?  They realize that most of the movement of the current market is sponsored by the government.  But you have to look at incomes as well.  The mid tier and upper tier of the markets are still extremely over priced in California.

Here is a look at the California median home price over time:

Now this is a fascinating chart because it shows how big the bubble got during the boom.  The fact of the matter is, the median family income in California still can’t afford the median priced home.  However, much of the data is distorted because the mix of sales.  That is, many of the homes that sold over the last year happened at the lower end of the market thus misrepresenting the median price.  So although the median price is down, it is a reflection of the massive amount of foreclosure resales.  In the mid to upper tier of the market prices remain stubborn on the downside.

That will change as more and more shadow inventory makes its way to market in 2010.  There is simply no other way around it.  Many of the Alt-A loans, those made to “better income” borrowers occurred in more expensive areas.  When these hit recast dates, a new inventory surge will hit the market and a simple rule of economics will play out.  That is, more supply equals lower prices.  There is no way around this fact.

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