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National Edition Regional Outlook, First Quarter 2002

In Focus This Quarter

Housing Market Has Held Up Well in This Recession, but Some Issues Raise Concern

Trends in housing markets are important performance drivers for many FDIC-insured institutions. The health of residential markets can affect the credit quality of residential mortgage loans, home equity loans, and loans to finance residential construction and is linked indirectly to the performance of other types of consumer and small-business debt. Further, an estimated $2 trillion in mortgage debt, approximately one-third of the mortgage market, was underwritten during 2001, with 56 percent of this activity in refinancing transactions.1 This activity makes recent trends in underwriting of particular interest. An ancillary issue for many mortgage lenders, interest rate risk, is not addressed in this article.2

1 Mortgage Market Forecast,, January 2002.

2 For a discussion of this issue, see "Regional Perspectives," Boston and Chicago Regions, Regional Outlook, First Quarter 2002.

The U.S. economy entered a recession in March 2001, and the question arises as to how consumer creditworthiness, housing values, and recent mortgage-lending practices will fare during this downturn. Developments contributing to increased credit risk include higher consumer debt burdens, looser mortgage loan underwriting standards, and the emergence of subprime mortgage lending as a significant line of business for some banks. Mitigating this risk has been the steady appreciation of home prices, which have shown signs of softening in some markets but not to the extent seen at a comparable stage in previous recessions.

Home price weakness may be more pronounced in 2002 as the effects of the recession take hold, but in the authors' judgment, systemic weakness in home prices is unlikely, absent a deep and long recession. Adverse mortgage lending trends are not expected to threaten the capital or earnings of the vast majority of insured institutions. Nonconstruction residential mortgages, even during the most pronounced periods of stress in the 1980s and early 1990s, remained the best-performing loan class, especially for lenders specializing in residential real estate; and, historically, these mortgages have been one of the lowest credit-risk loan types for all manner of insured institutions.3

3 See "Region's Insured Institutions Exhibit Lower Risk Profile than the Nation's, Appendix: Risk-Weighting Methodology," Table A in Boston Region, Regional Outlook, First-Quarter 2000.

That said, however, there are pockets of risk for insured institutions. There is evidence that borrowers with weak credit may be experiencing greater repayment difficulties, elevating the risks faced by subprime mortgage lenders. Further, a slump in residential real estate markets could be especially detrimental to insured institutions with significant exposures to housing construction because projects might not sell at projected asking prices or as quickly as anticipated. Finally, in specific markets where housing prices may have achieved unsustainable levels, some increase in housing-related credit quality problems can be expected, and in this regard, the San Francisco Bay area stands out as a place to watch.

The Recession Thus Far Has Had a Minimal Impact on Mortgage Delinquencies at Insured Institutions

Despite three quarters of recession, most housing indicators remained quite healthy this past year relative to trends seen in past recessions. For example, new and existing home sales both set records during the year, while new home construction failed to decline, an occurrence not seen in the past six recessions. Another indicator, year-over-year growth in existing home prices--as measured by either the Office of Federal Housing Enterprise Oversight (OFHEO) repeat sales price index or the National Association of Realtors (NAR) median single-family price statistic--showed deceleration but remained well above trends seen at similar points in past recessions. This behavior partly reflected the early robustness of household income in the face of recession and relatively low fixed mortgage rates during 2001, which helped to counter some of the initial adverse effects of the recession on housing demand.

One sign of potential weakness appeared late in 2001 in the modest year-over-year decline in median prices of new single-family homes (see Chart 1). Because existing home sales outnumber new home sales roughly fivefold, price trends in the latter are generally not predictive of prices for the much larger existing home market.4 However, as discussed later in this article, adverse pricing trends in the new home segment do raise concerns for residential developers and insured institutions that finance residential construction.

4 Existing home prices are also more reflective than new home prices of trends in broader economic indicators, such as aggregate per capita personal income.

Chart 1

[D]Chart 1 Although the Much Larger Market for Existing Homes Has Held Up, New Home Prices are Under Pressure.

The steady increase in prices of existing homes depicted in Chart 1 masks considerable regional variation. As detailed later in this article, home price growth began to weaken in 2001 in a number of metropolitan statistical areas (MSAs). While there is no clear common denominator among the markets in which this occurred, a number of these markets had both extremely rapid home price growth in the recent past and significant slowdowns in employment growth or outright contractions in employment last year.

Credit quality indicators for insured institutions' mortgage loans have shown only preliminary signs of weakness thus far. Through the first nine months of 2001, insured institutions showed negligible advances in median past-due ratios for mortgages and equity lines of credit, although continued strong mortgage origination activity in 2001 may have masked (in the aggregate) developing credit problems for more seasoned mortgage loans. For institutions that held at least $1 million in residential mortgages or home equity lines of credit and whose exposures comprised at least 5 percent of Tier 1 capital, some modest deterioration is evident in the worst-performing mortgages and home equity lines since 1999, as seen in Chart 2.5 Even if this recession lingers, worsens, or both, residential mortgage lending (nonconstruction and development-related) likely poses only modest risk to most insured institutions' earnings and capital, since it has held up better in prior recessions than other loan types.

5 It is interesting to examine the (adverse) tail of the credit quality distribution when looking at residential mortgage trends, as average and median past-due ratios move little and are typically very low--thus, only the highest 25th and 5th percentiles of past-due ratios are presented in Chart 2.

Chart 2

[D]Chart 2 Through September 2001, Mortgage-Related Delinquencies Remained Modest.

What Are the Risks Facing Housing Lenders in 2002 and Beyond?

In an environment of significantly slower economic growth than prevailed during the 1990s, can the strength of housing prices and the relatively benign credit quality environment for housing lenders be expected to continue? The answer will depend on the interplay of economic conditions and lenders' risk profiles. In the remainder of this article, we discuss the gradual increase in the risk profile for insured mortgage lenders that appears to have occurred during the 1990s, as well as some cyclical risks to their performance that may exist as the recession plays out.

Evolving Lending Practices Have Increased the Risk Profile for Mortgage Lenders

Although history suggests that residential mortgage defaults will be relatively low even in a recession, changes in the mortgage market since the 1990-1991 recession could affect mortgage performance during the present downturn. Many underwriting changes over the past decade have been driven in part by the growing importance of the secondary market for mortgage debt, and of Fannie Mae and Freddie Mac in particular. In 1980, federal and related agencies had direct or indirect interests in approximately 17 percent of all mortgage debt.6 By 2000, their share of the mortgage market had increased to roughly 41 percent. Insured bank and thrift mortgage exposures grew over the same period, but, as a share of direct mortgage debt, bank and thrift mortgage holdings decreased from 59 to 35 percent. These trends notwithstanding, insured institutions still provide substantial funding, directly or indirectly, to the housing market: as of September 30, 2001, 1 to 4 family mortgage loans and mortgage-backed securities held by insured institutions aggregated $2.3 trillion, up 37 percent from five years earlier.

6 These interests include residential, commercial, and farm real estate debts held directly by, or held in mortgage pools or trusts issued by, federal and related agencies. Source: Table 1186, Statistical Abstract of the United States: 2001, page 733.

Although an active secondary mortgage market has broadened homeownership, improved mortgage loan liquidity, and allowed insured institutions to allay credit risk, it has also heightened market competition and transformed the lending process. In presecondary market days, lenders largely had to retain originated mortgages in their own portfolios. Consequently, only lenders with ready funding sources (such as banks, thrifts, and insurance and finance companies) were able to compete in the mortgage markets. The advent of the secondary market enlarged the pool of available funding and permitted both insured institutions and other originators to transfer their mortgage business readily into entities such as mortgage pools and trusts. Consequently, many new players, including on-line and brick-and-mortar mortgage brokers, have entered the mortgage origination market.

The resulting robust mortgage loan competition, combined with Internet-based consumer research tools, has led to considerable commodification of the mortgage market. Rather than competing on the basis of traditional relationships, lenders' market shares are increasingly driven by price. For smaller savings institutions that focus heavily on residential mortgage underwriting, this issue has likely elevated business risk. Heightened competition has caused some loosening of mortgage underwriting standards and pushed lenders to use technology to expedite and streamline the underwriting process. Consequently, credit-scoring mechanisms and automated valuation techniques currently in place have not been tested through a full credit cycle. Because pricing competition has pressured margins, some mortgage lenders have pursued subprime or high loan-to-value (HLTV) mortgages. The ability of insured institutions to mitigate subprime losses through an economic downturn is untested to a large extent as well--finance companies dominated the high-risk mortgage market in past recessions.

In general, mortgage underwriting standards have loosened industrywide over the past decade. For instance, lenders have increasingly accepted higher loan-to-purchase price (LTPP) ratios for purchase money mortgages.7 According to the Federal Housing Finance Board, LTPP ratios are high and have risen in several metropolitan areas over the past seven years (see Chart 3). Between 1993 and 2000, the Honolulu, Tulsa, and Tucson markets exhibited the largest increases in mortgages with LTPP ratios exceeding 90 percent.

7 Purchase money mortgages are loans extended solely for the initial purchase of a home. Statistics on loan-to-value ratios for supplemental home equity loans/lines (e.g., piggyback or "80-10-10" financing), as well as refinanced mortgages, are not readily available.

Chart 3

[D]High Loan-to-Purchase Price Ratios Are Increasingly Common in Some Metro Areas

Although lenders often mitigate the risk of loss associated with low downpayments by requiring private mortgage insurance (PMI), recently the mortgage industry has allowed borrowers to avoid purchasing PMI. In particular, "piggyback" financing has made homeownership increasingly possible for households that cannot afford the traditional 20 percent down payment or do not wish to pay for PMI. With piggyback financing, the borrower often arranges a conforming 80 percent LTPP first mortgage and finances a portion of the remaining 20 percent with a concurrent second mortgage on the property (e.g., "80-10-10"). This type of transaction has become popular because interest paid on the (albeit more expensive) second mortgage is tax-deductible, whereas PMI premiums are not. Thus, piggyback financing is probably most attractive to individuals in higher-cost/tax areas or higher tax brackets, such as those in the Northeast and California. This trend effectively shifts the first loss position on all low down payment loans to the lender that retains the junior position. These institutions are, of course, compensated for some of this risk with the higher interest rates charged on the piggyback portion of these mortgages.

Competitive factors have prompted the industry to enhance underwriting automation. As part of the push, credit scoring has become a routine part of the credit analysis process, and, increasingly, lenders are using automated valuation models (AVMs) to determine collateral coverage. However, credit scoring and collateral valuation models have been in popular use only since the 1990-1991 recession; consequently, their predictive ability in a downturn is uncertain. Although some have touted AVMs as the answer to appraisal fraud, the ability of statistical models to simulate the qualitative judgments considered critical to traditional appraisals is unknown. Paper appraisals reportedly continue to dominate the industry; however, recently, the two largest government-sponsored enterprises have begun accepting AVMs in lieu of standard appraisals for loans under $275,000.8 For lenders that specialize in HLTV mortgages, there is less room for error with AVMs.

8 "Automated Appraisals Require Caution by Lenders," American Banker, October 10, 2001.

Cyclical Weakness Is Already Apparent in Subprime Mortgage Lending

Historically, certain insured institutions have made mortgage loans with narrow collateral margins or to borrowers with limited or blemished credit histories. However, significant entry by FDIC-insured institutions into mortgage lending to borrowers with weak or marginal credit, as a targeted line of business, generally has occurred only since the early 1990s. These "subprime" mortgages are neither defined nor reported on Bank Call Reports. As a result, gauging the extent of bank involvement in subprime lending at any point in time is difficult. However, the FDIC estimates that fewer than 1 percent of all insured institutions have significant subprime residential mortgage exposures. Nevertheless, according to some measures, subprime mortgages as a share of total mortgage originations peaked at 13 percent in early 2000, before moderating somewhat during the first three quarters of last year.9 Thus, a much larger number of institutions probably have some limited involvement in subprime mortgage lending. A survey by the Minneapolis Federal Reserve Bank found that 29 percent of banks in the Minneapolis District offered loans to low-credit quality consumer borrowers in 1999.10

9 Based on dollar volumes, data from Inside Mortgage Finance Publications, Bethesda, MD.

10 Ron Feldman and Jason Schmidt, "Why All Concerns About Subprime Lending Are Not Created Equal," Fedgazette, Minneapolis Federal Reserve, July 1999.

Subprime mortgage loan performance appears to have deteriorated notably during 2001. One source of support for this observation comes from delinquency trends on Federal Housing Agency (FHA)-insured mortgages, which are often granted to first-time homebuyers with troubled credit histories and borrowers with low down payments. The Mortgage Bankers Association reports that while the national delinquency rate on conventional mortgages rose 58 basis points in the year ending third-quarter 2001, the delinquency rate on FHA mortgages shot up by 234 basis points, to 11.4 percent (see Chart 4). This growing gap between delinquency rates on conventional and government-insured mortgages suggests that marginal and subprime borrowers are facing growing repayment difficulties.

Chart 4

[D]Recent Mortgage Delinquencies for Higher-Risk Loans Reached All-Time Highs

A database of more than 6.5 million subprime loans tracked by Loan Performance Corporation (formerly Mortgage Information Corporation) reported similar trends. The nationwide third quarter 2001 ratio of seriously delinquent subprime mortgages was 7.3 percent, up from 5.5 percent one year earlier.11 Moreover, subprime delinquencies significantly exceeded those found among prime mortgages, as just under 0.5 percent of conventional prime mortgages were seriously delinquent.12 Also of possible concern are vintage data trends, which show how pools of primary and junior-lien subprime mortgages perform over time. Mortgages originated in 2000 are performing poorly in relation to previous years' vintages.13 This simply could reflect the impact of the current recession. Alternatively, Loan Performance Corporation analysts have suggested that the 2001 refinancing boom might have created some adverse selection in mortgage pools originated during the relatively higher interest rate environment of late 1999 and early 2000.14 Because higher-coupon and variable-rate loans comprised a significant share of mortgage originations during that period, overall prepayment rates on the 2000 vintage might have been unusually high during 2001. Consequently, the best-quality loans in the 2000 pool might have refinanced, leaving loans of lesser credit quality behind and elevating the residual delinquency experience in that pool.

11 The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), Winter 2001 and Fall 2001.

12 The Market Pulse, Loan Performance Corporation, Fall 2001.

13 Per Loan Performance Corporation delinquency data, subprime primary mortgages originated in 2000 displayed higher delinquency ratios for their age compared with similarly seasoned subprime loans originated in 1996, 1997, 1998, or 1999. Moody's second-quarter 2001 Home Equity Index Update found the same to be true of subprime home equity loans.

14 "Another Look at the 2000 Book," The Market Pulse, Loan Performance Corporation (formerly Mortgage Information Corporation), Winter 2001.

Given these trends, an important issue for subprime lenders is their ability to anticipate and plan for the impact of an economic slump on their operations. Some institutions clearly adopt subprime lending as part of an overall business strategy, setting up monitoring and collection departments geared to dealing with such loans. Among large, national lenders, for example, one institution that makes 5 to 10 percent of its loans to subprime borrowers recently provided additional resources to its loan services and default management departments. This action followed a period when one-third of its increase in nonperforming single-family mortgage loans was associated with loans to subprime borrowers.15

15 Calmetta Coleman, "Default Worries on Home Loans Escalate as Lenders Report Delinquency," Wall Street Journal, October 29, 2001.

C&D Lending Risks May Be Elevated in MSAs with Potential Supply/Demand Imbalances

Historically, lending to finance housing construction is riskier than mortgage lending on existing structures. Insured institutions report construction and development (C&D) lending in a single category that includes both commercial and residential construction. While it is thus impossible to ascertain from quarterly call reports the extent of bank involvement in financing housing construction, anecdotal evidence suggests that, although smaller insured institutions engage to some degree in commercial property development, their C&D lending largely finances single-family construction. If markets with an oversupply of housing see weaker economic performance, insured institutions engaged in financing residential real estate development may be at risk. This could result in an increase in C&D loan delinquencies, losses, and other-real-estate-owned (OREO).

Demand for housing can be affected by two distinct trends: secular, or longer term; and cyclical, or shorter term. Over the long term, demographic trends, such as population growth rates and concentrations of households by age cohort, can affect overall demand for housing, as well as the types of homes demanded. Demand in local housing markets also can be affected by more cyclical factors such as recent changes in economic conditions, including interest rates. New supply of homes in local housing markets is produced in response to perceived or estimated future demand. Correct interpretation of market and economic signals is critical to the success of builders in metropolitan areas; however, this activity is complicated by the lags associated with developing, permitting, and constructing properties. The effect of overestimating future demand could be multiplied if several builders inaccurately gauge changes in demand. Consequently, a construction market with numerous smaller developers, such as Atlanta, may see amplified swings in construction activity and may experience excess supply during certain periods.

Although conceptually straightforward, measuring the balance between housing demand and supply is challenging, particularly at lower geographic levels. Shortcomings in data availability, quality, and timeliness can limit the effectiveness of this type of analysis. As already mentioned, some insight about current housing market conditions in specific metropolitan areas may be gained by analyzing both secular and cyclical trends. However, given the onset of recession last year, the role of cyclical factors is of prime concern at this time.

To measure the cyclical aspect of the relationship between a market's supply and demand, some analysts rely heavily on the concept of employment-driven demand.16 Such analysis involves tracking a demand/supply ratio based on employment growth and permit issuance. Areas where permitting activity continues to accelerate while employment levels decrease may produce an increasing imbalance in the local housing market.17

16 For example, see

17 This approach, although more reflective of recent economic events than perhaps more secular measures, is not without its drawbacks. For example, employment data from the Bureau of Labor Statistics' establishment survey are frequently revised, and, consequently, employment-driven demand may need to be reexamined.

Using a simplified version of employment-driven demand, we identified a number of metropolitan areas as being at risk for a rising imbalance in their housing markets (see Chart 5), the largest of which are Chicago, Greensboro (NC), Minneapolis, Phoenix, Portland (OR-WA), St. Louis, and, most notably, Atlanta. These markets are displaying signs that residential construction activity may not be responding in kind to local economies that have started to contract during this recession. Further, Phoenix, Portland, and Atlanta were identified previously as banking markets exhibiting elevated risk profiles.18

18 See "In Focus This Quarter," Regional Outlook, Fourth-Quarter 2001.

Chart 5

[D]Some Larger MSAs Continued to See Permit Growth during 2001, despite Declining Employment

Chart 6 displays the level (y axis) and trend (x axis) in C&D lending exposures for the top 25 MSAs by median C&D concentration as a share of assets.19 It is apparent that some markets identified in Chart 5 as having significant banking exposure to C&D lending also may have a cyclical imbalance in home building. Atlanta, for example, demonstrates one of the highest exposures, with a ratio of median C&D to total assets of 17 percent in third-quarter 2001, a roughly 100-basis-point increase from year-end 2000. In other words, while employment-driven demand has softened in the metropolitan area, single-family construction activity has continued, and community bank lenders may have increased their level of residential financing commitments.

19 We considered only MSAs that had at least six locally headquartered community banks that engaged in C&D lending activity and then charted the top 25 MSAs ranked by September 2001 median C&D/assets.

Chart 6

[D]Some Banking Markets Are Seing Rising Construction and Development (C&D) Exposure Coupled with Potentially Growing Supply/Demand Imbalances

Cyclical Risks May Be Developing with Respect to Home Prices

Popular comparisons have been made recently between the healthy run-up in housing prices during the past several years and the technology stock-fed speculative "bubble" in equity prices that persisted through early 2000. The subsequent bursting of this bubble and the resulting economic distress have raised concerns of a sequel featuring housing prices.

According to the OFHEO repeat sales price index, there has never been an instance of outright declines in aggregate U.S. existing home prices.20 However, home prices do exhibit strong cyclical tendencies, with the rate of appreciation slowing during national recessions. In addition, there have been some decidedly negative episodes during the past few decades in various metropolitan markets. At the national level, existing-home price growth historically has followed trends in population-adjusted personal income growth,21 and some have pointed to a growing imbalance between the two as a sign that home prices may weaken as the effects of the recession take hold (see Chart 7).

20 According to the National Association of Realtors' U.S. median price, a few episodes of price declines (on a quarterly, year-ago basis) are present in the time series--specifically first- and second-quarter 1989; fourth-quarter 1990; and first-quarter 1993--only the 1990 episode occurred during a recession. Also, as shown in Chart 1, U.S. median new home prices have experienced meaningful declines.

21 This relationship is generally true at the metropolitan level as well.

Chart 7

[D]The Widening Gap between Home Price and Income Growth Has Raised Some Concern

Given that home price bubbles have occurred in the past, most notably in Texas, California, and the Northeast during the 1980s, and that their ultimate deflation resulted in significant negative fallout for these areas' economies and insured institutions, it is useful to look at these historical examples as a potential "worst-case" scenario (with very low probability) for residential real estate markets during the current recession. It is unlikely that significant, systemic risks from home price bubbles have arisen yet for residential lenders. Of course, this situation could change if the current recession deepens or is protracted, or if growth during the subsequent recovery is anemic. Further, national trends can obscure dramatic variations in local markets, and a handful of MSAs today are coming off several years of rapid home price growth and falling affordability. These markets, and the residential lenders targeting them, may be more at risk as local economic growth falters.

Map 1 shows markets that have seen the most significant reductions in affordability (sharp price gains) during the past several years. Not surprisingly, many of them--namely larger cities in California and the Northeast--are those that historically have seen the biggest swings in prices and a penchant for speculative excess.

Map 1

[D]Drops in Affordability since the Mid-1990s Are Most Prevalent in California and the Notheast

In markets with rapidly declining affordability, credit risk arises from the increasing likelihood that new borrowers will commit a greater share of household financial resources to meet monthly payments. Credit problems could become more readily apparent given any subsequent disruptions to employment or income in these markets--especially among households with limited wealth or that require multiple job holders to meet mortgage payments. These risks may be amplified by the increased underwriting of HLTV and subprime mortgages during the past decade.

Disruptions to aggregate household liquidity from lost employment or decreased income can result in rising mortgage delinquencies. With respect to foreclosures, however, some research has suggested that the decline in prices relative to the balance owed on the mortgage (rising loan-to-value ratio) is the most significant factor.22 Even in instances of prolonged job/income loss, owners with positive equity are likely able to sell their homes profitably, thus avoiding foreclosure. Chart 8 shows the strong relationship between declining home prices and increasing foreclosure rates in New England a decade ago (the chart plots the inverse price change in order to emphasize the relationship).23

22 For instance, "Mortgage Default Risk and Real Estate Prices: The Use of Index-Based Futures and Options in Real Estate," Case, Shiller, & Weiss, NBER Working Paper #5078, NBER, April 1995, finds this to be the case, while citing past work that identified the link between rising LTVs and foreclosure rates.

23 In states where dominant metro areas have seen large price declines in past years, such as Massachusetts, this relationship is more pronounced than in larger states or the nation as a whole. For example, the two-decade correlation between foreclosures started and price change is -78 percent in Massachusetts versus roughly -60 percent in both California and the nation.

Chart 8

[D]Rising Foreclosure Rates Followed Falling Home Prices in New England a Decade Ago

The data available through late 2001 were mixed with respect to home resale price trends at the MSA level. On the one hand, while existing home prices as measured by the OFHEO home price index showed no markets with year-over-year price declines in fourth-quarter 2001, NAR's median resale price metric did show about a dozen markets with year-over-year declines, none exceeding four percent. A deceleration in year-over-year home price growth was evident for many markets (and the nation) using either measure. It should be noted that the OFHEO data do not include sales of high-priced homes and are less influenced by changes in the mix of homes sold than are average and median prices;24 this issue is more meaningful in the nation's most expensive markets, such as MSAs in the San Francisco Bay Area25 and parts of the Northeast, since prices for high-end homes (typically financed by jumbo mortgages) may be more volatile over the economic cycle.

24 Data are obtained from aggregating repeat sales or refinancings of the same properties over time and using statistical methods to calculate an overall rate of home price appreciation for each market. Sampled properties are confined to those whose mortgages are "conventional" and do not exceed a conforming loan limit (set at $275,000 in 2001) required for securitization through Fannie Mae and Freddie Mac. For more information, see

25 As considered here, this includes the following MSAs: San Jose, Santa Cruz-Watsonville, San Francisco, Santa Rosa, Oakland, Salinas, and Vallejo-Fairfield-Napa.

Table 1 lists markets whose 2001 deceleration in home price growth was in the top 10 percent of the more than 300 metro areas for which the OFHEO statistic is available. The table also provides (where available) each MSA's recent employment trend as an indicator of overall economic conditions. These markets may yet see even more pronounced deceleration in home price growth or even declines in home prices this year (as may others not shown). This possibility will be determined for the most part by the performance of each market's local economy.

Table 1

[D]Some Banking Markets Are Seing Rising Construction and Development (C&D) Exposure Coupled with Potentially Growing Supply/Demand Imbalances

The metro areas in the table are ordered by the magnitude of their deceleration in home price growth over the initial quarters of this recession. As a result, the marked deceleration in year-over-year price growth in the recently overheated San Francisco Bay Area puts many of its MSAs near the top of the list. In the table, San Jose, San Francisco, Oakland, Denver, and San Diego also previously were identified as banking markets with elevated risk profiles.26 For some of the smaller MSAs in Table 1 with more volatile appreciation rates, such as Utica and Fargo, comparisons of recent price trends are more appropriate using the 1998-2000 average as a benchmark, as these markets experienced pronounced spikes in year-ago price growth during first-quarter 2001.

26 See "In Focus This Quarter," Regional Outlook, Fourth Quarter 2001.

It is hard to generalize about which markets will see the most pronounced home price weakness as the recession continues. However, certain markets have shown a tendency in the past to be driven to a greater degree by speculative, rather than fundamental, factors. These markets are more likely to see significant downward corrections in price when economic activity falls for a prolonged period or by a sufficient magnitude. One study from the mid-1990s found, in comparing 14 cities in the Northeast and West with 16 inland cities, that while both groups tended to respond similarly to local and national economic forces (fundamental, or "equilibrium," price drivers), prices in the former group tended to be influenced to a greater degree by speculative, or "disequilibrium," variables, including recent trends in price appreciation.27 Cities along the nation's coasts also have tended to see the most significant price swings over the past 20 years.

27 Jesse M. Abraham and Patric H. Hendershott, "Bubbles in Metropolitan Housing Markets," Working Paper #4774, NBER, June 1994.

History also provides some insights into the nature and extent of any price declines in markets where economic conditions deteriorate. A study of two significant examples, Boston and Los Angeles in the 1980s and early 1990s, concluded that declines differed by property type (i.e., condos versus single-family) and price class (i.e., high-end versus entry-level).28 This dispersion in price declines arose from differing rates of appreciation (properties that experienced the greatest inflation during the boom saw the largest deflation) and from the nature of each city's economic decline, which differed according to concentrations of job losses by industry and wage type, underlying demographic factors, and housing supply trends.

28 Karl E. Case and Robert J. Shiller, "A Decade of Boom and Bust in the Prices of Single-Family Homes: Boston and Los Angeles, 1983 to 1993," New England Economic Review, March/April 1994.

Looking at recent developments, it seems that the greatest near-term risk of a significant downward adjustment in housing prices is in the San Francisco Bay area. In recent years, this area witnessed double-digit home price appreciation that exceeded growth in per capita income by a wide margin. A recent analysis from the University of California-Berkeley's Haas School of Business forecast that prices in the Bay Area housing market will decline by 15 percent overall (and by 30 percent for luxury homes) by the time the local economy's recession ends late this year.29

29 David Goll, "Bay Area Housing Market Will Remain Slow," East Bay Business Times, January 23, 2002. Meanwhile, the larger MSAs in Southern California have not seen as significant a disparity between home price appreciation and personal income growth during this cycle as during the 1980s. Also in contrast to the 1980s, New England (and the Northeast generally) has seen little speculative purchase or construction activity in recent years, which should help to mitigate any price weakness through the current recession in these markets.30

30 "Regional Perspectives," Boston Region, Regional Outlook, First Quarter 2002.


Home prices are holding up in most markets, and, generally, permanent residential mortgages have fared well in prior recessions. However, history might understate credit risks for insured institutions during this cycle because the mortgage lending business has changed since the last recession. Chief among these changes are robust mortgage market competition, which has contributed to narrower collateral margins; increased reliance on underwriting automation; and expanded involvement in the subprime credit market. In addition, residential C&D lenders in certain markets might be particularly vulnerable, since C&D credits typically undergo higher loss rates and some areas are experiencing continued construction despite a cyclical slowdown (as measured by employment trends). Permanent mortgage lenders in certain areas, such as the San Francisco Bay area, could also face higher loss rates and foreclosures going forward, as the current economic weakness places downward pressure on home prices and dampens the ability of households to meet mortgage payments.

Scott Hughes, Regional Economist
Judy Plock, Senior Financial Analyst
Joan Schneider, Regional Economist
Norm Williams, Regional Economist

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Last Updated 03/25/2002

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