Meet the Author

O. Emre Ergungor |

Assistant Vice President and Economist

O. Emre Ergungor

Emre Ergungor is an assistant vice president and economist in the Research Department at the Federal Reserve Bank of Cleveland. He is responsible for the household finance section of the Banking Policy and Analysis Group, which conducts research on regulatory policy and banking issues and provides advice on financial policy formulation. He also oversees the Federal Reserve System’s Muni Financial Monitoring Team (FMT), which monitors municipal bond markets, state and local funding, and public pension funds. Dr. Ergungor specializes in research related to financial intermediation, information economics, housing policy, and credit access in low- to moderate-income households.

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Meet the Author

Kent Cherny |

Research Assistant

Kent Cherny

Kent Cherny was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland.


Economic Trends

U.S. Real Estate: Looking for Progress in Price Stability and Financing

O. Emre Ergungor and Kent Cherny

The Case-Shiller composite price index continues to indicate contraction in U.S. residential home values. In the fourth quarter of 2009, the index stood at 139.14, down a cumulative 26.7 percent from its peak during the second quarter of 2006. By now the story of how we ended up here has become almost passé: a combination of low interest rates, loose lending standards, and financial innovation produced a boom in real estate prices on a broad, national level.

Rapid valuation increases allowed homeowners to continually refinance their mortgages and extract new equity as cash, as shown in the figure below. At its peak in the first quarter of 2006, the volume of equity extraction was over $900 billion.

By mid-2008 net equity extraction turned negative, as plummeting home values meant that many home owners were under water, with total housing debt exceeding the value of the underlying property.

Some homeowners and investors who opted not to walk away from their depreciating homes found they could no longer afford their monthly payments. Troubled loan rates have been and continue to be notably higher for adjustable-rate mortgages than for fixed-rate mortgages (in both the prime and subprime categories).

As of the fourth quarter of 2008, 17.1 percent of prime ARM mortgages were troubled loans (those either delinquent or in foreclosure), compared to 5.3 percent of prime fixed-rate mortgages. Likewise, 51.8 percent of subprime ARMs were past due or in foreclosure, compared to 27.8 percent for fixed-rate subprime mortgages. Many ARMs were originated with teaser rates that lasted only a year or two before kicking up to higher interest rates, which lenders did not see as terribly problematic when home prices were appreciating rapidly and mortgages could be continuously refinanced. But when home prices begin to fall, refinancing is less of an option, and a rising unemployment rate only adds to the upward pressure on delinquencies and foreclosures.

Is there a way to know when home prices will reach a bottom? Any guess is complicated by the current state of the economy and financial markets. High negative sentiment among consumers and investors, combined with impaired credit markets, could cause the market to undershoot when equilibrating long-run supply and demand. (This in part explains why policymakers at all levels have been acting to support the housing market: Homes serve as collateral for trillions of dollars in loans, and so are intimately tied to financial stability.)

Still, some commentators have put forth ideas for determining a general range in which home prices might stabilize. For example, economists at the Federal Reserve Bank of Atlanta compared  the historical relationship between home prices and the labor force size.

One other potentially useful ratio is that of home prices to owners’ equivalent rent, a component of the CPI. Between 1987 and the start of the credit bubble in the early 2000s, the normalized ratio (1987:Q1= 1.00) fluctuated around 1.00, staying within a 0.10 range. It really began to take off in 2002, peaked at 1.59 in 2006, and only in the fourth quarter of 2008 did it again enter the range it had been in before the bubble. Although this ratio does not necessarily indicate stabilization in the residential housing market, it may be a positive sign that prices are getting closer to their long-run fundamental values.

The Federal Reserve in December 2008 set the target federal funds rate to a range of 0.00 percent to 0.25 percent. This action, combined with other policy moves  bring liquidity to the system and support the mortgage market directly (via mortgage-backed security purchases), has helped to lower rates for the purchase and refinance of residential homes. At 4.98 percent, the rate on conventional 30-year fixed-rate mortgages is lower than at any point during the credit boom itself.

Like residential property, commercial real estate experienced its own boom in values (although it peaked about a year later than the residential market). Apartment, office, retail, and industrial real estate values all increased dramatically in the 2005-2008 period. Since the market peak in mid-to-late-2007, all have fallen at least 9 percent (retail), with industrial property values falling 25 percent. Though prices have fallen substantially from their highs, a bottom is difficult to predict, given that commercial mortgage cash flows are heavily dependent on economic conditions. The ability of commercial enterprises to stay in business and meet their rent or mortgage payments is likely to closely track the severity (and eventual end) of the current recession, as will commercial real estate prices.

Hundreds of billions of dollars of commercial real estate loans were packaged into commercial mortgage-backed securities (CMBS) in recent years, and the illiquidity in asset-backed markets generally has hit CMBS in a big way, as shown by their associated risk premiums. AAA-rated tranches of CMBS currently trade at about the 10-year Treasury rate plus 10 percent. The lower grades of securities trade at spreads of 60 percent to 90 percent. As noted earlier, market prices can hit distressed levels if financial markets are not operating normally. Exorbitant spreads in the CMBS market reflect both the credit-quality degradation associated with the recession and the impairment of the financial markets. A major concern is that problems in the credit market will prevent large amounts of commercial real estate debt from being rolled over (that is, refinanced).

Notice, however, that AAA spreads recently began to decrease. This may be a response to the recent announcement that the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) would accept CMBS as collateral and thus aid the return of liquidity to the market.