Crashing through "fair market"

House prices are finally approaching fair value. Unfortunately, unless the housing bubble behaves differently than almost every bubble before it, house prices will now crash right through fair value and stay below it for a number of years.

When prices do finally bottom, moreover, they aren't likely to recover quickly.

We think housing prices will reach fair value/trend line, down 40% from the peak based on the
S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where
prices where as of the end of Q1 2009. It’s almost certain that prices will reach these levels.

• The key question is whether housing prices will go crashing through the trend line and fall well below fair value. Unfortunately, this is very likely.

In the long-term, housing prices will likely settle around fair value, but in the short-term prices will be driven both by psychology as well as supply and demand. The trends in both are very unfavorable.

– Regarding the former, national home prices have declined for 33 consecutive months since their peak in July 2006 through April 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price appears cheap – and sellers desperate.

– Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes already likely exceeds one year and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as they are already doing in California.

• Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010

• We are also quite certain that wherever prices bottom, there will be no quick rebound

• There’s too much inventory to work off quickly, especially in light of the millions of foreclosures over the next few years

• While foreclosure sales are booming in many areas, regular sales by homeowners have plunged, in part because people usually can’t sell when they’re underwater on their mortgage and in part due to human psychology: people naturally anchor on the price they paid or what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices

• Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter.