FHFA: Stress Tests Reveal How Low House Prices Can Go

The Federal Housing Finance Agency (FHFA) recently released a new working paper titled, “How Low Can House Prices Go? Estimating a Conservative Lower Bound,” identifying a conservative lower bound for home prices in relation to long-term trend. Contributors to the paper included Alexander Bogin, senior economist for FHFA, Stephen Bruestle, lecturer at Penn State Erie, and William Doerner, senior economist for FHFA.

Both credit risk and capital are associated with mortgage assets and are usually calculated using a stress test, the authors note.  Factors that should be considered when determining the severity of credit-related losses include: how far house prices are above long-term trend and how far they are below trend. The paper describes how to determine how far homes are falling below trend.

“Leveraging a model based upon consumer and investor incentives, we are able to explain the depth of housing market downturns at both the national and state level over a variety of market environments,” the authors said. “In brief, as house prices fall below trend, housing becomes an increasingly attractive investment—it’s empirically documented, mean-reverting nature may engender higher expected returns.”

According to the working paper, when home prices are on a steady decline, this is an incentive that attracts investors and consumers to the market which causes a huge mass of demand that causes home prices to rebound. The same approach held true for an in-sample back-test using data from 1987 to 2001, where the authors found that their estimation approach does not understate any state-level house price declines. Their estimation approach only understates severity in three states in an out-of-sample back test using data from the most recent financial crisis.

“This estimation technique could prove particularly helpful in measuring the credit risk associated with portfolios of mortgage assets as part of evaluating static stress tests or designing dynamic stress tests,” the authors said.

An important determinant of how severe the stress test results will be is the price path the house is on, and this can either be static or dynamic in nature, the paper reveals. A static path means there is a fixed decline in home prices that is usually based on historical experience. A fixed decline can mean different levels of effective stress when applied at different points in the housing cycle or the depth of the house price shock relative to long-term trend. This results in an inadequate level of stress where house prices are above their long-term trend, but an improbable amount of stress when the market is downs and home prices are at or under their long-term trend.

On the other hand, the paper says that fixed house price shocks have caused stress situations that are unlikely by any historical standard based on the recent crisis but applied during recovery (2012-present). Unlike a fixed house price shock, a dynamic path responds to the current market conditions and provides a precise estimate of the severity of the future of house price downfalls. This is an important part of dynamic stress testing and is used to assess how accurate the static stress test is.

“Since the recent financial crisis, there has been an increasing focus on improving stress testing and thus far, the stressed housing paths have been largely static in nature, essentially ignoring current market conditions.” the authors conclude. “This area of work is particularly important for evaluating the reasonableness of static stress tests or developing dynamic stress tests that could help prepare financial institutions for low probability but high impact events such as the recent financial crisis.”