The defining characteristic of the economic downturn of the last few years has been the collapse in real estate prices from their 2006 peak. The losses have impacted the economy in a variety of ways. Aside from devaluing many families' single largest asset, declining home prices removed the equity extraction that had been juicing consumption for years. The housing crash has also impacted the labor markets by both destroying many high-paying jobs in the construction trades and impairing the mobility of workers saddled with negative equity.

While it isn't news that home prices impact the prepayment and credit performance of mortgage loans, it is nonetheless useful to review some of the lessons of the past few years. One is that the performance of all mortgage products is linked to stable home prices. In the early throes of the "mortgage crisis," there was commentary that the gross underestimation of subprime default rates was due to the lack of long-term performance data on the product; there were, by contrast, many years of performance history on prime mortgages. In retrospect, however, there was a dearth of performance data for all mortgage products in an environment of declining home prices. Between 1972 and 2006, for example, the Freddie Mac national home price index averaged 6% year/year increases, without a single negative quarter. This implies that the historical performance of all mortgage products, including prime loans, had been distorted by the steady increases in home prices.

The sharp decline in home prices also upended many assumptions of how borrowers treat their mortgages and respond to adverse financial circumstances. The prevailing assumption was that prime borrowers would continue to service their mortgages while letting other debts lapse. However, recent data seem to suggest that underwater borrowers often attempt to maintain their liquidity and mobility by continuing to pay credit cards and auto loans while allowing their mortgages to become seriously delinquent, especially given the protracted delays involved in foreclosure proceedings. The ultimate expression of this trend is the phenomenon of strategic default.

Thus, even the performance of borrowers with strong credit can disappoint when home prices experience a substantial and protracted decline. The strong relationship between mortgage performance and real estate prices also suggests that mortgage loans are riskier assets than had previously been assumed, irrespective of product and borrower attributes. This notion raises a host of questions on topics including lending practices (e.g., down payment requirements), risk retention (whether having more "skin in the game" makes financial institutions riskier) and capital requirements.

This also means that policies taken toward housing will impact the financial markets, and vice versa.The focus of recent housing initiatives has almost exclusively been on short-term remedies such as foreclosure prevention and tax credits, while financial reform efforts have ignored the impact of the proposed legislation on housing. The Obama Administration and Congress need to address the long-term future of housing and focus on restoring the housing market to more normal functioning. Such steps should include helping to keep mortgage money available for all home price segments, while opposing destructive actions such as the elimination of the mortgage interest deduction, which would have a devastating impact on housing and the overall economy.

A key source of uncertainty for the mortgage and capital markets remains whether and/or when the real estate markets might return to their historical pattern of steady increases. The lingering impact of homeowner losses, coupled with disruptions in housing finance and shifting demographic patterns, may mean that we're headed into a sustained period where home prices are more volatile, and long-term appreciation more uncertain, than in the past.


Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is

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