In the mid-1990s, the public policy goal of increasing the U.S. homeownership rate collided with a huge leap in financial innovation. Lenders shifted from originating and holding mortgages to originating and packaging them for sale to investors. These new financial products enabled millions of Americans who hadn’t previously qualified to buy a home to become owners. Housing construction boomed, reaching a postwar high—9.1 million homes were built between 2002 and 2006, a period when 5.6 million U.S. households were formed. ; The resulting oversupply of homes presents policymakers with a formidable challenge as they struggle to craft a sustainable economic recovery. Usually a driver of economic recoveries, the housing market is foundering as an engine of growth. ; Generations of policymakers since the 1930s have sought to increase the homeownership rate. By the late 1960s, it had reached 64.3 percent of households, remaining there through the mid-1990s, in apparent equilibrium with household formation during a period of sustained U.S. economic growth. A fresh push to increase ownership drove the rate up 5 percentage points to its peak in the mid-2000s. Home price gains followed the rate upward.Mortgage loans ; Construction industry ; Housing - Prices

Danielle DiMartino Booth

David Luttrell

English

Research Papers in Economics

Insights from the 
Federal reserve Bank oF dallas
EconomicLetter
vol. 5,  no. 14
deCeMBer 2010   
Usually a driver of   
economic recoveries, 
the housing market 
 is foundering as 
an engine of growth.
I
n the mid-1990s, the public policy goal of increasing the U.S. home-
ownership rate collided with a huge leap in financial innovation. 
Lenders shifted from originating and holding mortgages to originating and 
packaging them for sale to investors. These new financial products enabled 
millions  of  Americans  who  hadn’t  previously  qualified  to  buy  a  home 
to  become  owners.  Housing  construction  boomed,  reaching  a  postwar 
high—9.1 million homes were built between 2002 and 2006, a period when 
5.6 million U.S. households were formed. 
The  resulting  oversupply  of  homes  presents  policymakers  with  a 
formidable  challenge  as  they  struggle  to  craft  a  sustainable  economic 
recovery. Usually a driver of economic recoveries, the housing market is 
foundering as an engine of growth.
Generations of policymakers since the 1930s have sought to increase 
the homeownership rate. By the late 1960s, it had reached 64.3 percent of 
households, remaining there through the mid-1990s, in apparent equilib-
rium with household formation during a period of sustained U.S. economic 
growth. A fresh push to increase ownership drove the rate up 5 percent-
age points to its peak in the mid-2000s. Home price gains followed the 
rate upward.
Reverting to the Mean Price
As  gauged  by  an  aggregate  of  housing  indexes  dating  to  1890,   
real home prices rose 85 percent to their highest level in August 2006. 
They  have  since  declined  33  percent,  falling  short  of  most  predictions   
for a cumulative correction of at least 40 percent.1 In fact, home prices 
still  must  fall  23  percent  if  they  are  to  revert  to  their  long-term  mean   
(Chart 1). The Federal Reserve’s purchases of Fannie Mae and Freddie Mac
The Fallacy of a Pain-Free Path
to a Healthy Housing Market
by Danielle DiMartino Booth and David Luttrell	 EconomicLetter	 Federal reserve Bank oF dallas 2 	 Federal reserve Bank oF dallas  EconomicLetter
government-sponsored-entity bonds, 
which eased mortgage rates, supported 
home prices. Other measures included 
mortgage modification plans, which 
deferred foreclosures, and tax credits, 
which boosted entry-level home sales.
Measuring the success of these 
efforts is important to determining the 
trajectory of the economic recovery 
and providing policymakers with a 
blueprint for future action. New-home 
sales data, though extremely volatile, 
are considered a leading indicator for 
the overall housing market. Since expi-
ration of the home-purchase tax credit 
in April, sales have fallen 40 percent 
to an average seasonally adjusted, 
annualized rate of 283,000 units. This 
contrasts with the three years through 
mid-2006 when monthly sales averaged 
1.2 million on an annual basis. Before 
the housing boom and bust, single-
family home sales ran at half that pace. 
Because current sales are at one-fifth 
of the 2005 peak, new-home invento-
ries—now at a 42-year low—still rep-
resent an 8.6-month supply. An inven-
tory of five to six months suggests a 
balanced market; home prices tend to 
decline until that level is achieved.
One factor inhibiting the new-
home market is a growing supply 
of existing units. The 3.9 million 
homes listed in October represent 
a 10.5-month supply. One in five 
mortgage holders owes more than 
the home is worth, an impediment 
that could hinder refinancings in 
the next year, when a fresh wave of 
adjustable-rate mortgages is due to 
reset. The number of listed homes, in 
other words, is at risk of growing fur-
ther. This so-called shadow inventory 
incorporates mortgages at high risk 
of default; adding these to the total 
implies at least a two-year supply.2
The mortgage-servicing industry 
has struggled with understaffing and 
burgeoning case volumes. The aver-
age number of days past due for loans 
in the foreclosure process equates to 
almost 16 months, up 64 percent from 
the peak of the housing boom. One 
in six delinquent homeowners who 
haven’t made a payment in two years 
is still not in foreclosure.3 Mounting 
bottlenecks suggest the shadow inven-
tory will grow in the near term.
Notably, not all homeowners in 
arrears suffer financial hardship due to 
unaffordable house payments. Those 
with significant negative equity in their 
homes may choose to default even 
though they can afford to make the 
payments. Such “strategic default” is 
inherently difficult to measure; one 
study found 36 percent of mortgage 
defaults are strategic.4 Though the 
effect is not readily quantifiable, the 
growing lag between delinquency and 
foreclosure provides an added induce-
ment for this form of default.
Mortgage Modification Limits
One set of policies to aid home-
owners in dire straits involves mort-
gage modifications, though these 
efforts have only minimally reduced 
housing supplies. The most far-
reaching effort has been the Making 
Home Affordable Program (previously 
the Home Affordable Modification 
Program, or HAMP), in effect since 
March 2009. After only one year, can-
cellations—loans dropped from the 
program before a permanent change 
was completed—eclipsed new modi-
fications (Chart 2). Since March, the 
number of cancellations has continued 
to exceed new trial modifications, 
which involve eligibility and documen-
tation review, and successful perma-
nent modifications.
The fact that many mortgage 
holders have negative equity in their 
homes stymies modification efforts. In 
the case of HAMP, the cost of carrying 
a house must be reduced to 31 percent 
of the owner’s pretax income. Even if 
permanent modification is achieved, 
adding other debt payments to arrive 
at a total debt-to-income ratio boosts 
the average participant’s debt burden 
to 63.4 percent of income. In many 
cases, the financial innovations of the 
credit boom era, enabling owners to 
monetize home equity, encouraged 
high aggregate debt.
A study found that in a best-case 
outcome, 20 to 25 percent of modifica-
tions will become permanent.5 In 2008, 
one in three homeowners devoted at 
least a third of household income to 
housing; one in eight was burdened 
Chart 1
U.S. Real Home Prices Returning to Long-Term Mean?
Index, 1890 = 100
–1 standard deviation
+1 standard deviation
50
70
90
110
130
150
170
190
210
Q2:2010 2000 1990 1980 1970 1960 1950 1940 1930 1920 1910 1900 1890
–23%
+85% –33%
SOURCES: Irrational Exuberance, 2nd ed., by Robert J. Shiller, Princeton, N.J.: Princeton University Press 2005 and 2009, 
as updated; authors’ calculations.	 EconomicLetter	 Federal reserve Bank oF dallas 	 Federal reserve Bank oF dallas  EconomicLetter 3
with housing costs of 50 percent or 
more.6 Failed modifications suggest 
that, without strong income growth, 
the bounds of affordability can be 
stretched only so far.
Without intervention, modest 
home price declines could be allowed 
to resume until inventories clear. 
An analysis found that home prices 
increased by about 5 percentage points 
as a result of the combined efforts to 
arrest price deterioration.7 Absent incen-
tive programs and as modifications 
reach a saturation point, these price 
increases will likely be reversed in 
the coming years. Prices, in fact, have 
begun to slide again in recent weeks. 
In short, pulling demand forward has 
not produced a sustainable stabilization 
in home prices, which cannot escape 
the pressure exerted by oversupply 
(Chart 3).
Lingering Housing Market Issues
About 3.6 million housing units, 
representing 2.7 percent of the total 
housing stock, are vacant and being 
held off the market. These are not 
occasional-use homes visited by 
people whose usual residence is else-
where but units that are vacant year-
round. Presumably, many are among 
the 6 million distressed properties that 
are listed as at least 60 days delin-
quent, in foreclosure or foreclosed in 
banks’ inventories.  
Recent revelations of inadequately 
documented foreclosures and the 
resulting calls for a moratorium on 
foreclosures—what was quickly coined 
“Foreclosuregate”—threaten to further 
delay housing market clearing. While 
home price declines may be arrested 
as foreclosure paperwork issues are 
resolved, the buildup of distressed 
supply will only grow over time. 
Perhaps less obviously, some lenders 
with the means to underwrite new 
mortgages will remain skeptical about 
the underlying value of the collateral.
With nearly half of total bank 
assets backed by real estate, both 
homeowners on the cusp of nega-
tive equity and the banking system as 
a whole remain concerned amid the 
resumption of home price declines.8 
This unease highlights the housing 
market’s fragility and suggests there 
may be no pain-free path to the even-
tual righting of the market. No perfect 
solution to the housing crisis exists. 
The latest price declines will undoubt-
edly cause more economic disloca-
tion. As the crisis enters its fifth year, 
uncertainty is as prevalent as ever and 
continues to hinder a more robust 
Chart 2
HAMP Modifications Ramping Down
Monthly modifications started (thousands)
0
20
40
60
80
100
120
140
160
180
Canceled
Permanent
Trial
July ’10 May ’10 Mar. ’10 Jan. ’10 Nov. ’09 Sept. ’09 July ’09 May ’09
158 155
Sept. ’10
SOURCE: Treasury Department, Making Home Affordable Program Servicer Performance Report through October 2010.
Chart 3
Payback Effects Follow Tax Credit Expiration
Diffusion index, +50 = increasing
30
35
40
45
50
55
60
65
70
Closed transactions
Number of offers
Sales price
Time on market
July ’10 May ’10 Mar. ’10 Jan. ’10 Nov. ’09 Sept. ’09 July ’09
Tax credit
expiration
Sept. ’10 Nov. ’10
SOURCE: Campbell/Inside Mortgage Finance, Monthly Survey of Real Estate Market Conditions, November 2010.EconomicLetter  is  published  by  the 
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economic recovery. Given that time 
has not proven beneficial in rendering 
pricing clarity, allowing the market to 
clear may be the path of least distress.
DiMartino Booth is a financial analyst and 
Luttrell is a research analyst in the Research 
Department of the Federal Reserve Bank of Dallas.
Notes
1 See Irrational Exuberance, 2nd ed., by Robert 
J. Shiller, Princeton, N.J.: Princeton University 
Press, 2005 and 2009, as updated by author 
(www.econ.yale.edu/~shiller/data.htm).
2 Authors’ calculations using the Census Bureau’s 
new-home sales report, the National Associa-
tion of Realtors’ existing-home sales release and 
Capital Economics’ July 13, 2010, U.S. Housing 
Market Monthly report.
3 Data from LPS Applied Analytics. 
4 See “The Determinants of Attitudes Towards 
Strategic Default on Mortgages,” by Luigi Guiso, 
Paola Sapienza and Luigi Zingales, Economics 
Working Papers no. ECO2010/31, European Uni-
versity Institute, July 2010 (previously circulated 
as “Moral and Social Constraints to Strategic 
Default on Mortgages,” NBER Working Paper no. 
15145, National Bureau of Economic Research, 
July 2009). The number of strategic defaulters 
as a percentage of total defaulters rose to 35.6 
percent in March 2010 from 23.6 percent in 
March 2009. 
5 See “Foreclosure Pipeline to Govern Home Price 
Inflation: A Dialogue with Mortgage Servicers 
and Policy Officials,” Zelman & Associates, May 
18, 2010.
6 See “The State of the Nation’s Housing 2010,” 
Joint Center for Housing Studies, Harvard Univer-
sity, June 2010.
7 See “Housing Markets and the Financial Crisis 
of 2007–2009: Lessons for the Future,” by John 
V. Duca, John Muellbauer and Anthony Murphy, 
Journal of Financial Stability, vol. 6, no. 4, 2010, 
pp. 203–17.
8 Real estate secures 58 percent of all U.S. bank 
loans, and real estate-backed assets account for 
46 percent of total bank assets. See “U.S. Hous-
ing: How Bad For Banks?” BCA Research Daily 
Insights, Sept. 27, 2010. CoreLogic reports that a 
5 percent decline in home prices would result in 
an additional 2.5 million underwater borrowers. 
See “Housing: Stuck and Staying Stuck,” by Nick 
Timiraos and Sara Murray, wsj.com, Sept. 24, 
2010.

The fallacy of a pain-free path to a healthy housing market

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