The hope that housing markets had stabilized in mid-2010 was dashed by subsequent declines in home construction and prices (Charts 1 and 2). Homebuilding peaked about five years ago, and housing prices almost four years ago. Amid such a prolonged downturn, a key question becomes, When will the housing market stabilize and support the economic recovery? We suggest that new home construction may stabilize and start recovering slowly within the next year or so. Our econometric results also indicate that national house prices may hit bottom late this year or in early 2012 and then recover slowly.Housing - Prices ; Mortgage loans

Anthony Murphy

David Luttrell

John V. Duca

English

Research Papers in Economics

Insights from the 
Federal reserve Bank oF dallas
EconomicLetter
Vol. 6,  No. 8
AUGUST  2011  
New home construction 
may stabilize and start 
recovering slowly within 
the next year or so.   
National house prices 
may hit bottom late this 
year or in early 2012 and 
then recover slowly.
T
he hope that housing markets had stabilized in mid-2010 was 
dashed by subsequent declines in home construction and prices 
(Charts 1 and 2). Homebuilding peaked about five years ago, and hous-
ing prices almost four years ago. Amid such a prolonged downturn, a key 
question becomes, When will the housing market stabilize and support the 
economic recovery? We suggest that new home construction may stabilize 
and start recovering slowly within the next year or so. Our econometric 
results also indicate that national house prices may hit bottom late this year 
or in early 2012 and then recover slowly. 
Key Drivers of Housing Activity
Conventional housing models focus on standard supply and demand 
factors. New construction is very cyclical and reacts with a lag to changes 
in house prices. Moreover, greater housing supply from construction 
booms, like that of the early to mid-2000s, tends to restrain house prices 
and, subsequently, construction.  
Factors affecting demand include changes to personal income, after-
tax mortgage interest rates and expected housing capital gains or losses. 
Greater income and expectations of future home price appreciation raise 
housing demand; higher interest rates restrain it. Low unemployment and 
income growth boosted housing from mid-2001 to mid-2007.  
The most recent house price and construction run-up exceeded 
levels recorded during the 1990s economic expansion, when unemploy-
ment rates fell even lower and income grew faster. Why is this? Standard 
econometric models accounting for these factors simply cannot explain the 
surging house prices and building seen in the mid-2000s.
When Will the U.S. Housing Market Stabilize?
by John V. Duca, David Luttrell and Anthony Murphy  EconomicLetter  Federal reserve Bank oF dallas 2
Our research suggests the miss-
ing factor is mortgage credit standards, 
which, with other factors, determine 
whether potential homebuyers qualify 
for a loan.1 More people qualified for a 
mortgage during the so-called subprime 
boom because lenders eased the mini-
mum down-payment ratios, maximum 
debt-payment-to-income ratios, mini-
mum credit scores and other criteria.2 
The relaxed credit standards can 
be seen in a new survey-based data 
series on the average mortgage-loan-
to-house-price ratio, or loan-to-value 
(LTV) ratio, for first-time homebuyers 
(Chart 3), or its counterpart, the down-
payment ratio. The average, cyclically 
adjusted LTV ratio rose to as high as 
94 percent (that is, a 6 percent down 
payment) at the height of the subprime 
boom, before retreating during the 
bust. The ratio was about 88 percent 
(12 percent down payment) during 
the 1990s.3 As a result of lower down-
payment requirements, the effective 
demand for housing rose in the mid-
2000s, pushing up prices and construc-
tion. This fed into higher house-price 
expectations among borrowers and 
lenders, further boosting prices. During 
the bust, mortgage credit standards 
tightened, damping housing demand 
along with prices and construction.
New Home Construction and Sales
During the subprime boom, con-
struction of single-family homes surged 
to a high of 1.8 million units per 
year, far above the 1.1 million units 
required to cover population growth 
and physical depreciation of structures. 
Construction then collapsed, falling 
roughly 75 percent from the peak by 
mid-2009. After the economy hit bot-
tom in June 2009, housing permits 
picked up somewhat, aided by a series 
of federal tax credit programs, many 
aimed at first-time homebuyers. As the 
tax credit effort expired in mid-2010, 
construction sagged. Homebuilding 
sank to record lows shortly after a 
California homebuying tax credit 
expired in late 2010 and as unusually 
severe winter weather struck much 
of the country. Before expiring, these 
tax credits temporarily boosted home 
transactions, partly by shifting sales 
forward, although the housing market’s 
fundamental weakness remained. 
Several factors are hindering the 
housing recovery.4 First, many lenders 
are still cautious, requiring high down 
payments. Second, many houses are 
in foreclosure, and legal complica-
tions have delayed their resolution. 
Third, still other mortgage holders are 
deeply “underwater”—what they owe 
far exceeds the market value of their 
Chart 1
Housing Permits and Construction Bump Along Bottom
Permits (millions)                        Construction (billions of 2005 dollars)
0
50
100
150
200
250
300
350
400
450
500
.2
.4
.6
.8
1
1.2
1.4
1.6
1.8
2
’10 ’07 ’04 ’01 ’98 ’95 ’92 ’89 ’86 ’83 ’80 ’77 ’74 ’71
Real single-family
construction
Single-family
building permits
.2
.4
.6
.8
Apr. ’11 June ’10 Aug. ’09 Oct. ’08 Dec. ’07
Permits
Permits (millions) Construction (billions of 2005 dollars)
50
100
150
200
250
Real construction
NOTES: Shaded bars indicate U.S. recessions. Chart inset shows data since December 2007 in more detail.
SOURCE: Census Bureau.
Chart 2
Home Prices Decline After Tax Credit Expires
Percent change, year/year
Freddie Mac
S&P/Case-Shiller
U.S. Index
–20
–15
–10
–5
0
5
10
15
20
’10 ’08 ’06 ’04 ’02 ’00 ’98 ’96 ’94 ’92 ’90 ’88
Tax
credit
expires
Tax
credit
passes
SOURCES: Federal Home Loan Mortgage Corp.; S&P, Fiserv, and MacroMarkets LLC; authors’ calculations.  Federal reserve Bank oF dallas  EconomicLetter 3
property. By some estimates, there are 
about 5 million deeply underwater 
homes, amounting to 10 percent of 
mortgaged homes and 6.5 percent of 
all homes.5 Many of these homes are 
at risk of foreclosure, which would 
further boost the supply of homes for 
sale and depress existing house prices 
and new construction. 
Conversely, affordability has 
improved, and the impact of the 
supply overhang may be overstated 
because deeply underwater and fore-
closed homes are concentrated in a 
handful of states, including Arizona, 
California, Florida and Nevada. With 
job growth expanding in areas where 
less overbuilding occurred, housing 
starts will likely pick up in states such 
as Texas. Additionally, as the eco-
nomic recovery continues, the pace of 
household formation is likely to rise, 
bolstering demand. On balance, many 
forecasters see single-family home con-
struction recovering slowly to around 
500,000 units next year from an annual 
rate of 400,000 in early 2011. 
Where Are House Prices Heading?
During the boom and subsequent 
bust, house prices were affected by 
unusual factors, including large swings 
in mortgage financing standards and 
tax credits for first-time homebuyers. 
The national tax credit was important, 
amounting to about 4 percent of the 
average price of a house bought by 
first-time homebuyers—the key mar-
ginal group in the housing market.  
Our econometric models of 
U.S. house prices, estimated using 
data through third quarter 2009, take 
account of these factors, as well 
as conventional drivers of housing 
demand.6 We used our model esti-
mates and forecasts of underlying 
variables to simulate the future path 
of one house price index. This exer-
cise, carried out in early 2010, pre-
dicted that house prices would resume 
declining after the expiration of the 
U.S. tax credit in mid-2010, falling 
about 5 to 6 percent after third quar-
ter 2010 before likely hitting bottom 
in late 2011 or early 2012 (Chart 4). 
The simulation, designed to capture 
medium-run house price develop-
ments, shows nominal house prices 
overshooting fundamentals during the 
subprime boom, undershooting dur-
ing the bust, and then slowly recov-
ering and reverting to trend, barring 
any further major shocks. Since early 
2010, our simulation has tracked the 
actual movement in the Freddie Mac 
purchase-only home price index.
Of course, the simulations are 
based on assumptions about the likely 
paths of a range of economic vari-
ables determining the fundamental or 
long-run prices of housing—incomes, 
interest rates, mortgage credit stan-
dards, etc.—some of which are hard to 
predict. We assumed that the income, 
interest rate and construction variables 
move in line with the average Blue 
Chip Economic Indicators forecasts 
and, perhaps more controversially, that 
average down-payment ratios stabilize 
at 2002 levels, just over 10 percent. We 
also implicitly assume that the medi-
um- to long-run path of house prices 
is unaffected by the current high stock 
of foreclosed properties.
Housing Wealth Prompts Spending
House prices alter housing wealth, 
which in turn affects consumer spend-
ing. During the housing boom, rising 
perceptions of wealth likely induced 
people to save less for retirement. 
Additionally, the ability of families to 
borrow against higher housing wealth 
increased, particularly from the mid-
1990s until the housing bust. In our 
research on consumer spending, we 
find that these effects are both eco-
nomically and statistically important. 
For example, a $1,000 increase in 
housing wealth was associated with 
about a $10 to $15 rise in annual con-
sumer spending in the mid-1990s; the 
impact tripled to nearly $40 per $1,000 
by the mid-2000s, before receding. As 
a result, recent house price declines 
significantly slowed consumer spend-
ing. These negative effects will likely 
ebb and then turn positive after house 
prices start recovering.
Anticipating a Slow Recovery
The housing sector contributes to 
gross domestic product growth directly 
via new home construction and indi-
rectly through consumer spending. In 
Chart 3
Loan-to-Value Ratio Swings in Subprime Boom and Bust
Percent of home purchase price
From an
average
12% down
payment…
Retreat of
LTVs in
subprime
bust
75
80
85
90
95
100
’09 ’07 ’05 ’03 ’01 ’99 ’97 ’95 ’93 ’91 ’89 ’87 ’85 ’83 ’81 ’79
…to an
average
6% down
payment
Higher
LTVs in
subprime
boom
SOURCE: “Shifting Credit Standards and the Boom and Bust in U.S. House Prices,” by John V. Duca, John Muellbauer and 
Anthony Murphy, Federal Reserve Bank of Dallas, Working Paper no. 1104, April 2011.EconomicLetter  is published by the 
Federal Reserve Bank of Dallas. The views expressed 
are those of the authors and should not be attributed 
to the Federal Reserve Bank of Dallas or the Federal 
Reserve System.
  Articles may be reprinted on the condition that 
the source is credited and a copy is provided to the 
Research Department of the Federal Reserve Bank of 
Dallas.
  Economic Letter is available free of charge by 
writing the Public Affairs Department, Federal Reserve 
Bank of Dallas, P.O. Box 655906, Dallas, TX 75265-
5906; by fax at 214-922-5268; or by telephone at 
214-922-5254. This publication is available on the 
Dallas Fed website, www.dallasfed.org.
Richard W. Fisher
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the early and mid-2000s, the contribu-
tion was large. When the subprime 
bubble burst, housing exerted a sub-
stantial drag on the economy. The loan 
losses and increased uncertainty that 
accompanied the bust also slowed the 
economy by impairing the ability of 
financial intermediaries and securities 
markets to provide finance.7 Although 
the short-run outlook for the housing 
market is uncertain, it appears that 
new home construction and house 
prices at the national level will stabi-
lize and start slowly recovering within 
the next year or so. 
Duca is a vice president and senior policy advisor, 
Luttrell is a senior research analyst and coordi-
nator of economic and financial analysis, and 
Murphy is a senior research economist and policy 
advisor in the Research Department at the Federal 
Reserve Bank of Dallas.
Notes
1 “House Prices and Credit Constraints: Making 
Sense of the U.S. Experience,” by John V. Duca, 
John Muellbauer and Anthony Murphy, The 
Economic Journal, vol. 121, no. 552, 2011, pp. 
533–51.
2 “The Rise and Fall of Subprime Mortgages,” 
by Danielle DiMartino and John V. Duca, Federal 
Reserve Bank of Dallas Economic Letter, vol. 2, 
no. 11, 2007.  
3 “Shifting Credit Standards and the Boom and 
Bust in U.S. House Prices,” by John V. Duca, 
John Muellbauer and Anthony Murphy, Federal 
Reserve Bank of Dallas, Working Paper no. 1104, 
April 2011. The LTV series comes from the bien-
nial Survey of American Housing and is cyclically 
adjusted.
4 “The Fallacy of a Pain-Free Path to a Healthy 
Housing Market,” by Danielle DiMartino Booth 
and David Luttrell, Federal Reserve Bank of Dallas 
Economic Letter, vol. 5, no. 14, 2010.
5 See “Housing Statistics Hit Rough Waters,” by 
Carl Bialik, Wall Street Journal, Jan. 8, 2011.
6 See note 3.
7 For a discussion of these effects, see “Housing 
Markets and the Financial Crisis of 2007–09: 
Lessons for the Future,” by John V. Duca, John 
Muellbauer and Anthony Murphy, Journal of Fi-
nancial Stability, vol. 6, no. 4, 2010, pp. 203–17.
Chart 4
Nominal House Prices Likely to Bottom in 2012
Freddie Mac Purchase-Only Home Price Index (1987:Q1 = 100)*
Period of
homebuyer
tax credt
0
50
100
150
200
250
300
350
400
’16 ’15 ’14 ’13 ’12 ’11 ’10 ’09 ’08 ’07 ’06 ’05 ’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90
Model
simulation
Actual
In sample Out of sample
* Seasonally adjusted.
SOURCES: Federal Home Loan Mortgage Corp.; authors’ calculations.

When will the U.S. housing market stabilize?

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When will the U.S. housing market stabilize?

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