Dennis Heffley

MaryJane Lenon

English

Research Papers in Economics

8  THE CONNECTICUT ECONOMY  WINTER 2009
BY DENNIS HEFFLEY AND  
MARYJANE LENON*
One  of  the  many  “perfect  storms” 
that  recently  joined  forces  to  cause 
world  financial  markets  to  implode 
occurred in housing markets, as pric-
es plunged and hapless owners faced 
foreclosure.    Connecticut  and  other 
New England states have seen some 
high winds and heavy rain.  But how 
hard  have  they  been  hit  relative  to 
other states and the U.S?  
REAl EFFECTS OF UNREAl 
TRANSACTIONS
  Most of us (economists included) 
find the descriptions of credit default 
swaps, mortgage-backed securities, 
derivatives, and even more obscure 
financial instruments tedious and 
confusing.  What we do understand 
all too well are the “real” effects that 
sour financial markets are having 
on markets for housing, labor, and 
everyday goods and services.   Because 
it accounts for a major share of con-
sumer spending, and given its critical 
role in the current crisis, we focus here 
on the housing market. 
  Actually a complex set of markets, 
segmented by geography, quality and 
ownership status, “the housing market” 
affects us in many ways.  All but the 
homeless  consume  housing  services, 
either as renters or owners, and many 
owners regard their homes as impor-
tant vehicles for saving and transferring 
wealth to children, friends, or worthy 
causes—assisted by favorable tax pro-
visions.  Furthermore, where we buy 
or rent housing often determines the 
quality of education our kids receive, 
the other public services we share, and 
the taxes we pay to support such activi-
ties.
  Observers  blame  much  of  our 
financial distress on homebuyers’ igno-
rance or greed, “innovative” practices 
of  mortgage  lenders,  or  the  naiveté 
of  housing  officials  and  regulators.   
But name-calling, finger-pointing and 
punishments  will  more  likely  benefit 
lawyers than the public.  It could be 
more helpful if we set aside our current 
mistrust  of  housing  institutions  and 
instead seek a clearer understanding of 
housing  market  patterns,  particularly 
foreclosures  and  falling  home  prices 
and the link between them.
hOUSE PRICES AND 
FOREClOSURES
  Foreclosures by mortgage lenders 
occur in even the best of economic 
times, but they accelerate during 
recessions, when housing markets or 
homeowners’ incomes, or both, head 
south.  A lender may initiate foreclo-
sure proceedings when an owner fails 
to meet the obligations specified in a 
mortgage agreement.  If the market 
value of a house declines sharply, it 
may become financially attractive 
for the occupant to forfeit the lower-
valued property in order to shed the 
higher-valued mortgage obligation.  
Falling home prices also may prompt 
a lender to pull the foreclosure trigger 
sooner to resell the repossessed prop-
erty before its value further erodes.
  But the link between home prices 
and foreclosures is not a one-way path.   
Foreclosures also can reduce the prices 
of both foreclosed and sound proper-
ties.  Banks often discount foreclosed 
properties  to  move  them  quickly  off 
their  books.    But,  as  they  do,  these 
“bargain” properties lower the market 
value  of  other  properties—a  “conta-
gion” effect that can be quite strong in 
housing developments, where foreclo-
sures can sharply lower the appeal and 
market  value  of  an  entire  neighbor-
hood of similar homes.  Foreclosures 
are  more  likely  to  occur  and  spread 
in  non-descript  housing  tracts  with 
“cookie-cutter” units than in areas with 
unique features and an interesting mix 
of homes.  In simple economic terms, 
“product  differentiation”  offers  some 
protection from price competition in a 
stale market.
  Whether falling home prices gen-
erate more foreclosures, or vice versa, 
is  a  case  of  chicken-or-egg  causality.   
We could spend plenty of time trying 
to unravel the two effects, but the pri-
mary point remains: larger reductions 
in  house  prices  are  associated  with 
bigger  increases  in  the  percentage  of 
mortgages in foreclosure, as the scat-
terplot illustrates.
  Combining recent state-level house 
price changes, based on data from the 
Office of Federal Housing Enterprise 
Oversight (OFHEO) for the year end-
ing  June  30,  2008,  and  Mortgage 
Bankers  Association  (MBA)  data  on 
changes  in  the  percent  of  subprime 
mortgages  in  foreclosure  between 
2007-Q2  and  2008-Q2,  shows  a 
strong negative relationship.  Each 1-
point rise in the percent of subprime 
loans in foreclosure is associated with 
a drop of about 1.33 percentage points 
in house prices; and about 76% of the 
interstate variation in price changes is 
explained by differences in the growth 
of subprime foreclosures.  
hOW hAVE CONNECTICUT AND 
NEW ENGlAND FARED?
  Clearly  on  the  rise,  foreclosures 
remain  a  relatively  small  share  of  all 
mortgages  nationally.    In  2008-Q2, 
Foreclosures and Falling   
Home PricesWINTER 2009  THE CONNECTICUT ECONOMY  9 
2.8%  of  all  U.S.  mortgages  were  in 
foreclosure, but this figure varied con-
siderably by mortgage type.  Foreclosure 
percentages in that quarter were 1.4% 
for prime, 1.3% for VA, and 2.2% for 
FHA mortgages.  But, for higher-risk 
subprime  mortgages  the  figure  was 
11.8%,  more  than  double  the  5.5% 
rate  of  a  year  earlier  (2007-Q2)  and 
still rising.  
  National figures matter, but they 
hide  interesting  state-level  differences 
in the prevalence of foreclosures which, 
given  the  relationship  in  the  earlier 
graph, also reflect major differences in 
house price changes.  At the state level, in 
2008-Q2, Florida (19.8%), California 
(16.9%) and Nevada (16.6%) led all 
states in the percent of subprime mort-
gages in foreclosure.  These “problem 
states” also had sharp declines in house 
prices after peaking in the last half of 
2006.    As  shown  in  the  top  part  of 
the “stacked” graphs, the price decline 
in each of the three states was earlier 
and much more pronounced than for 
the U.S.  [By the way, the figures plot-
ted in this graph and the one below it 
are area-specific indexes.  Each index 
is pegged to a value of 100 in 1980, 
so each line shows how prices in that 
area have changed over time.  But, in 
any given time period, comparing one 
index with another says little about the 
house price levels in those areas.]
  New  England  has  not  avoided 
the  twin  problems  of  mortgage  fore-
closures and falling home values.  For 
2008-Q2, Rhode Island (15.4%) and 
Maine  (14.2%)  ranked  4th  and  7th 
among  all  states  in  the  percentage 
of subprime mortgages in foreclosure.   
Massachusetts  (12.7%)  and  Vermont 
(11.9%)  were  further  down  the  list, 
but  only  Connecticut  (11.0%)  and 
New Hampshire (8.5%) had subprime 
foreclosure figures below the U.S. aver-
age (11.8%).  Yet, when it comes to 
house prices, it’s interesting to contrast 
the  indexes  for  the  three  southern 
New  England  states—Connecticut, 
Massachusetts,  and  Rhode  Island—
and  the  entire  New  England  region 
with the patterns seen in the “problem 
states.”    The  bottom  portion  of  the 
stacked  graph  shows  that  all  three 
southern  New  England  states  saw  a 
decline in house prices in recent years, 
but none as severe as the major down-
turns in the Sunbelt.
WhAT’S AhEAD?
  The  New  England  states  clearly 
took their lumps after the late 1980s 
run-up in house prices.  Connecticut 
prices, for example, took 12 years to 
regain their 1988 peak.  This prolonged 
decline  and  recovery  may  have  left 
New England homebuyers and inves-
tors a bit more cautious than in the 
“problem states,” where only California 
registered a slow but sustained drop in 
prices throughout most of the 1990s.   
Florida and Nevada saw mostly steady 
growth  before  prices,  fueled  by  easy 
credit,  turned  sharply  upward  in  the 
early part of this decade.  Less “bub-
ble experience” may have conditioned 
Sunbelt  homebuyers  to  believe  that 
prices would continue to rise unabated.   
But New Englanders had seen this pat-
tern more recently, were subject to the 
fallout for a longer period, and conse-
quently were less eager to jump back 
into the housing market.  So far, that 
foot-dragging  may  have  reduced  the 
need for the more severe price adjust-
ments seen elsewhere, but it remains 
to be seen if the region can forestall a 
serious  deterioration  of  home  values 
in the face of growing unemployment 
and falling incomes.  New Englanders’ 
storied resilience may come in handy 
down the road.
FORECLOSURES: CAUSE OR SYMPTOM 
OF DECLINING HOUSE PRICES?
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LESS SEvERE ADJUSTMENTS IN 
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SOURCE: OFHEO House Price Indexes
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*MaryJane Lenon is Associate Professor of Economics 
at Providence College and a frequent contributor to 
this publication.

Foreclosures and Falling Home Prices

http://cteconomy.uconn.edu/articles/DH_W2009.pdf

Foreclosures and Falling Home Prices

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