Reliable Housing Market Forecasts Need Both Statistics and Human Judgment

Freddie Mac's monthly Insight & Outlook report for August 2015 released Monday found that a substantial amount of human judgment is required in addition to statistics when determining if a housing market is overvalued or when home prices are likely to drop.

The housing industry's affordability metrics can determine when home prices are high relative to historical norms and household income, but they cannot reliably predict if or when home prices will drop either nationally or in a particular market, according to Freddie Mac. But human judgment is also needed to determine whether a housing market is overvalued due to the "surprising" amount of disagreement among various metrics that determine overvaluation.

"Statistics by themselves cannot tell us whether housing in a particular market—or the nation as a whole—is overvalued," Freddie Mac chief economist Sean Becketti said. "At best, affordability statistics wake us up to potential danger. In this way, they are like the signs posted every summer in national parks that indicate the current danger of a forest fire. We recognize when the danger is elevated, but we can't predict for sure if or when someone will accidentally drop a match in the wrong spot."

Future increases or decreases in housing prices are important in determining credit risk, and therefore setting the appropriate guarantee fee for Freddie Mac-backed mortgages, according to Freddie Mac. Freddie Mac funds houses nationwide, which gives the Enterprise an advantage over local lenders and homeowners: Since isolated local declines in house prices are averaged in with nationwide house price increases, Freddie Mac-insured loans experience the average nationwide house prices changes. The diversification cannot protect Freddie Mac against a housing bubble; instead, according to Freddie Mac, various industry practice and regulation reforms in the last seven years provide protection against a repeat of a housing boom and bust.

"Statistics by themselves cannot tell us whether housing in a particular market—or the nation as a whole—is overvalued."

"In this month's Insight & Outlook, we also revisited the topic of low down payment mortgage programs—like Freddie Mac's Home Possible Advantage—that expand affordability for creditworthy borrowers," Becketti said. "We compared actual losses on low down payment loans to losses on 20-percent down payment loans over the 10-year period 2003 to 2013, a period that includes the housing crisis. The 30-year fixed rate loans with 3 percent down payments were only 17 percent riskier than 20-percent down payment loans over that period. As a comparison, 7/1 ARMs were 155 percent riskier than 30-year fixed rate mortgages over the same period, and 5/1 ARMs were five times as risky."