What Happens to Banks When House Prices Fall? U.S. Regional Housing Busts of the 1980s and 1990s

mortgage debt market and thereby increase the losses lenders experience on loan defaults. The popularity of nontraditional mortgage loans, such as interest-only loans and adjustable-rate loans that permit negative amortization (“option ARMS”), raises additional concern about default risk because such loans expose borrowers to more interest-rate and house-price risk than traditional fixed-rate, amortizing loans. This article explores the implications of a substantial decline in nominal house prices by revisiting episodes of large decline in house prices that occurred in several U.S. states during the 1980s and 1990s. States that experienced large declines in residential real estate prices tended to suffer more bank distress, and longer and deeper declines in economic activity, than did other states. Several states have recently experienced increases in house prices that rival rates of appreciation experienced by states that subsequently saw marked house price declines in the 1980s and 1990s. In the aggregate, however, U.S. banks H ouse prices in the United States have soared over the past five years. A common measure of the trend in house prices is the repeat sales index produced by the Office of Federal Housing Enterprise Oversight (OFHEO). According to this measure, between 2001:Q1 and 2005:Q3, U.S. house prices increased by an average of 40 percent in nominal terms and 29 percent relative to the consumer price index (excluding the shelter component of the CPI). This rapid appreciation has led some analysts to forecast a correction in real house prices—possibly even a decline in nominal prices. A decline in nominal house prices would reduce household wealth, which could restrain the growth of consumer expenditures and overall economic activity. Mortgage default rates could increase sharply if a decline in house prices were accompanied by slower growth of household income or rising interest rates. Furthermore, a decline in house prices would reduce the value of collateral behind the $8 trillion residential The recent rapid appreciation of house prices in many U.S. markets has prompted concern over the possible effects of a sharp decline in prices, especially for commercial banks and other real estate lenders. This article examines regional real estate booms and busts in the 1980s and 1990s: Only about half of state house price booms were followed by a severe decline in prices, but large declines occurred in several states that did not have a prior boom. Banks in states that had large house price declines experienced high loan default rates and, thus, low profit and high failure rates. Although U.S. banks may have become more exposed to residential real estate recently, they appear less vulnerable to a decline in house prices than banks in states with large price declines in the earlier period. (JEL G210, R110, R310)