In this month's Atlantic, Bob Shiller has a thought-provoking piece on how to attenuate the mortgage meltdown. In that piece, however, he juxtaposes Freddie Mac Chief Economists' Frank Nothaft's statement that the company has modeled the company's financial health assuming a 13.8 percent decline in house prices with his own that real house prices have fallen by 15 percent from peak to trough.
From the standpoint of mortgage performance, it is nominal, not real, house prices that matter, because mortgage balances do not adjust to changes in the price level. So long as nominal prices rise, the incentive to default is low, because home equity will be increasing.
Just as problematic, Shiller is applying the Case-Shiller Index to make conclusions about Fannie/Freddie performance. But for evaluating Fannie/Freddie, the OFHEO purchase index is best, because it only contains loans that Fannie/Freddie actually fund, and because it is based only on transactions. This index has fallen 3.1 percent from peak so far. This is nothing to celebrate, but it is well within the realm of what Freddie modeled.
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