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short essays and reports on the economic issues of the day
2006 ■ Number 3

Are Banks Vulnerable to a Housing Bust?
David C. Wheelock
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.
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 index).
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 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 mortgage debt market and would 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.
How exposed are banks to residential real estate? As a
share of their total assets, commercial bank holdings of residential real estate loans and securities have risen markedly
since the mid-1990s. For example, between 1999:Q1 and
2005:Q1, the sum of bank holdings of 1-to-4-family residential real estate loans and the market value of their holdings of mortgage-backed securities (excluding those issued
or guaranteed by a government agency or governmentsponsored enterprise, such as Fannie Mae and Freddie Mac)
increased from about 15 percent of total bank assets to


nearly 20 percent. More comprehensive measures that
include all residential real estate loans show similar increases
in exposure, as does the ratio of untapped home equity lines
of credit to total bank assets.
These simple exposure measures provide little information, however, about whether banks today are more vulnerable to a decline in house prices than they were in the past.
Although the share of bank assets consisting of residential
real estate loans and securities has increased since 1999, so
too has bank equity-capital relative to total bank assets.
Between 1999:Q1 and 2005:Q1, equity-capital increased
from 8.5 percent of total bank assets to 9.9 percent of total
assets. Because capital serves as a cushion against loan and
security losses, the increase in real estate loans and securities as a share of bank assets is less worrisome than it would
have otherwise been.
The national averages, of course, mask considerable
variation across banks in their holdings of residential real
estate loans and securities and in their capital-to-assets
ratios. One might assume that risks are greater for banks
located in regions that have seen the most rapid house price
appreciation. Loan-to-value ratios have tended to be lower
in such regions, however, suggesting that the mortgage market may have adapted to a possibly higher risk of house
price declines in those states. Further, the growth of the
mortgage-backed securities market and proliferation of
interstate branch banking may have reduced banks’ exposure
to local real estate shocks by facilitating greater geographic
diversification of their real estate loan and securities portfolios. Finally, a portion of the residential real estate loans
and securities held by banks are guaranteed by third parties,
and many banks purchase only highly rated securities that
have little credit risk. Thus, to get a complete picture of
how vulnerable individual banks are to a decline in house
prices, we need to know more about the composition of
their real estate loan and securities portfolios. ■

Views expressed do not necessarily reflect official positions of the Federal Reserve System.