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Using Monte Carlo simulations to establish a new house price stress test

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  • Follain, James R.
  • Giertz, Seth H.

Abstract

The focus of this paper is on the house price stress test (termed ALMO) that was designed to assess the fiscal strength of Fannie Mae and Freddie Mac and, if necessary, to trigger remedial action in order to avert a crisis. We assess whether the ALMO stress test was an adequate representation of an extremely weak housing market, given the best available information leading up to the Great Recession. A Monte Carlo simulation model is developed to estimate the severity of low probability events (i.e., severe house price declines). We illustrate the complexity and subjective nature of the process used to generate a plausible house price stress test scenarios. A major finding is that the ALMO stress test scenario severely understated (possibly by 50% or more) what an updated statistical process would have suggested. Part of this stems from idiosyncrasies related to the construction and implementation of ALMO, while other factors include a fundamental shift in the relationship between housing price appreciation and key explanatory variables - especially over the past 10-15 years, which shows a heightened role of momentum in explaining changes in housing prices. We offer several suggestions for a new stress test that include: continual updates and testing; variation across markets; and, like the recent FRB stress test, the scenario should be based on real (rather than nominal) price patterns.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Housing Economics.

Volume (Year): 20 (2011)
Issue (Month): 2 (June)
Pages: 101-119

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Handle: RePEc:eee:jhouse:v:20:y:2011:i:2:p:101-119

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Web page: http://www.elsevier.com/locate/inca/622881

Related research

Keywords: Housing Financial crisis Stress test;

References

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  1. Case, Karl E & Shiller, Robert J, 1989. "The Efficiency of the Market for Single-Family Homes," American Economic Review, American Economic Association, vol. 79(1), pages 125-37, March.
  2. Arturo Estrella & Frederic S. Mishkin, 1998. "Predicting U.S. Recessions: Financial Variables As Leading Indicators," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 45-61, February.
  3. Stephen Malpezzi, 1998. "A Simple Error Correction Model of House Prices," Wisconsin-Madison CULER working papers 98-11, University of Wisconsin Center for Urban Land Economic Research.
  4. Edward E. Leamer, 2007. "Housing IS the Business Cycle," NBER Working Papers 13428, National Bureau of Economic Research, Inc.
  5. Jesse M. Abraham & Patric H. Hendershott, 1994. "Bubbles in Metropolitan Housing Markets," NBER Working Papers 4774, National Bureau of Economic Research, Inc.
  6. Estrella, Arturo & Hardouvelis, Gikas A, 1991. " The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-76, June.
  7. Dennis R. Capozza & Patric H. Hendershott & Charlotte Mack, 2004. "An Anatomy of Price Dynamics in Illiquid Markets: Analysis and Evidence from Local Housing Markets," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 32(1), pages 1-32, 03.
  8. Goodman, Allen C. & Thibodeau, Thomas G., 2008. "Where are the speculative bubbles in US housing markets?," Journal of Housing Economics, Elsevier, vol. 17(2), pages 117-137, June.
  9. Harter-Dreiman, Michelle, 2004. "Drawing inferences about housing supply elasticity from house price responses to income shocks," Journal of Urban Economics, Elsevier, vol. 55(2), pages 316-337, March.
  10. Case, Karl E. & Quigley, John M., 2009. "How Housing Busts End: Home Prices, User Cost, and Rigidities During Down Cycles," Berkeley Program on Housing and Urban Policy, Working Paper Series qt6mh9m4ff, Berkeley Program on Housing and Urban Policy.
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