We cannot be sure about how much further house prices will fall. Experts say another 15 per cent decline is required just to return to the pre-bubble price path. But there is nothing to stop the decline from continuing once it reaches that point. The growing gap between mortgage debts and house prices will continue to increase the rate of defaults. Many homeowners who can afford to make their mortgage payments will choose to default, move to rental housing, and wait to purchase until house prices have declined further.

As homeowners with large negative equity default, the foreclosed homes contribute to the excess supply that drives prices down further. And the lower prices lead to more negative equity and therefore to more defaults and foreclosures. It is not clear what will stop this self-reinforcing process.

Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until house prices stabilise, these securities cannot be valued with any confidence. And that means that the financial institutions that own them cannot have confidence in the liquidity or solvency of potential counterparties — or even in the value of their own capital. Without this confidence, credit will not flow and economic activity will be constrained.

Moreover, because financial institutions’ assets were bought mainly with borrowed money, the shortage of credit is exacerbated by their need to deleverage. Since raising capital is difficult and costly, they deleverage by lending less.

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