Friday, August 24, 2007

Housing Bubble: Out of One, the Many?

by Tom Bozzo

The mysterious knzn has a very interesting post up that makes a (quantitatively) simple but well-argued claim that a portion of the run-up in house prices that's been called the "housing bubble" can be linked to house-price fundamentals, namely changes in the value of the capitalized stream of shelter services [*]. Lest any sigh of relief emanate, the Thing to Note is that the path of prices detached from the fundamentals a couple years ago, and an unpleasantly large reduction in prices would be needed to reattach the two now.

One of the catches to this argument is that the maybe-not-so-bubbly-up-to-a-point national house price index is a composite of areas where prices inflated very rapidly — esp. certain big coastal cities — and many others that saw much more modest increases. This graph shows something of the spread of results by metropolitan area:

House Price Index

There is a similar, but much less pronounced, pattern in measured inflation in shelter costs:

Consumer Price Index for Shelter

The suggestion is that the low interest rates were the main "fundamental" driver. The low rates would be applicable more-or-less nationally, so they create a puzzle as to why lagging areas are so laggard. In some cases, there may be fairly obvious local strengths or weaknesses (see: metro Detroit, metro D.C.) but less so in others (e.g.: what accounts for the small lead Madison, with strong regional fundamentals, has over persistently depressed Syracuse).

There are also some key limitations to the OFHEO price data that limit its ability to measure the market's degree(s) of effervescence. Notably, it only counts transactions involving "conforming, conventional mortgages purchased or securitized by Fannie Mae or Freddie Mac." So it doesn't capture action in the markets for non-conforming and unconventional mortgages, which is a problem over a period where those are soaring as a fraction of the mortgage market.

So at the risk of handing out knzn or someone else with access to the relevant data some homework, what I'd like to see is that, for a broader set of transactions than the OFHEO base, and that prices and fundamentals track each other locally for bubblier and less-bubbly areas. Perhaps it's true, but I don't think it's been shown.

[*] In effect, and in something a little more like English, what you'd be willing to pay in a lump sum for the roof-over-head function of housing, in lieu of rental payments.

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Good point about the limitation of the OFHEO data. I probably would have to admit that the nonconforming sector diverged significantly above the fundamental before the fundamental started falling. In retrospect, things were obviously going haywire in the market for nonconforming credit, so to the extent that the nonconforming housing market is segmented from the conforming market, there is reason to expect that it would have diverged. But I'm not sure what data to use.

Regarding local markets, the problem becomes a lot more difficult when you can't make a simple assumption about the future path of rents. I basically assumed that real rents would be constant, which I think is reasonable for the country as a whole but probably not for any local market, except by chance, and it's not easy to come up with an estimate of what future rents would be. There was a paper by Himmelberg, Mayer, and Sinai (from the NY Fed, maybe, I'm not sure) a couple of years ago that did try to do some of the hard work for local markets and came mostly to the conclusion that they were not generally overvalued (at the time -- which probably, as with my analysis, means that they are overvalued today).
Wharton. PDF Link here.

(Yes, I am a month behind.)
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