Caclulated Risk had some interesting observations this week about why forecasts for housing differ so widely across analysts.
During the housing boom, there were two distinct views of the causes of the boom. The consensus view was that the boom was mostly driven by fundamentals and perhaps a little “froth” in 2005.
The minority opinion was that the housing market had become a bubble. The minority view was based on evidence of speculation: flippers, a high percentage of investment purchases, and homebuyers using excessive leverage, especially with nontraditional mortgage products.
Now that the housing bust is here, there are also two views of the bust. The consensus view is that the “worst is over”. The minority view is that the bust has a ways to go.
Not surprisingly, those that felt the boom was based on fundamentals now believe the worst is over. And those that felt the boom was driven by excessive speculation believe the housing market will continue to slowdown. How one viewed the housing boom colors how one looks at the housing bust.
I would define a bubble as a price appreciation that is driven not by fundamentals but instead by the pure expectation of future price appreciation. One of the difficulties I had with the bubble story was that the extent of house price appreciation differed so much across different communities. The graph below shows the state-by-state 5-year housing price appreciation between 2001:Q1 and 2005:Q1. Did house prices in California, Nevada, and Florida go up so much faster than in Ohio, Tennessee, or Indiana just because people nearer the oceans expected more price appreciation? Or was it instead related to the fact that the “bubbly” communities were the ones where population and the number of people trying to buy a home were growing most quickly?
To be sure, there was also an aggregate component to the national house price appreciation that had very little to do with the growth of the aggregate U.S. population. But this could easily be attributed to the very low interest rates over this period:
You can of course try to model what the correct price response to local fundamentals should be. But no matter how carefully you build those models, there will always be something you have left out. An old paper of mine shows that the response of the market to those factors you’ve left out– for example, the response of the market price to an unobserved anticipation of future local population growth– would look exactly the same in terms of observable data as would a speculative price bubble.
If it is indeed the case that low interest rates were a key factor in the housing boom and that rising interest rates have now been the key factor responsible for the housing downturn, it seems logical to me to expect that the decline in mortgage rates since this summer might begin to reverse the housing slide. As of two weeks ago, there certainly were some hints consistent with that possibility: pending home sales up in August, recovery of stock equity prices (particularly for homebuilders), uptick of housing starts and new home sales in September, and decrease in months’ inventory of unsold new and existing homes. However, the October housing starts and permits numbers provided quite a nasty jolt to that happy story.
Even without the troubling October figures, and even if one takes a fundamentals view of recent developments, it is hard not to share CR’s concern about the explosion of unconventional mortgages. Low interest rates were presumably one factor behind this. But any neoclassical economist would naturally be concerned about the possibility that some kind of market failure or perceived government guarantees may have prevented the risk from being accurately priced. Moreover, to the extent it is the case, as CR observes, that even the conventional wisdom had acknowledged a “little frothiness” in some markets by 2005, the change from expectations of price appreciation to price depreciation could itself have a significant impact on the market.
One thing I’m sure of– both CR and I will be watching this week’s home sales figures with great interest.