Friday, April 11, 2008

Shiller at the BSAS

I want to thank one of my former students from Boston College, Harry Markopolos, for sending me his notes from a talk delivered last month by Robert Shiller to members of the Boston Security Analyts Society. Shiller, who is a member of the faculty at Yale University, is also the man who closely tracks housing prices. He was instrumental in developing the now famous S&P/Case-Shiller Home Price Index. I had the pleasure of interviewing him a couple of years ago shortly after he released the second edition of his prescient book, "Irrational Exuberance." I call the book prescient because the first edition correctly called the top of the stock market in 2000; and the second edition correctly called the top in housing.

As everyone knows, housing prices are still falling. Shiller expects them to keep falling for quite some time since the monthly year-over-year declines are still accelerating. Actions taken by government officials may slow these price declines, but eventually the market will have to find its equilibrium. In fact, it would probably be better for our economy if the government did not intervene and allowed this process to proceed as quickly as possible.

Shiller pointed out that the price gains seen in recent years were historically unusual. From 1890 to 1990, housing prices appreciated at about the same rate as inflation. Starting in 1990, however, prices took off as home buyers began to view a house more as an investment rather than just a place to live.

Shiller pointed out that for many home owners, their house is their most valuable asset. Unlike other assets, however, it was nearly impossible to hedge against a drop in value. But he has helped develop financial derivatives linked to the Case-Shiller indexes that allow home owners to do just that. Shiller believes the existence of such instruments make it much less likely that a housing bubble will develop again in the future.

Interestingly, Shiller said that in every market he examined, lower-priced homes exhibited the greatest price increases during the recent housing bubble. He attributes this to the widespread availability of sub-prime mortgages, which sometimes did not even require a down payment or the verification of income. This made it possible for individuals, who would not have otherwise qualified for mortgages, to buy homes. As a result, lower-priced homes saw the biggest increase in demand, and therefore, the biggest percentage increase in price. But now, this is also where most of the pain is being felt. Unfortunately, other segments of the housing market and the wider economy are not entirely immune. They, too, are feeling some pain.