An Interview With Housing Index Guru Robert Shiller

Includes: ICF, IYR
by: IndexUniverse

Robert Shiller is one of the best-known and most widely respected economists of our time. The Stanley B. Resor Professor of Economics at Yale University, Shiller is also a fellow at the Yale International Center for Finance. Shiller is the author, among other books, of Irrational Exuberance, which predicted the bursting of the Internet bubble with exquisite timing.

Shiller’s latest passion is focused on developing financial products that will let people hedge against “macro” risks, like housing prices, GDP growth and economic recessions. The S&P Case-Shiller Home Prices are the first accurate home price indexes, and are the backing for an emerging futures market at the Chicago Board Options Exchange [CBOE]. Shiller is also a founder of MacroShares LLC, which is working to develop these futures and other “macro” hedging products.

He spoke recently with assistant editor Heather Bell about his research and the future of housing prices in America. What do trends in home pricing tell us about the overall economy?

The home price boom that we’ve seen since the late 1990s is unprecedented in magnitude, and so I think it puts us in uncharted territory. People like to look at past housing cycles as an indication of what will happen this time, but since this is a bigger boom than we’ve ever seen, it’s going to be hard to predict. The only possible exception is the home price boom at the end of World War II, when the soldiers came home and they started families and bought houses. That’s maybe of similar proportions, but it’s very different in its causes. Where is residential real estate headed right now? Can you speculate on that?

It has been going down for a year now. We have different indexes. Our national index—I’d like to quote it in real terms—has already fallen six and a half percent. That’s if you correct for inflation, which I think is a good thing to do, because I’m an economist. The way that these price falls often occur is there’s stagnation in the market, and then regular inflation just erodes the real value of the homes. Home price slumps have historically taken place over many years. Is this downward trend going to continue?

Futures markets are predicting declines, but the futures markets go out only one year. However, starting September 17, they go out five years; we’ll have a better idea of what people think is reasonable. I have a scenario in mind in which it could go down a lot. That possibility doesn’t seem to be mentioned very often. I’m surprised it doesn’t, because it happened before, at least for individual cities. That could have big effects, of course, on the economy.

First of all, it would cause homeowners to default in great numbers. This hasn’t happened yet. We’ve seen defaults rise, but home prices haven’t fallen very much. If there were big drops in home prices, we’d see a lot more defaults. In the Great Depression in the 1930s, home prices in nominal terms fell 25% and there was a huge rash of mortgage defaults. But that was also caused by unemployment. It was a big national crisis. I don’t think it’s going to be that big, but we could have a lot of defaults and foreclosures, which would, of course, harm the economy. Is it possible to have a national housing recession?

At the Federal Reserve Bank of Kansas City’s Jackson Hole symposium (August 31 – September 2), Ed Leamer presented a paper showing that housing has been an important part of just about every recession. It’s not the whole thing, but it’s been a big part of it. This time I think it could be a bigger part of it than usual because, again, we had such an enormous boom. You had said earlier that there was a somewhat similar housing boom in the U.S. in terms of the post World War II era.

Yes, but that had real causes. President Roosevelt wanted to be sure that all resources that were needed for the war would be available, and so he thought there was no reason for people to build houses. He said no house could be built without permission, and the War Production Board had great power. In order to build a house you had to make a case that it was needed for national defense, so he had shut down the construction industry for years. Everybody was off fighting the war; they weren’t buying houses or building houses. Then they came home and they wanted to live normally again, and the houses weren’t there. Prices shot up, and a lot of people were expecting prices to fall, because they thought it was a temporary result of the end of the war. But they never did. It was one of those surprises. Prices shot up and then they kind of leveled off, and they stayed level until the 1970s—a long time. Yes, that is a long time. Everything changes so quickly now.

I don’t think people know what to expect in home prices. Right now they are looking at what we’ve seen over the last decade and thinking that this is the future. But I think it’s not really right to expect these kinds of price increases. That was going way too fast. How much of the current trend in housing can be linked to what’s going on with the subprime mortgage meltdown?

Now that’s part of the issue. It’s a kind of feedback. In a sense, the housing boom caused the subprime crisis, and the subprime crisis caused the housing boom. It goes both ways. So I think the housing boom caused the subprime crisis by creating this tremendous optimism and lack of fear for mortgage-backed securities. And of course the development of the subprime institutions and the willingness of investors to take on subprime mortgages as investments freed up a lot of credit for homeowners, and it allowed the boom to proceed. It was certainly part of the boom. It’s certainly not the whole thing.

We have indexes that show it was substantially lower-priced homes that outperformed the higher-priced homes, so this housing boom was a low-priced home phenomenon. That fits in with the idea that it’s related to subprime lending. There are housing futures contracts trading on the Chicago Mercantile Exchange (NASDAQ:CME), but they don’t seem to have taken off as hedging instruments. It would seem like in this environment they would be something people would be looking to. Is it a matter of investor education, maybe?

We’re working on this. There’s no reason why people can’t hedge their home, and the futures market that we created at the CME is designed to allow people to protect themselves against home price risk without selling their home. The biggest thing that we’re going to do is to extend the horizons of the futures contract starting September 17.

A big criticism of our futures markets is that they go out only one year. We’re going to push them out to five years. And that’s a more realistic hedge. I think it’s a better product, and we’re hopeful that they will get going. Incidentally, if they get going on a big scale, it will be a major revolution in our economy. We’re committed to making them happen, and I believe they will, and it will be a major change. How would it be a major revolution in the economy?

Right now housing is so illiquid, people can’t protect themselves without selling the house and moving and taking the kids out of school and putting them in some other school. Why should making a financial decision require something like that?

But hedging is not just for individuals; it’s all kinds of businesses that are exposed. The subprime people, for example, could have hedged. The structured investment vehicles—the hedge funds who invested in subprime mortgages directly or indirectly—they could have protected themselves with a hedge on real estate prices. It strikes me, being a finance theoretician at a university, that we’re doing a weak job of implementing what we know about risk management. But I think, one way or another, we’re going to have better risk management tools for real estate risk.

It is a revolution in the sense that already in the futures market, while it is not very big, prices move on their own without a lot of relation to the prices in the cash market. So we’re seeing price discovery of a fundamental nature, and moreover, the futures prices look a lot more like random walks than do the cash market prices. I think we’re seeing already some signs of much greater efficiency, and I think ultimately, if the futures markets get really established, they’re going to change the structure of pricing in the cash market. Homes will be priced differently. Eventually, people will be watching these futures prices when they set the price they ask for their home. In the case of this past boom, some of the housing prices have seemed unreasonably high. Would an established futures market serve to prevent those extreme prices?

There has been a dispute about whether futures markets increase or decrease volatility. I think the probable outcome is that it will decrease volatility in general, because it will open the market up.

For example, right now if somebody is pessimistic about the home market, there’s no way to short the market, and there’s no way for them to express their opinion. There’s the futures market, but it’s not very liquid yet. If you can provide an instrument to allow people to short the home market, then it ought to stabilize booms. We would have liked five years ago to have futures five years out. And I wouldn’t be surprised if those futures markets would have predicted something like what’s happening. If people could see it in the futures market and if it was a big and important market, then they might have second thoughts about their expectations.
Do you anticipate anything like home price insurance becoming available?

Yes, that’s a big, important idea that I think will come. We’ve talked to insurance companies. I’ve been doing it for 15 years; I’m not deterred by slow processes.

Insurance companies often like the idea. In particular, homeowners’ insurers say that something like this could create a lot more business for them, as it’s not a fast-growing industry. But then they said, “It’s a neat idea, but how do we hedge the risk?” We’ve been doing this step by step. We said, “All right, we’ll start a futures market.” Then we go back to them, and they’re still not happy. They say, “Well, your futures market isn’t big enough.” So we keep working away, and eventually we’ll get it. But I do think insurance companies are interested in offering it if they can find a way to do it, and they’ve told us that.

Another thing is some insurance companies told us that they talked to homeowners, and homeowners tell them, “Home prices never fall and so I don’t need insurance on the value of my home.” But if home prices fall at this time, that might change that opinion and they might see the need.