Monday, December 18, 2006

MIT on the Bubble

Earlier this year William Wheaton, professor of economics at the MIT Center for Real Estate weighed in on the nations residential housing bubble in an excellent paper entitled “Past Housing ‘Cycles’ and the Current Housing ‘Boom’: What’s Different This Time?”.

The paper attempts to explain current home prices by developing an econometric model of home prices using home price data only up through 1998. Then home prices are “forecast” by applying actual 1998 – 2005 historic economic data to the model.

The main idea here is that prices could possibly be sound if there is a way to produce an analytical model that accurately predicts what has actually occurred since 1998.

Models were developed for 60 of the country’s Metropolitan Statistical Areas (MSA) and then the results were compared against what actually happened to prices during this cycle.

The result was a resounding failure for the models in that none of the models could accurately pick up the price movement that actually occurred.

In 47 areas, prices followed a similar pattern to the papers example area of Boston which, per its model, should have experienced a home price correction in 2001 as wages and jobs headed down in the wake of the dot-com recession.

But in reality, no home price downturn ever materialized. Instead home prices actually soared to historically high levels during this period.

In 5 other areas, the models called for little to no price movement which was not inconsistent for theses particular areas that, historically, had not seen cyclical price patterns. Yet, again the actual result did in fact see a substantial move up in prices over this period.

Additionally, in the remaining 8 areas, of which included 6 in Florida, and Phoenix and Las Vegas the statistical models failed completely. These areas were similar in that during the period between 1980 - 1997, they had actually seen steady declines to prices and then prices abruptly surged, doubling or more in just that last few years.

So, in the end the models either dramatically under-forecast actual upward price movement or completely failed to explain the erratic upward price movement exhibited by eight truly unusual markets.

So what was concluded by this study?

The paper concludes by finding that the astonishing upward price movement seen in the current housing cycle was NOT fueled by the often cited “fundamentals” such as baby boomer demographics or construction regulation restraining supply but was instead “driven by an explosive growth in credit availability – in particular the new emergence of the so-called ‘subprime’ lending market”.

Additionally, the paper does a good job of shining the spotlight on another important factor fueling the boom namely the explosive growth of the second home market.

As was noted before, second homes are a bit of a misnomer as the term seems to conjure up a vision of vacation home when in fact the overwhelming majority of second home purchases have been for investment properties that were purchased in an act that was tantamount to speculation.

Professor Wheaton hasn’t seemed to achieve quite the level of popularity that other notable economists such as Robert Shiller or Nouriel Roubini have seen recently but given his contributions and his clear, precise and personal manner hopefully he and his work will receive more notice.

Listen to Professor Wheaton spar with David Lereah back in May of 2005 where Lereah wrongly predicted that housing was NOT going to slow during 2006 as well as other more recent NPR appearances on “All Things considered” during September of this year.

Professor Wheaton Radio Appearances:


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