Friday, August 01, 2008

Making His Case – An Conversation with Professor Karl Case

Earlier in the week Karl Case, Professor of Economics at Wellesley College and co-creator of the Case-Shiller home price index, joined WBUR’s Deb Becker to discuss his outlook for housing particularly in light of the latest results of the S&P/Case-Shiller home price data.

All things being equal, Professor Case’s view could be described as mixed to notably optimistic with suggestions that the housing decline and its associated economic turmoil could bottom as soon as this year.

Needless to say, this form of sentiment coming from one of the country’s most respected economists and residential housing experts caused a bit of a stir within the comments of this blog and elsewhere (article1, article2, article3).

Fortunately, Professor Case is very gracious and was willing to elaborate on his sentiment in a response to several questions that I posed to him via email.

The following is his full response, in conversational tone (and with charts!), with my original questions listed at the end:

Why am I optimistic? First of all optimism is a relative term. I started writing about housing bubbles and their dangers a long time ago (New England Economic Review May 1986). Let there be no doubt, we have a big problem. Several housing bubbles have burst all at once; prices are indeed in free fall in many places; institutions are dead and dying and the losses are well up in the trillions. The Case-Shiller numbers are ugly. See table 1.

We are in uncharted waters. There is a significant chance that we are all wrong about how this will unwind. If nothing else, the history of markets teaches us humility. The headlines around our release last Tuesday implied that prices were in free fall everywhere and that this would never end. All I tried to point out was that not everything in the release was negative.

So what is positive?

While the big four (Florida, Arizona, Nevada and California) are down roughly 30% and falling, prices are simply not falling everywhere. Seven metro areas were up slightly May over April. My comments were made in Boston so I took it as an example. Certainly there is slight seasonality in the index, however it has been mild compared to the seasonality in the mix which affects medians. It could also be that the mix between auction properties and everything else changed but auction sales didn’t drop until June and these are the May numbers.

Boston looks quite similar to the way it looked during the last downturn. The Boston index is down 12% from peak which was in September 2005. Last time the bubble burst in Boston the index dropped 16% peak to trough and it took 43 months (October 88 through February 92). The first up-tick in ’92 (seasonal or not) signaled the end, but it bounced along the bottom for two more years. Certainly Boston has slowed from a peak rate of increase much earlier…But I have argued since the mid-80s that Boston was a bubble; it had to give back, and it has. What else is positive in Boston? Existing home sale have been up in every month since February, and the number of foreclosure auctions dropped in June. Realtytrac seems to have the best numbers. In addition, employment is up 23,000 in June statewide and 16,000 in Boston.

Coming along is the FHA bill as well as the last hunk of fiscal stimulus (small). Exports are up big time thanks to the weak dollar and GDP was up in the second quarter.

Prices are simply not out of line with income everywhere. If you plot house price income ratios by state, in a vast majority of cases they are flat. I will enclose a few.

The market is traditionally a quantity clearing market. When demand drops, sellers hold out. Prices are sticky and inventory rises. We have a ton of evidence about that. Since there is a positive rate of household formation, inventories fall and balance is ultimately restored. In every major downturn in the housing market since the early 70s the pattern of housing starts over time has signaled peaks and troughs. In every cycle, starts go over 2-2.5 million and then drop to under a million. In every case, starts have fallen by over 60% to below a million. And every time that we have hit a million, new production picks up. Some point to the fact that this expansion was very long and we simply overbuilt. That may be true. The housing expansion did ignore the very mild 2001/2 recession. But absorption basically kept pace with boomers buying multiple houses and foreigners buying on the weak dollar. Nonetheless it was a long huge expansion. Vacancies are up but inventories are not out of line with past recovery cycles.

I agree that the auction sales short circuit the sticky seller story, and some argue that we should drop them from the index. Nonsense. They are part of the market. The fact that in some states they are a huge proportion of sales (Arizona > 80) means that you have to think hard about what the term “market price” means. In fact, nationwide in June, auction sales were just over 17% of total existing and new sales nationwide.

Even in this environment optimistic home buyers are out there. Bob and I have surveyed homebuyers every few years starting in 1988. We get a remarkable return on a ten page questionnaires sent to 500 each in Orange County CA, Boston, San Francisco and Milwaukee. In 1988 over 90% of all buyers thought prices would rise over the next year (99% in San Francisco and 90% in Boston). In 2008 a majority of buyers in all cities still believe that house prices will rise this year!!! (65.3% San Francisco/64.5% Boston/75% Milwaukee/53.5% Orange County)

For me what is encouraging in the numbers that came out Tuesday was that most states don’t seem to be falling into the abyss. We have at least three stories: 1. simple glut in Florida, Arizona and Nevada. These will simply be written down. 2. A boom that was a bubble in California and to a lesser extent in the Northeast: California has been through this detoxification three times and it seems to survive every time. For many, it is unpleasant, but most who have equity left are back in the game soon.

If you believe the Flow of Funds data, during the period 2000 to 2005 we added $10 trillion to the stock of residential capital valued at replacement cost and land ($5 trillion each). Since 2005 we have added over a trillion more in capital, but we have given back about $1.7 trillion in land value. In addition, our 10 city composite is still 82% above its 2000 value. Is the glass half empty or half full? All I know is that it isn’t completely empty, and when glimmers of hope appear, we should acknowledge them.

The Following are my original questions:

In your interview with WBUR’s Deb Becker you indicated that the Boston housing market might be approaching a bottom but doesn’t the pattern we have seen this year in the Boston Case-Shiller index simply reflect the typical strong seasonality of our market? (i.e. prices increased sequentially from February to June-August for each of the last three years then declining strongly during the fall and winter months reaching new lows. See attached chart 1.)

Isn’t it also true that annual price appreciation has essentially been declining in the Boston area since early 2001 indicating a more fundamental decline is underway? (i.e. peak annual YOY appreciation occurred in March of 2001 and declined steadily until the first annual YOY depreciation occurred in April 2006 and prices have continued to slide to today. See attached chart 2.)

In your interview you seemed to indicate that there might be a turnaround for housing coming even as soon as this year but isn’t our economy, both locally and nationally, simply sliding into the next systemic shock which could materialize as either unusually high unemployment, high energy and commodity driven price inflation, an unmanageable unwind of Fannie and Freddie, widespread regional bank failures or all of the above?

I realize that it’s generally considered civil to be optimistic when it comes to discussing the plight of the housing market and the economy but isn’t there, rationally, two sides to each market with many participants that would benefit should home prices continue to decline dramatically?

Finally, it seems that, in past housing declines, the market “bottoms” setup slowly and bounced along at the lows for two to three years before resuming growth in-line with prospective wider economic growth. Given this fact, isn’t it reasonable for homebuyers to simply wait it out until there are some real signs of price stability? (i.e. what’s the rush?… who says you can’t time the bottom when the bottom is generally established during 2 to 3 full selling seasons.)