MacroScope

Before the crash: Ambling through the ‘archives’

May 31, 2012

Moving from one house or apartment to another is mainly onerous, but one of its few pleasures is coming across papers you have not seen for years: the adventure stories your grown son wrote when he was eight years old or the book report he wrote on William Shakespeare’s Richard III when he was 10.

Another potential source of amusement is finding an older newspaper or magazine article or column, preserved on purpose or inadvertently. One reads these pieces with the benefit of time: You, dear reader, have seen the future at which the columnist, either hapless or prescient, could only make a guess, educated or otherwise.

So herewith are excerpts from two side-by-side columns published in the Summer 2005 edition of TIAA-CREF’s “advance,” two years before the financial crisis sent the global economy into its worst downturn since the Great Depression.

On the left side of page 19, Robert Shiller, professor of economics at Yale University, began a column entitled “Homes are a Risky Long-Term Investment.”

On the right side, Richard Peach – then a vice president at the Federal Reserve Bank of New York and now a senior vice president in the area of macroeconomic and monetary studies – wrote under the headline: “Is There a Housing Bubble?”

Here is what Professor Shiller was thinking in 2005:

People have a sense that their home is likely to be worth a lot more some decades hence. Many feel like millionaires to be, just from the prospective value of their homes. But this sense of security is mostly an illusion.

Shiller supported this thesis with three arguments:

1) Real (inflation corrected) home prices have shown only the barest hint of an uptrend during most of the last century.

2) In much of the country we are in a record-setting home price bubble, which may be sharply corrected downward.

3) Some years after baby boomers retire, there may be selling pressure on home prices as many cash-strapped retirees try to sell their homes at around the same time.

Because no long-term series of data on U.S. home prices existed, Shiller assembled figures from various sources and constructed his own series. He found real home prices – the price of a home with inflation subtracted – were not that much different in the 1890s from the 1990s. The real home price is what matters because it reflects the buying power the seller gets when he sells his home.

Shiller acknowledged that land was expensive in some congested areas of the country, but noted it was cheap almost everywhere else. Home construction costs also did not rise much for the last century because productivity gains meant real wages in the sector have not increased.

In 2004, U.S. real estate in some areas recorded the “sharpest upswing ever seen in the national data,” Shiller said. “The upswing looks quite anomalous by historical standards, suspiciously like a bubble,” he wrote. And the price upswing seemed mainly driven by low interest rates, likely a temporary phenomenon, he added, concluding:

We should temper our expectations (about housing prices) and realize there is substantial risk. Real estate generally belongs in one’s long-term portfolio, but real estate is not the assuredly spectacular investment that many people have been thinking it is.

Opining from the right side of page 19, Richard Peach, vice president at the Federal Reserve Bank of New York, asserted that hardly a day went by without another article in the press claiming the United States was experiencing a housing bubble on the verge of bursting.

Peach, who worked at the Mortgage Bankers Association and the National Association of Realtors in the 1980s and early 1990s, said “solid fundamentals underlying the housing market” included a 10-year Treasury bond yielding less than 5 percent that had cut the cost of financing a home. Strong income growth, “primarily for those in the upper half of the income distribution,” was another fundamental reason for home prices to be rising, he said.

Peach’s shakiest excuse for a “fundamental” reason for rising home prices was this: “The baby boomer generation has reached its peak earnings years and appears to have strong preferences for large homes loaded with amenities.”

National home prices are high, but “they do not appear to be overvalued relative to fundamentals,” Peach said.

Peach noted that some had argued that easy access to credit with liberal payment schedules, such as adjustable rate and interest-only mortgages, “could act as a potential trigger event that might cause home prices to fall when the interest rates on those loans are adjusted upward.”

“However, it is not clear that such loans are inherently riskier than the traditional fixed-rate mortgage,” Peach said, citing data from the Mortgage Bankers Association of America, and criticizing “alarmist press reports.”

In the summer of 2005, Peach offered his view about what was going on in the U.S. housing market:

The adjustment to a world of lower long-term interest rates is causing an upward adjustment in the value of the U.S. housing stock. Once that level of adjustment is finished, the rate of home price appreciation will likely settle down to something around the overall rate of inflation.

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