12. Real Estate Finance and its Vulnerability to Crisis
Articles,  Blog

12. Real Estate Finance and its Vulnerability to Crisis


Professor Robert
Shiller: I want to start out by talking about real estate as
an asset class. It’s actually the biggest and
most important asset class. The value of real estate in the
United States today is–of real estate owned by households
directly–is about twenty trillion dollars,
which makes it comparable or maybe a little bit bigger than
the stock market. Stocks owned directly by
households are only about six trillion dollars.
For a typical household, the home is the major source of
wealth that they’ve accumulated. Of course, other stocks are
held by institutions on their behalf, but in terms of direct
ownership, homes are the main thing that people own.
There’s also commercial real estate, which is smaller than
owner-occupied homes, but we own that indirectly too,
as a people, through the stocks that we own
and through the institutions we participate in.
It’s very important and it has some important
financial–there are a lot of financial institutions built
around dealing with the fundamental problems of real
estate. I want to talk first about
institutions and then move to what I think is,
myself, more interesting,
which is the real estate boom and the kind of fluctuations
we’ve seen in real estate over the years.
I’m going to start out by talking about commercial real
estate and the kind of vehicles that we use to invest in
commercial real estate. Then I want to talk about
mortgages, which is the way that we finance both commercial and
owner-occupied real estate. Then finally,
I want to come to the real estate boom that we are recently
in. Let me start by–the way–the
kind of institution that you probably know relatively little
about–or commercial real estate.
Commercial real estate–that means real estate owned not by
individual households but by businesses.
The institution I wanted to talk to you about first is
called a DPP, a Direct Participation Program,
which has been traditionally the single most important form
of holding of commercial real estate.
When you drive along and you see all these commercial
buildings, you might wonder who owns them.
Well, sometimes they’re owned by corporations,
but I think the more important institution is the DPP,
which is a financial vehicle that owns commercial real estate
on behalf of investors. The most important DPP is
called a limited partnership or LP.
There’s a very simple reason why real estate tends to be held
in limited partnerships rather than corporations and that
reason is the corporate profits tax.
Corporations are taxed on their profits and DPPs are not.
You want, if you are setting up an organization to hold real
estate, you want to do it, if you can, as a DPP because
you don’t want to pay those taxes.
Whenever possible, an ownership vehicle for
commercial real estate will have the form of a DPP.
A limited partnership is one kind of DPP and it has–it’s not
a corporation, so it’s a partnership.
The simplest kind of partnership would be if several
of you got together and formed a business.
In a normal–in a simple partnership, the partnership
would not be taxed because it’s you doing business just as
partners, so you are taxed but not the
partnership. The problem with partnerships,
generally, has been that they don’t have limited liability.
A corporation is an entity that could be sued or could lose more
money than it’s worth, but the value of a corporation
can never fall below zero to the investors because the investors
are not liable for the mistakes of the corporation.
If you buy stock in a company the most you can lose is the
money you put up, so that’s called limited
liability. If you take part in a
partnership you are individually liable for the debts of the
corporation. That’s a problem with the
partnership structure because you could join a partnership and
the partnership does something awful and loses more than you
put into it and they can come after you for those losses.
There is something, however, called a limited
partnership that has two kinds of partners: a general partner
and a limited partner–or usually,
many limited partners. The general partner takes on
the liability; the limited partners don’t have
liability. So typically,
real estate is held in a limited partnership.
It’s limited because–well,
they want to put it in a limited partnership because they
don’t–it’s not easy to sell other people on joining the
partnership if they could get unlimited liability for doing
so. There is a general partner who
takes on the liability and the limited partners,
who are many, are the participants who do not
share the liability. The general partner is
typically the organizer of the partnership.
Someone who buys a fifty-story building downtown and then,
well, arranges to buy and gets partners–limited partners–to
join in financing it; that’s the arrangement.
You have a general partner, then limited partners,
and you don’t hear about DPPs. I’m telling you something that
you probably haven’t heard a lot about.
This is not commonly advertised or described–just like hedge
funds are not commonly advertised and
described–because it is thought that DPPs are suitable only for
wealthy and sophisticated investors.
They’re complicated, so the general rule has been
that only accredited investors should participate in them.
I mentioned this before–in the U.S.
and in other countries as well, they’re a similar thing.
We defined an accredited investor as someone who can
participate in a DPP or other sophisticated programs.
The definition is in Regulation D, which defines an accredited
investor. For many years now,
to qualify as an accredited investor, you have to have one
million dollars in wealth or income in excess of $200,000 or,
if you’re married, $300,000 for the couple.
In 2006–I mentioned this before–in 2006,
the SEC proposed raising the definition to make it harder to
be an accredited investor, but they haven’t done that yet;
so, it remains at one million dollars to do it.
Nonetheless, DPPs don’t advertise.
You see mutual fund advertisements everywhere.
You don’t see advertisements for participation in commercial
real estate like this because the government would be on their
backs if they did it. Since it’s available only to
accredited investors, you can’t be advertising
because everyone would see it; that’s why the financing of a
lot of this real estate is something of a mystery,
because they can’t talk openly about it.
These DPPs go back a long time but there began to be complaints
about them because people said, well why is it,
because I’m not an accredited investor, I can’t get into real
estate like these other people do?
Why isn’t there something offered to me that’s like a DPP
that’s available to everyone? Another way of putting it,
the government is effectively saying that unaccredited
investors are free to invest in corporations that invest in real
estate and they’re subject to the corporate profits tax.
Wealthy people have the choice of getting around the corporate
profits tax. So, in a sense,
the tax structure was regressive.
It was saying, we’re going to have lower taxes
on rich people than on ordinary people;
that didn’t seem fair at all, so there was a complaint aired
about DPPs in the late 1950s. People said,
let’s change it, let’s make it so that everybody
can have something like a DPP. Congress finally acted and it
was in the year 1960 that Congress defined a new
investment vehicle called a Real Estate Investment Trust;
this is for everyone. A Real Estate Investment Trust
is for small investors, although wealthy,
big investors can invest in it also.
So, they had to make a distinction.
These are called REITs, Real Estate Investment Trusts.
Congress had to make a distinction between these and
corporations and it’s kind of a subtle distinction because there
are lots of corporations that own real estate.
Like, for example, Wal-Mart might want to–they
pay corporate profits tax. After 19–I don’t know if
Wal-Mart–was it around in 1960? I don’t know.
Let’s say it was. Wal-Mart, after the 1960 Act of
Congress, would say, hey we’re a real estate
investment trust, we own real estate–all these
stores–but that’s not what the intent of this bill was.
They wanted REITs to be companies that just owned real
estate and Wal-Mart is primarily a retailer.
They specified that 75% of assets must be real estate and
75% of income must be real estate income–so that would be
ruling out Wal-Mart. And 95% of income must be paid
out–they can’t retain earnings. That limits it further.
They’re supposed to be like a pass through vehicle–they’re
owning real estate on your behalf, so they shouldn’t be
retaining earnings. Also, they had to be long-term
holders; it had to be less than 30% of
income from sales of properties less than four years–less
than–no more than 30% of their income from sale of
properties had to be from properties held less than four
years. They didn’t want flippers;
they didn’t want the company that’s speculating in real
estate, they want it to be a holder of real estate.
Real Estate Investment Trusts became very important in three
waves. One–the first wave of REIT
growth occurred right after Congress passed the 1960 bill.
The first wave was in the 1960s and, at that time,
Congress had limits–state governments had limits on the
interest that savings banks could pay people on their
accounts. So, a lot of people switched
from savings accounts to REITs–that’s called
disintermediation. An intermediary is a bank,
so when they pull out of banks they were disintermediating and
going from banks into REITs. Although, in some sense,
it wasn’t really disintermediation because you
could say a REIT is a different kind of intermediary between the
individual and the investment. The second boom in REITs
occurred after 1986. The Tax Reform Act of 1986 made
DPPs much less valuable to investors, and so a lot of
wealthy people switched from DPPs to REITs.
Before 1986, the tax law allowed use of DPPs
as a tax loss device. People would invest in
buildings solely for tax purposes because you could write
off the depreciation on the building,
so people were cynically setting up DPPs as tax shelters
only. Congress said,
finally–I think wisely–in 1986, that we don’t want to
create rules that encourage people to do a different sort of
business just to evade taxes. So, they made a–they said that
losses that–depreciation that–In 1986,
the Tax Reform Act of 1986 said that depreciation on structures
in DPPs is called a passive loss and can be used to offset only
passive income, which comes from something like
another DPP. So it eliminated the tax
advantage. If they didn’t have a
particular tax advantage to DPPs, they went into REITs.
The third REIT boom was in the 1990s and I think this third
REIT boom is different from the others because it didn’t arise
from any government regulation change.
It arose from the beginnings of the housing bubble–the real
estate bubble that we’re now in. There just became a lot of
enthusiasm for REITs. It’s not just a bubble;
it’s also that REITs began to be more diversified.
They have many different kinds of REITs for different kinds of
real estate. It became a more interesting
and diverse asset class. That’s what I wanted to say
about commercial real estate. The two principle ways that
commercial–well, there are three ways.
One is commercial real estate is held by corporations in the
line of business, but after that it would be DPPs
and REITs. We have democratized–Now,
REITs are a rapidly growing force in investing and now we
have substantially democratized real estate holdings so it’s not
exclusively DPPs that are holding–not primarily–we have
a lot of REITs now. Next topic, I want to talk
about mortgages. Mortgages are debts secured by
property as collateral. When you mortgage a property
that means that you offer the property as collateral for a
loan. That means that if you fail to
pay on the loan, the property is taken by the
lender to satisfy your debts. It makes it possible for people
to borrow who otherwise couldn’t borrow.
If you put a property up as collateral, then the lender
knows that they can get the money back from you.
The critical thing is the loan-to-value ratio,
or LTV. A mortgage lender doesn’t want
to lend more than the property is worth because that would mean
a loan-to-value ratio over one. Then if you fail to pay on the
mortgage–pay off the debt–the lender can seize the property
and sell it. But if the loan to value ratio
is greater than one, they won’t be able to get all
the money back. Moreover, whenever they seize a
property and try to sell it, it usually loses value anyway
in the process. For example,
if there’s a homeowner who you’ve lent money to and the
homeowner is defaulting on the mortgage,
the homeowner might wreck the house–that happens all the
time–or they might steal things from it.
Who knows, they’re angry and they’re living in this house.
They can stall you for a year; you’re trying to sell the
house, they hire lawyers and sue you and you’ve got to hire
lawyers. There are lots of costs,
so you want to have a loan-to-value ratio,
which is sufficiently low, that the collateral will cover
the value of the loan. The history of mortgages is
that they have generally over time gotten more easy on
loan-to-value ratio and also on maturity.
The maturity of a mortgage is the date when it’s paid off.
If we go back to the 1920s–and I’ll compare that with now–the
typical mortgage had a loan-to-value ratio of 60% and a
maturity of five years, often even less than that.
They also had–they were–back then, in the 1920s,
they were called balloon payment.
What that means is that you would borrow $5,000 to buy a
house and in five years and every year along the way you’d
be paying interest on your mortgage.
Then, in five years you had to come up with $5,000.
It was interest, interest, interest until the
end and then it was the $5,000. Of course, five years is too
short because most people live in a house for more than five
years. But, the assumption was,
well, when five years comes up you refinance the mortgage;
you get a new one. The banks weren’t willing to
lend more than five years because they didn’t trust you;
they thought things would change and whatever.
After 1929, real estate prices fell dramatically and people
became unemployed. The unemployment rate in the
United States rose to 25%. Lots of people could not
refinance their mortgages because they were unemployed.
You go to a bank and say, I want to borrow to refinance
my mortgage, which is due now. They’re asking me to pay $5,000;
I don’t have $5,000. But the bank would say,
hey you’re unemployed; we can’t give you a mortgage.
Anyway, your loan-to-value ratio is getting pretty
precarious because your house is now down 30% in value;
your loan-to-value ratio, if we were to give you $5,000,
would be something like 90%. They would say,
no way are we going to do that; our rule says we can’t lend on
a LTV of higher than 60%. So, people would be turned down
for the refinancing of their mortgage.
What happened? They would lose the house.
That happened in huge numbers in the 1930s.
The 1930s was the biggest housing crisis in U.S.
history. You see what the problem was:
the mortgages were too short. The loan-to-value ratio–well
it’s not so much the loan–the maturity was short and the
balloon payment at the end that they changed.
In 1933, under the Roosevelt Administration,
Congress created something called the Home Owners’–I
mention this–it’s actually relevant to right now–Home
Owners’ Loan Corporation, or HOLC, that was financed by
the U.S. Congress.
It started offering, indirectly, but started
offering mortgages to all these people who couldn’t refinance.
It did it through banks; they gave the money to banks to
make loans to people who were in trouble.
They created a very important change.
They said five years is too short–it’s got to be
longer–they said fifteen years. And get rid of this balloon
payment thing at the end–that was a dumb idea.
People can’t pay that, if they’re in any trouble,
they can’t come up with the whole value of the loan all at
once. They demanded that the
mortgages be self-amortizing–this is what
came in in 1933. It was a very important change
in mortgage finance. Self-amortizing means that
you’re not just paying the interest every year–or every
month–you’re paying interest plus principal.
So, when the mortgage ends, you’re just clear and free;
you don’t have to pay anything–nothing comes at the
end. The HOLC said,
that’s a lot more sensible; so they demanded that that be
done. Of course, banks would be
reluctant to do it by themselves, but the government’s
coming with a checkbook to write the money,
so they can make the mortgage, and guarantees it.
The HOLC said, don’t worry if they don’t pay,
we’ll pay. So, the banks said,
of course we’ll do that; that created a major change in
mortgage lending. This is especially relevant
because–I don’t know if you saw–maybe you did–in The
New York Times yesterday, Alan Blinder,
who is a Former Vice Chairman of the Federal Reserve Board
under Greenspan and is now a Professor at Princeton,
had an article saying, we need to bring back the HOLC
now. In fact, our own Senator
Christopher Dodd has a bill in Congress right now to bring back
the HOLC, basically. He has a new name for it–I
think it’s called Home Equity Protection Corporation–but
almost the same idea. Ideas that were common–that
were new–in the 1930s are being brought back.
We don’t have to make the change.
Well in a sense, the other thing that happened
was, in 1934, Congress set up the Federal
Housing Administration–FHA. The FHA is specifically aimed
at guaranteeing mortgages for low-income people and it was a
vision that Roosevelt had to bring more and more people into
owning homes in this country. The FHA went further than the
HOLC; they demanded that mortgages be
twenty years and also self-amortizing.
Maybe it was more of a paternalistic role of government
that came in then. The government said the private
sector, with these kinds of mortgages, is not doing things
right; it’s not planning for our
future in the right way. So they made the switch.
It was really the government that made the switch from
five-year mortgages to the long-term mortgages.
Now today, the standard mortgage, which you would
probably get when you buy your first house, is not fifteen or
twenty–it’s thirty years. Well, they just kept going up.
The thirty-year mortgage came in the early 1950s but it seems
to have gotten stuck at thirty-year.
That’s because, well, when you buy your first
house you might be twenty-five, so thirty years brings you to
age fifty-five; that’s close enough to
retirement. I guess most people think
thirty years is long enough, but that’s the way mortgages go
ever since. We have to–what we’ve seen
recently–we had more government intervention back then in the
mortgage industry. Since the 1990s,
we’ve seen a proliferation of new kinds of mortgages that
especially are offered to low-income people by certain
lenders. We’ve had a growth in
popularity of ARMs, which are adjustable rate
mortgages. Adjustable rate mortgages have
a long term–they might last for thirty years–but the interest
rate is not fixed for the whole thirty years.
A typical ARM is two and twenty-eight,
which means that it has a low teaser rate for two years–a
teaser, hat they call it–and then
rates that go up after two years and then tied to some other
benchmark rate of interest, like the Treasury bill rate.
The problem is then that these were sold to low-income people,
in many cases, who didn’t understand what they
were getting and that after two years the interest rate would
reset up. So we would see resets after
two years to a much higher level and some of these people would
discover that they can’t afford them.
We need–and there’s a lot of talk in Congress right now–we
need to think about new regulations that protect
individuals, much like the regulations that
the HOLC and the FHA made. We have to do it again because
the mortgage institutions have deteriorated somewhat.
There’s a lot of anger about this–I know that on Thursday
Angelo Mozilo, who’s head of Countrywide,
which is one of the biggest mortgage lenders to low income
people and made a lot of subprime loans,
is being called before a House Committee to testify.
I want to try to watch it if possible.
It’s going to be interesting, because there’s a lot of anger
about what’s happened, similar to the anger that we
saw in the 1930s. HOLC is no longer with us;
it was actually set up as a temporary corporation by the
government. The FHA is still with us and we
just had an FHA Modernization Act;
Congress is starting to propel that forward so it’ll be a
bigger part of our-– I wanted to say a little bit
about the math of mortgages. The typical–I’m going to talk
about the conventional thirty-year mortgage,
which has been a standard in the United States ever since the
early 1950s. It’s not a standard in most
countries, actually. I think it was partly the New
Deal legislation that made it very strong in the United
States. In Canada, the mortgages tend
to be shorter term. It’s something like what we had
in the ’30s, although they have other institutions that protect
homebuyers, so they don’t see the turmoil
that we saw in the 1930s. A typical home–a conventional
thirty-year–this is what most people get today and
that’s–except for subprime. Subprime borrowers seem to be
the ones who are being really hit with new ideas.
But if most people who are good borrowers, who know what they’re
doing, want these, they want a conventional
thirty-year mortgage because it will fix a mortgage payment for
the rest of the thirty years and you have nothing to worry about.
If you can afford the mortgage payment, then you’re all set.
You just pay it every month and then you just stop paying at the
end of thirty years. If they quote the rate on the
mortgage, call that r–traditionally,
you would be paying monthly. If you do it in monthly terms
your interest rate is r/12 because there are
twelve months in a year. How do they figure out what the
mortgage payment is? Well, the mortgage balance is
equal to the mortgage payment times–now we just use the
annuity formula, which is the formula that we’ve
learned again–we’ve seen it again and again.
[1/ (r/12)][1 – 1/(1 +
r/12)^(12T)], where T is the term,
in years, of the mortgage. I should maybe make this the
same–have to get my brackets right.
This is just the annuity formula, remember?
What this equation merely says is that the present value of
your remaining payments is always equal to the mortgage
balance. This is how they actually
compute the payments because you can take, if you want–if
someone is borrowing–let’s bring it up to today–they’re
borrowing $200,000. The median price of a home
today is just over $200,000 in the U.S.
If it’s an 80% mortgage, you would be borrowing
$160,000, so you’d have a $160,000 here and you know what
this is. Whatever the mortgage rate is
quoted, you substitute it into this formula and you find out
what the square bracket thing is.
Then to get the monthly payment, you take the square
bracketed thing and you divide by the mortgage balance and
that’s the monthly payment; that’s how it’s calculated.
One peculiar property of this–incidentally,
at every point of time this thing holds, this is time to
maturity. This is years to go and so
12T would be the number of months to go before it ends.
At every point of time your mortgage balance is equal to
your mortgage payment times that square bracketed thing,
where T is the amount of time you have left.
Suppose you are moving after five years, you took out a
thirty-year mortgage and you’re moving after five years.
When you first bought the house they told you what the mortgage
payment was and they’re fixing that forever,
well for thirty years. When you get–when you sell the
house, what do they do? They go back to this formula.
If you sold it after five years, then there are
twenty-five years left, so 25 x 12 is the number of
months left; they plug that into this
formula. The mortgage payment was
decided when you took out the mortgage, so that never changes;
they than figure out what your mortgage balance is.
Then the deal is that when you sell the house they
subtract–you’ve got to pay this.
They subtract this from the purchase price of the house and
then you’ve got the cash to go and buy another house.
That’s how it works, okay? It’s very important to
understand that the mortgage balance is recomputed,
according to this formula, every month and they will send
you a statement showing how your mortgage balance is falling.
A peculiar property of this is that the mortgage balance falls
slowly at first and then it gradually picks up;
it’s just a property of this formula.
When you first buy a house most of your payment is going to
interest. Your mortgage payment is
constant through time but the fraction of it that goes to
paying off principal versus interest changes through time
and it just changes as dictated by this formula.
That’s because, at the end if–suppose you’re
one month or two months away from the payoff of the mortgage,
you don’t have any balance left, so the interest that
you’re paying is–hardly any balance left–is very low and so
you’re payment is paying off principal,
mostly. Whereas, at the beginning,
the mortgage balance is dropping only very slowly
because you’ve got a lot of interest to pay and your
mortgage payment is constant. So, that’s a funny property of
conventional mortgages–that the mortgage balance declines very
slowly at first and then it falls rapidly when it comes to
maturity. I’ll just mention–I want to
mention a couple other institutions that are very
important in real estate and those are Fannie and Freddie.
In 1938, as part of the New Deal–I’ll just write Fannie Mae
1938–under the Roosevelt Administration in order to
further work on the problem in housing,
which was still troubling them, they created a government
institution called Federal National Mortgage Corporation.
People on Wall Street found that difficult to say–Federal
National Mortgage Corporation–so they nicknamed
it Fannie Mae; it sounds like a woman’s name.
The idea was that they would help advance the mortgage market
by buying up mortgages from mortgage originators and
therefore allowing them to make more mortgages.
They would buy mortgages from originators.
What is an originator? An originator is a company that
lends money to households; they raise money and then they
lend it out as mortgages to households.
Then they deal with the households by having a local
office and telling people what their balance is and calling
them up if they’re not paying and that sort of thing.
Well, they were–a servicer is someone who–might make a
distinction between originator and servicer.
The originator is the one makes the loan;
the servicer is someone who manages the paying of the loan.
Congress thought that these people could be given more money
to operate if someone would buy the mortgages from them,
so Fannie Mae started doing that in 1938.
Then the government created a second such institution
called–and they gave it a boy’s name–with a nickname,
boy’s name–Freddie Mac. So, the government created
competitors and it privatized them so that both Fannie and
Freddie became what are called GSEs–these are Government
Sponsored Enterprises. Technically,
Fannie and Freddie are private companies–they’re traded
stocks; you can buy shares in Fannie
and Freddie. They’re not part of the
government, but they were created by the government and
they are massive supporters of the housing market.
The general market assumes–and also the government still
regulates them. It tells how–there’s a
conforming loan limit that is a limit on how much Fannie and
Freddie–how big a mortgage they can make to one homeowner.
It was just part of the new President Bush’s plan to
increase the conforming loan limits on Fannie and Freddie to
allow them to lend at a higher price.
So, you can see the government is still involved in them.
While they’re technically private companies now,
they are still thought to be related to the U.S.
Government. People are willing to lend to
these organizations at low interest rates because they
think there’s an implicit government guarantee.
There are critics of Fannie and Freddie who say,
the government guarantee doesn’t sound right because why
is the government guaranteeing a private company?
On the other hand, the government says,
it’s not guaranteeing them. But nobody believes the
government when they say that because people say,
surely the U.S. Government is not going to
allow Fannie and Freddie to fail.
This is very important suddenly, now with the housing
crisis. If you just saw the news
yesterday, Fannie Mae is predicting, well,
they are predicting that Fannie Mae is going to make huge losses
in their latest earning statement.
It’s still–they can make losses for a long time before
they’re in trouble, so presumably there won’t be a
problem, but in principle there could be
and so that’s the kind of issue that we have now.
I want to talk about the current boom and I have so much
to say about this. This is the plot that I created
for the second edition of my book, Irrational
Exuberance, that shows the real estate
market in the United States since 1890.
What is really significant–I created this plot just a couple
of years, in 2005. To my surprise,
nobody had before created a hundred-year long home price
index, which seems surprising to me
because the long history of home prices seems like a relevant
fact; we want to know what markets do.
A lot of people have the impression that home prices only
go up and that they’re a wonderful investment.
I thought we should try to find out what home prices have done.
I constructed a series of home prices–that’s the red line and
the red line is–you can see how it’s moved through history.
It has suddenly shot up in the latest years;
this is since the late 1990s. This behavior recently,
I think, confirms that we are living in a very unusual time in
the housing market and it’s going to put a lot of stress on
us. The only other time we’ve seen
a boom like this was right after World War II and that’s shown by
this line here; that wasn’t as big.
After World War II, there were two things that,
I think, contributed to the huge housing boom at that time.
One of them was that the U.S. Government had shut down the
construction industry during the war, so they didn’t build any
houses for close to five years; obviously we had a shortage of
housing. The other thing was the
soldiers came back from World War II and they wanted families.
They started something that you may have heard of called The
Baby Boom, so the birth rate shot way up and everyone wanted
a home. One bedroom wasn’t good enough
anymore, they wanted–you don’t want the baby in the same room
with you; you want to have two bedrooms.
You might even want two bathrooms, so the demand for
housing went up. The current boom is different
because there’s nothing like that happening and so it’s
strange. The question is:
what caused the current boom? I have some other data shown
here. The green line is the building
costs and you can see that building costs,
since 1890, in real terms–everything is
corrected for inflation–have gone up a little bit since 1890,
but not a whole lot. In fact, for the last–this is
the Engineering News Record Building Cost Index;
it’s an index used by people in the construction industry.
Since around 1980, building costs have been
falling. That, I think,
is partly because the biggest single component of building
costs is labor. As you know,
income inequality is getting worse, low-income wages are not
going up, so that component of housing has been declining in
real terms. The other components are not
doing much. The other thing I have down is
population, although the population of the U.S.
has been pretty steady–that pink line looks awfully
steady–and I have interest rates.
Now a lot of people talk about interest rates.
I was just reading Alan Greenspan’s new book,
The Age of Turbulence. I don’t know if you saw this;
it came out last year. He said, he didn’t think there
was a bubble. I don’t know how he could not
think there was a bubble, but he didn’t see it.
His honest–he said, maybe froth in the real estate
market but not a bubble. Anyway, I was reading–well,
why didn’t he think there was a bubble?
He said, well part of the reason is interest rates were
coming down. If interest rates are coming
down, as you can see they are, that means the rate of discount
is going down in the present value formula,
so asset pricing should go up. I guess that’s plausible.
It doesn’t match up very well though because interest rates
have been going down since 1980 and the boom is very sudden,
so it seems to me that Greenspan should have seen this
bubble coming. What caused–that’s the–I
wanted to show you one city–I actually do a short comparison
between a couple of cities–Los Angeles and Milwaukee.
Is there anyone here from Los Angeles?
We’ve got a good number. What about Milwaukee?
Nobody from Milwaukee–I might be insulting Milwaukeeans when I
talk about this–not really. Milwaukee–is there someone up
there? No.
Milwaukeeans are much more stable than–this is actually
praise for Los–for Milwaukeeans not–Milwaukeeans are much more
stable than Angelinos, I guess you call them, right?
Los Angeles residents? Look what the housing–the blue
line shows what home prices in real terms have done in Los
Angeles over the last thirty years.
We compare Milwaukee–look at that, isn’t that amazing?
Milwaukee has been extremely steady over this period.
One theory is that, well it’s, as people say,
I’m going back to Los Angeles. The problem with Los Angeles is
that they’ve had unsteady employment and unemployment.
If the economy is sagging, then the Los Angeles housing
prices will respond. Well, you can see the pink line
shows the employment in Los Angeles, and indeed,
it did move around corresponding to the booms and
busts in the Los Angeles market but not so dramatically.
If you look at Milwaukee, the employment figures don’t
look that much different than Los Angeles.
What’s different? There’s something about Los
Angeles that’s different from Milwaukee and that is that in
Los Angeles there’s just a history of volatile markets.
I wanted to try and figure out why.
The reason we picked these two cities–we asked realtors–Karl
Case, who’s my colleague, he teaches at Wellesley
College. Back in 1988,
when we started this study, we asked realtors around the
country, what is the hottest market in the United States?
They said, oh that’s Los Angeles or maybe Anaheim,
which is right outside. Then we said,
what’s the deadest market in the United States?
There wasn’t as much agreement on that, but one of the names
suggested was Milwaukee; nothing has ever happened there
in terms of real estate. Now, I think that
ultimately–interestingly enough, Los Angeles had a real
estate boom and bust in the 1880s;
that’s hard to believe. There was a huge boom in real
estate prices in L.A. in–it peaked in 1886 and then
it crashed. Now, you might think that’s a
long time ago, 1886?
Isn’t that when the cowboys and Indians were out there in the
Old West in the covered wagons? Well that’s right,
but there was a real estate boom in Los Angeles.
I went back and studied this boom rather extensively
by–there’s one book written about it.
There’s also The L.A. Times, which you can get
now online with no problem from the–you can read every day’s
newspaper. It turns out–I was talking
about what happened in L.A. in the 1880s–a view arose that
Los Angeles was just the most wonderful place on Earth.
The climate out there is beautiful, especially if you
feel that on a winter’s day like today,
you might wish you were in–some of you might wish you
were there. It wasn’t just California,
because California was a huge state, with all kinds of–but
mostly empty–land. People somehow got the idea
that Los Angeles is just this wonderful city and so they
started bidding up real estate prices.
You can explain that to me, some of you from Los Angeles.
It turned out to be kind of wrong because in the 1880s they
started building so many houses in response to the demand that
there was eventually a crash; but somehow people got this
idea at some time. We compared Los–we couldn’t go
back in a time machine and do questionnaire surveys in the
1880s, but we could do it in the 1980s.
So, Case and I did identical questionnaires in Los Angeles
and Milwaukee and these are median price expectations.
In 1988, when there was a boom in California,
but of course not in Milwaukee, the average person in Los
Angeles thought home prices would go up 10% a year for the
next ten years–that’s the median,
I’m sorry. 10% a year is a pretty fast
appreciation. If it goes on for ten years
that means that the–it’ll double in seven years,
so it’d be going up like two and a half fold.
That was quite a nice expectation.
If you compare that with Milwaukee, they thought only 4%,
which is about the inflation rate.
So, there was something different between Los Angeles
and Milwaukee. The Los Angeles people had
extravagantly high expectations. We saw it again in 2003,
when people in Los Angeles expected 8% appreciation every
year. It’s coming down now in 2006;
they’re gradually coming down as the boom unwinds.
You notice Milwaukee is going up.
I think what’s happening is that we’re becoming more
national and Milwaukeeans are starting to think more like
Angelinos–that it’s one boom–so they start to expect it
to happen in Milwaukee. Los Angeles and Milwaukee were
tied in 2006 for their expectations.
This is the boom. People had great fear of being
left out of the real estate market.
I think the boom was driven by fear.
In 1988, we asked people in Los Angeles, are you worried that
unless I buy now I won’t be able to afford a house in the future?
We had 80% agreement with that in Los Angeles;
so people were really worried. In Milwaukee, it was only 27%.
You kind of wonder, how can it be that people had
such different views depending on which city they lived in?
Well, I can kind of explain it; there are a couple of factors.
One is, in 1988 home prices were rising rapidly in Los
Angeles, not so in Milwaukee, so people were just
extrapolating the price increase.
The other thing is that Los Angeles just has this sense of
its own glamour and excitement that–you know it is the home of
movie stars. What city is more glamorous?
Beverly Hills is part of Los Angeles;
it’s the most expensive city in the U.S.
This sense, this glamour thinking, along with price
increases, caused Los Angeles to boom;
so it’s the boomiest U.S. city. We asked people whether they
had a perception of excitement directly and in Los Angeles,
in 1988,54% said yes; whereas, in Milwaukee only 21%
said yes. As the years go by,
you notice that Milwaukee is starting look more and more like
Los Angeles. Alan Greenspan,
in his book, says that he thinks housing
markets are all local and there is no–he says this firmly in
his book–there is no national housing market.
In fact, it’s becoming more national because Milwaukeeans no
longer think that they are some kind of outpost that’s unrelated
to the excitement of glamorous cities;
they see it happening at home as well.
Now, I wanted to compare it with another question that
I–people have this simple idea that there’s a best investment.
This is about the stock market, but I asked a number of–this
I’ve been doing since 1996–do you agree with the following
statement? “The stock market is the best
investment for long-term holders who can just buy and hold
through the ups and down of the market.”
I only started asking this in 1996 when the stock market boom
was well under way, but already 69% of my
respondents, who were high-income investors,
strongly agreed. That percent grew to the peak
of the market in 1999; after the peak in 2000 it began
to fall. We see what happens is that
when the markets–people are chasing past returns.
When the stock market is going up they think that–they
increasingly think that the stock market is just the best
investment, until when it starts falling,
then they start retracting from that.
I didn’t have–I lost it–what is going on here? We see the same thing in real
estate. The percent who think it’s the
best investment is higher in Los Angeles than in Milwaukee,
and since the peak of the bubble in 2003,
it’s been declining in Los Angeles but,
surprisingly, rising in Milwaukee.
They’ve almost–they’ve pretty much converged in 2006.
The lesson is, I think, that we have a
glamour-city phenomenon–that excitement about real estate
prices–centered in places like Los Angeles,
but it’s spreading and becoming more and more of a national
phenomenon and that’s the bubble.
Part of–this is the–it’s not loan-to-value ratio–this is the
ratio of mortgage debt to personal consumption
expenditure. Over the boom period,
we’ve been seeing a gradual uptrend;
just as loan to value ratios were only 60% in the 1920s,
now they’re up to 90% or 100%. We’re much more willing to take
risks on mortgages. People are also borrowing much
more. You can see that in the early
1950s mortgage debt was only something like 25% of personal
consumption expenditure, but now it’s up to about 100%.
We’re much more expansive in mortgage financing than we were.
I put this chart out to just show the international aspect of
home prices. Here, the blue line is the
Case-Shiller Home Price Index for greater Boston.
The red line is the Halifax Home Price Index for greater
London–we’re talking UK now. They’re both deflated by the
Consumer Price Index or, in the case of the UK,
the Retail Price Index to give us a real home price.
Isn’t it striking how similar London and Boston are?
They both had dramatic booms. The London boom of the late
1980s is really something–look at that.
It went up, peaked, suddenly turned around,
came all the back down. I don’t know what to–and then
it kind of waffled around in London and then it shot up even
higher. Then, look what’s
happened–this is the latest quarter–it’s starting to fall
rapidly. Just a couple of months ago
London seemed to be soaring and now suddenly there’s this
pessimistic atmosphere because we don’t know what’s going to
happen in London. Look how it fell in 2004;
there was this sharp drop and most people thought that the
housing boom was over but then it went up again to a new peak
in 2007. We have an international crisis.
This is another couple of countries.
I managed to find price indexes for Norway and Netherlands going
back to 1890 and compared that with the U.S.
We’re seeing a similar pattern in all three of these countries.
These are the only countries that I’ve been able to find that
have high-quality, repeat sales price indexes
going back a hundred years. You can see that in all these
countries real estate prices didn’t show much trend until
recently and now they all have real estate booms.
We have an international boom. Why is that?
Why would we have an international boom?
I talk about this in the book you have, Irrational
Exuberance, and I’ll let you read that and
not summarize it here. But, part of the reason I think
is, globalization is creating a global culture and the
excitement and enthusiasm that we once saw in isolated cities,
like Los Angeles, are spreading out and are seen
more and more around the world. It’s tied in with our sense of
rapid economic growth. We’re living in an era of
excited economic optimism and it’s feeding into home prices in
the U.S., in Europe, in China,
in Korea, in India, in South Africa,
Australia, New Zealand–lots and lots of places have seen
home price boom and I think it’s not anything unique to any one
country that explains it; it’s the psychology.
This is residential investment in the United States as a
fraction of GDP. I have it shown with the–the
vertical lines on this chart indicate recessions and this
shows–this is from 1948 to 2007 and every recession that we’ve
had since 1948 is shown. For example,
we had a recession that started here–I believe that was
’48–and then it ended in ’49. Then we had another recession
that began in 1953–that’s that line–and it ended in ’54,
and so on. The most recent recession we’ve
had is 2001; it began and ended in the same
year, 2001. We may be in a recession now;
a lot of people are saying that, so I would be tempted to
draw a new line here, somewhere around here,
maybe December of 2007. The National Bureau of Economic
Research, who announces recession dates,
hasn’t announced yet whether there’s a recession,
so we’ll probably find out in a few more months whether we’re
already in a recession. I suspect we are.
Now the interesting thing is, the green line here is the
expenditure on real estate investment.
What does that mean? There are three main components.
One is building new houses, another one is building new
apartment buildings–that’s commercial instead of–but it’s
still adding to the housing stock–and the third one is
improvements of existing houses. People put new additions on or
they redo the kitchen and bathroom and whatever.
So, we add all of that up and that’s residential investment.
You can see that residential investment, as a fraction of
GDP, has been very variable through history of the United
States since World War II and that it’s had a strong
relationship with recessions. You can see what residential
investment has done recently. We had a huge peak in
residential investment and the peak was a couple of years
ago–I believe 2006 or thereabouts–at the level of
residential investment was the highest it has been since
1951–that’s over here. That’s the only time since
World War II that we’ve had a higher level of residential
investment. Even 1951 was a very unusual
year–I’ll tell you why–because we were getting into the Korean
War. People remembered that during
World War II the U.S. Government shut down the
housing market. They said, no more new houses
to be built, so everyone thought–in fact they were
talking about World War III, they were really scared.
You don’t remember how awful it looked because the U.S.
was proposing to invade Korea and then the Soviet Union and
China were being very angry and we thought we’d be in some war
with Communist China or some awful war.
People got really scared, but what they did was
they–this was the Baby Boom. They just got back from World
War II, they didn’t want another war, they wanted to live a
normal life, they wanted to have kids,
and then this terrible war was coming, they thought.
So, they rushed and bought houses.
Everyone was scrambling to get a house before they shut down
the housing market. It turns out that it didn’t
turn into World War III and–maybe they did shut down
the housing–or they must have curtailed it,
but it created that boom. What’s causing this boom here?
It’s almost as big as the 1951 boom.
Well, the answer is high prices, I believe.
We had this huge bubble in home prices and it pushed prices up
to extraordinary levels. What does that do to builders?
Well, builders can sell for a really high price,
so they start building a lot of houses.
They will do it as long as the home price is high relative to
their construction costs. We’ve seen a boom in building
in the United States that is at a record level,
except for that one Korean War blip, and so I think it’s a
highly abnormal situation that we’ve been in.
Now, look how suddenly and sharply it’s correcting
downward. Why is it correcting downward?
Well, that’s because the housing market is now in
decline. When the housing market is in
decline, the ability to sell houses drops dramatically.
Builders were doing extremely well until a couple of years
ago–their stock was soaring–now all of a sudden
they’re in crisis. Well, it’s no surprise;
this is what a housing bubble does.
You can see various–this is the growth rate of home
prices–actually I should update this.
This is now tipped negative. The peak–this is the
Case-Shiller ten-city index. Housing permits have dropped
way off because, of course, they’re not building
homes anymore. This shows a strong seasonality
and then a drop off since 2006. Here’s my last slide–The
National Association of Homebuilders surveys its
membership to ask them what is the traffic of homebuyers?
What they mean by that is, if you’re a builder and you
have this place where you show off your model homes,
how many people are coming by to look at your model homes
today as potential buyers? The blue line is the traffic of
homebuyers. You can see that it has reached
the lowest level ever. It has dropped precipitously
and you note that the pink line, which shows the rate of growth
of home prices, the rate of growth of home
prices, has fallen just right along with the traffic of
homebuyers. I think it’s pretty clear
what’s happening. People saw the rising home
prices; they thought they would rise
forever; they were flocking in,
trying to get into the housing market before it outpriced them.
Now suddenly, the word is that it’s falling,
so suddenly they don’t want these homes, so the inventory of
unsold homes has shot up; builders can’t sell them and
prices are falling. That’s the situation we’re in.
We’ll talk more about this very interesting situation because it
ties in with so many other aspects of financial markets.

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