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
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.