The Housing Bust Begins

By Eric J. Fry The Rude Awakening, August 22, 2006

"We've had the biggest housing boom in the history of this country," explains Yale professor, Robert Shiller. "That can't go on forever...I'm thinking that this boom is so much bigger, that we will see a substantial fall that will affect the country overall...We're not [automatically] bound for an enormous decline, but I think it's likely." Shiller aired his skeptical remarks during an interview with Bloomberg News over the weekend. The housing boom has been so large and all-encompassing, Shiller argued, that the coming bust also promises to be large and all-encompassing.

Helpfully, Shiller does not warn of impending disaster without also providing a partial refuge. The Yale professor helped to create indexes that track home values in ten major metropolitan centers. These new indexes, dubbed the Case-Shiller Indexes, underlie a new batch of futures contracts that debuted three months ago on the Chicago Mercantile Exchange (CME).

The new contracts reflect home prices in most of the nation's hottest property markets, namely: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York Commuter Index, San Diego, San Francisco and Washington D.C. "Why did you create these futures contracts?" the Bloomberg interviewer asked Shiller. "They're designed to allow people to adjust their exposure to a risky market," he replied. "The total value of real estate owned by households in the United States is $20 trillion. Bigger than the stock market. Not everyone needs to hedge. But a lot of people should be adjusting that risk exposure."

Remarkably, very few homeowners are availing themselves of these new hedging instruments. Only $71 million worth of housing futures are currently changing hands. "That's peanuts by Wall Street standards," Shiller admits. Furthermore, $71 million would not amount to even a single peanut in relation to the $20 trillion of household real estate equity. In other words, our nation of leveraged homeowners remains completely unhedged against the prospect of falling home prices - a prospect that seems increasingly likely if we are to trust the newly minted Case-Shiller futures contracts.

"In all 10 [futures contracts]," Shiller reports, "we have what's called backwardation. That means that the futures price is below the price that it is today. All of the markets are predicting price declines. And these price declines range from 4% to 5 1/2% by May of 2007...That's not me talking; that's the market."

To help frame his bearish expectations for the housing market, Shiller refutes the myth that residential real estate has been a great long-term investment. "It has not been a great investment," he says flatly.

Between 1890 and 2004, Shiller's book, "Irrational Exuberance" explains, U.S. residential real estate increased by only 66%, in real terms - that's only 0.4% per year. By comparison, U.S. home prices soared by 52% between 1997 and 2005 - or by 6.2% a year. Since home prices have soared so far above their long-term trendline, he reasons, a reversion toward the mean would not be surprising.

"Many contend that a sustained pullback in house prices is unthinkable," remarks James Grant, editor of Grant's Interest Rate Observer. "But the unthinkable - or, at least, the highly atypical - has already happened. In 2001-2005, prices levitated."

Shiller agrees.

"So why did it happen?" The Bloomberg News interviewer wanted to know.

Shiller, an economist by trade, cited no economic rationale for the boom. Rather, he provided an explanation rooted in the curiosities of human behavior.

"One of the mysteries of human society is how we interact with each other," he said. "We are an empathic species. When you have emotions, I see it in your face and I feel the same emotions. That means we kind of move as herds. And so when other people are getting excited and they are talking about the real estate market, it gets me excited too. You can't stay above it. If you are human, you get drawn in. But then when the emotions start changing, you get drawn into that too. And the emotion does seem to be changing. It looks like we're at the beginning of a change in psychology."

The recent housing data bear out his assessment.

Clearly, emotions are changing. The feel-good era of the housing market is visibly yielding to the feel-less-good era.

Prepare yourselves.