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Current Valuations & Economic Implications


The paper at the bottom of this page has remained here since the time it was submitted in mid 2005. Currently (June 2008), many of the lax mortgage standards that where documented have know become common knowledge. The media now regularly reports on the ‘loose lending standards’ that lead to the current “mortgage meltdown” or “mortgage crisis”. However, I still do not believe the main-stream media has caught on to the price/rent or price/income aspect of housing valuations nor the constraining effects that these valuations are bound to have on future home prices.

Fundamentally, I assert that a simple index based on price/income could be used by the media for placing current housing-market valuations in a historical context; this could be beneficial in maintaining market stability. However, as I write this I am reminded of a quote by Warren Buffet, "I have seen no trend toward value investing ... There seems to be some perverse human characteristic that likes to make easy things difficult." Of course Buffet was writing mainly of stocks, but I argue this insight could be aplied to price/income methods used by economists in determining home valuations. Perhaps this provides some insight into why the main-stream media has not adopted a convention for evaluating home prices like they do for stocks (p.e. ratios), and why the main-stream media seems unwilling to place either one in any historical context.

The current state of the housing market raises two questions that I will be addressing through June 2008; in my view both issues remain unaddressed in any thoughtful manner by the main-stream media:
1) Is there a quick and easy method to stay informed regarding local housing market valuations?
2) What impact is the current state of housing likely to have on the overall economy?

Local housing valuations

I will start with local housing by recalling a study by economist Richard Dekaser. Dekaser continues to update U.S. housing valuations for ~300 metropolitan areas in the U.S. This study is:
• partially based on price/income ratios
• updated several times per year
• the most convenient method that I know of for estimating local valuations.
• represents a more thorough analysis than this staff of one could ever hope to compile.
• is free.
• unfortunately (for this research) factors current mortgage rates into "fair values".

For my research, I would prefer that Dekaser not base his analysis on current interest rates to determine each market’s fair value. This places a higher valuation on homes during years with low interest rates and lower valuations for years with high interest rates. In regard to placing current home valuations in a historical context, or estimating the potential for future price increases or decreases this makes Dekaser’s analysis less than ideal. However, it is an extremely methodical study of all major metropolitan areas and therefore deemed useful when viewed with the understanding that current interest rates effect Dekaser’s determination of fair value. In this context I view Dekaser’s work several times a year (keeping in mind the effect that current interest rates have on his analysis). A very intuitive overview of Dekaser’s study can be found by clicking here, with more details, including methodology, on the side.

Macrovestor remains focused on asset allocation, i.e., comparing returns on identical cash purchases. The site aspires to be a collection of tools for identifying under and over valued investments; money can be borrowed for any investment class that is determined to produce a greater rate of return than the loan’s rate. This is why I don’t consider interest rates when comparing investment classes side-by-side. Treasury yields (i.e interest rates) are simply another investment class. Treasury yields, loans, etc. from an investors stand point, can be compared to projected investment gains of stocks, real estate, etc.

In regard to a seperate interest-rate related issue, predicting the direction of interest rates for the purpose estimating the future value of an investment, I will once again quote Warren Buffet:
"Stop trying to predict the direction of the stock market, the economy, interest rates, or elections." (emphasis mine)
In regard to interest rates, this is a reoccurring theme with Buffet. Buffet believes that he is not capable of predicting future interest rates, and therefore he does not let them influence his investment decisions. In other words, he values an investment in the same way regardless of current interest rates. For the purpose of asset allocation and predicting future price investment gains (or decreases), I will stay with this convention of not factoring current interest rates.

Housing’s effect on GDP

In regard to the slow-down in housing and the effect on the overall economy, one of the most pertinent and credible papers that I am aware of is a paper done by/for the IMF. This is an elaborate study (click here for pdf) that looks at many “price bubbles”, in many economies, and in many different decades. The paper looks at the macroeconomic and financial aftereffects of the bursting of an asset price bubble. The study compares downturns in real estate to downturns in equities; one of the bottom-line determinations is that on average equity price bursts negatively affected the economy for 2-1/2 years while shaving 4% off of GDP. Housing price bursts have historically lasted almost twice as long with the negative effect on GDP twice as large. My thoughts on this topic are,,, well still being formulated; so I will end here before I misspeak (miswrite). I will be thinking and writing more on these topics through June 2008 with the aspiration of delivering an accurate but more concise view on the current state of housing.

Robert Shiller discusses Housing (3 videos)

Economist Robert Shiller discusses the downturn in the housing market:

Taped in January 2008.

Taped around February 2008.

Taped in late 2007.

Real Estate


Housing Valuation Methods

In the long run, home price increases can not outpace median household income. It is for this reason that variations of two valuation methods have traditionally been used by economists. One method compares home prices to household income (price/earnings), and the other method compares home prices to rent (price/rent).

The first chart below represents price/earnings ratios, and was compiled for this page by simply dividing median U.S. house prices by median household income, both from the U.S. Census Bureau. It covers the years 1967 through 2nd quarter 2005. (Note: 2004 and 2005 median household income was estimated based on percentage gains of personal income as provided by Economagic.com.)

Figure 1. Median Sales price of U.S. Homes Divided by Average Household Income.
Note. Median sales prices where averaged from all 12 months as stated from U.S. Census Bureau (2004, August). Median and Average Sales Prices of New Homes Sold in United States. Retrieved September 5, 2005 from http://www.census.gov/const/uspricemon.pdf
Note. Median household income for 1967-2003 was taken from the “Third fifth” column of U.S. Census Bureau (2004, August). Historical Income Tables – Household, 2005. Retrieved September 5, 2005 from http://www.census.gov/hhes/income/histinc/h03ar.html
Note. 2004 and first two quarters of 2005 household income were estimated by calculating annual percentage increase of personal income from Economagic.com (2005). Personal Income. Retrieved September 7, 2005 from http://www.economagic.com/em-cgi/data.exe/nipa/T2t1l1q

The second chart (figure 2) represents price/rent ratios and was compiled by John Krainer for the Federal Reserve Bank of San Francisco. The table refers to the US as a whole (not San Francisco). The Chart was published on October 1, 2004; ratios of price/rent are certainly higher now.

Figure 2. Price-Rent Ratio
Note. From Krainer, J. (2004, October). House prices and fundamental value. Retrieved September 30, 2005, from http://www.frbsf.org/publications/economics/letter/2004/el2004-27.html

Different Housing Markets; Different risks

The national market is certainly higher than historical averages as shown in figure one and two, but it is very important to understand that different markets have very different valuations and therefore different risks associated with them. Consider the following two studies; each study comes from two very reputable sources.

National City Study

Richard Dekaser, Chief Economist for National City, a mortgage lender, has issued a widely cited study that highlights valuations in 299 local metropolitan markets. Dekaser's (2005) study is very unique, in that it analyzes long term statistics from 1985-2005 in the 299 local markets he studies. His study is based on price/earnings and other local factors. Listed below in table 1 is a list of 53 markets “representing 31 percent of the total U.S. housing market” (p.1) that DeKaser considers overvalued by 30% or more.

Table 1 From DeKaser R. (2005, July). House prices in America: Valuation methodology & findings. Retrieved September 20, 2005 from http://www.nationalcity.com/content/corporate/EconomicInsight/documents/finalreport.pdf

    Markets overvalued by 30% or more where chosen by DeKaser “(…) based on a review of actually observed price corrections over the past 20-year history.” (p.3) DeKaser actually analyzed 63 past corrections of 10% or more that occurred over a period of 8 quarters or more in local markets. He notes that:
  • “The median, or typical price correction is 17%”(Appendix IV)
  • “The median, or typical, degree of overvaluation prior to a correction is 30 percent.” (Appendix IV)
  • “The more severe the overvaluation, the greater the subsequent declines tended to be …” (Appendix IV)
  • “The more severe the overvaluation, the shorter the duration [of price correction] tended to be …” (Appendix IV)

PMI Group Study

For an objective look at local market conditions, Akkeraen & Ogishi have also done a very interesting study, this one for the PMI Group. The study rates the 50 largest housing markets in the United States. According to this study “… the nation’s 50 largest markets now have on average a 21.3% chance of experiencing a decline in house prices over the next two years” (2005, p.3). Keep in mind that this report was compiled with first quarter 2005 housing price data; National housing prices have since continued to rise faster than national income.
Akkeraen & Ogishi calculated, at the time, that six of fifty markets had a greater than 50% chance of decline in the succeeding two years. Similar to Dekaser’s study, some markets are considered much riskier than others. The author's Risk Index rates each individual market by what they calculated to be the percentage chance of a decline in the next two years (e.g. 200 = 20%, 300 = 30%, etc.). Listed below in table two are the markets they considered to have a 20% or larger chance of decline in the two years succeeding the study.

Table 2
From Akkeraen, M.V., & Ogishi A. (2005, Summer). Economic and real estate trends. Retrieved September 1, 2005, from http://www.pmigroup.com/lenders/media_lenders/pmi_eret05v3s.pdf

Historical Housing Price Increases

Respected economist and best selling author Robert Schiller claims that real home price appreciation has averaged 0.4% annually plus inflation from 1950-2004. Schiller’s study accounts for the fact that a house built in 1950 is built very different than a house built in 2004 (sq. footage, features, etc.) (2005). This is the difference between comparing statistically median or average house valuations and any single house. The average single house has grown slower than statistically average house prices (which keeps increasing in size and quality).
For the purpose of objectivity and to confirm Schiller’s findings a separate study is considered. Glaeser, Gyourko & Saks show that US average home prices had risen by 1.7% plus inflation from 1950 through 2000 (2005). However, they clearly state in the paper’s abstract that much of the increase reflects “housing quality”. Their study does not compare the selling prices of a similar quality and size house in 1950 and 2000. It is for this reason the two studies seem fairly closely to each other’s findings, and seem close to accurate.
Schiller’s methodology, in my opinion, closely reflects the average long term annual price increases the owner of a house should expect in the long term: 0.4%, plus inflation, more or less.

Interest Rates and Lending Practices

Falling Interest rates

The largest price/earnings and price/rent valuations of modern history (figures 1 & 2) have coincided with the largest dip in mortgage rates since Freddie Mac began keeping statistics in 1971 (2005). It should not be difficult to imagine how access to more cash via lower mortgage rates can influence a rapid increase in housing prices. However, the increased access to funds does not stop with historically low rates.

Loose Lending Practices

A traditional mortgage requires 20% down. If less is put down, mortgage insurance (MI) is generally required.

In a surprising report for the PMI Group, Charles Calhoun a former senior researcher for Fannie Mae & former Deputy Chief Economist for the Office of Federal Housing Enterprise Oversight makes these observations about new loan products (2005), “Following already impressive growth since 1999, the annual rate of growth in second-lien home equity lending has been estimated at nearly 39 percent for 2004, and is expected to exceed 30 percent in 2005.” (p. 5 ) “Current GSE [Fannie Mae & Freddie Mac] regulatory reporting and risk-based capital standards were developed prior to the rapid growth in the piggyback market, and did not anticipate the significance of the potential risk.”(p. 4)

As a result “First-lien purchasers like Fannie Mae and Freddie Mac may not always know about the existence of simultaneous second liens, much less second liens that are originated at different times or by different primary lenders.” (p. 21)

His story just keeps sounding more like chaos, he claims that as a result of loose regulatory requirements, and the simultaneous second mortgages taken by buyers with little or no money down, that the GSE’s, in addition to being tricked (my interpretation) into making the loan without realizing the existence of a second mortgage, bankers are often qualifying borrowers with no PMI insurance due to the GSE’s impression that there was a significant down payment when there really was none.

    Calhoun cautions that “Piggyback loans may contribute to the risk of speculative bubbles in local housing markets by qualifying borrowers for larger loans at higher LTVs, [loan to value] thus initially supporting a rapid rise in housing values, but may ultimately fail in greater numbers, generating higher loss rates in response to declining housing values” (p. 9). Calhoun also makes these observations about new loan products:
  • There has been a rapid rise in the amount of high loan-to-value mortgages (over 80% of property value) in recent years.
  • There has been a rapid rise in the amount of second-lien mortgages in recent years.
  • " Among the MSAs [Metropolitan Statistical Areas] ranked in the top 10 in terms of market risk [he is referring to PMI’s Risk Index as partially shown above in table two], 7 regions had more than half of their mortgage lending for home purchases in piggybacks during the first half of 2004 ..."
  • Motivations of bankers to use piggyback loans (second-liens often used for home purchase) include:
    a) Additional fees.
    b) Non disclosure of second liens in order to fit Fannie Mae, Freddie Mac or other mortgage buyer/investor’s requirements.
    c) Salability of riskier loans. (Lower credit scores can be doctored up with two smaller loans.)
    d) Salability of high total loan to value (LTV) rate mortgages (above 80%) without mortgage insurance.
  • Piggyback loans have altered the historical relationship of mortgage sellers and institutions that invest in these securities.
  • Second liens are increasingly being used to increase the marketability of first liens to investors (sometimes without mortgage insurance). These loans would otherwise not meet their credit standards.
  • Piggyback loans appear to be much more prevalent in high risk areas as noted in Akkeraen & Ogishi's Risk Index and may contribute to speculation.
  • "The risks of high-LTV loans are well documented. In fact, no single factor is more important for predicting the likelihood of mortgage default" (p.15).
  • Regulators are increasingly concerned with: interest only loans, reselling of low or no documentation loans, high income/debt ratios, High LTV ratios, lower credit score requirements, appraisal methods, and increased transactions created through brokers, or delegated to other institutions (p.18).
  • "The risks of high-LTV loans are well documented. In fact, no single factor is more important for predicting the likelihood of mortgage default" (p.15).


Akkeraen, M.V., & Ogishi A. (2005, Summer). Economic and real estate trends. Retrieved September 1, 2005, from http://www.pmigroup.com/lenders/media_lenders/pmi_eret05v3s.pdf

Calhoun, C.A. (2005, June) The hidden risks of piggyback lending. Retrieved September 7, 2005 from http://www.pmigroup.com/newsroom/media_newsroom/hiddenriskspiggyback.pdf

DeKaser R. (2005, July). House prices in America: Valuation methodology & findings. Retrieved September 20, 2005 from http://www.nationalcity.com/content/corporate/EconomicInsight/documents/...

Economagic.com (2005). Series title: 10-year treasury constant maturity. Retrieved September 29, 2005, from http://www.economagic.com/em-cgi/data.exe/fedbog/tcm10y

Economist.com (2005, June). The global housing boom: In comes the waves. Author. Retrieved September, 18, 2005, from Economist.com database

Freddie Mac (2005, September). 30-Year Fixed-Rate Mortgages Since 1971. Retrieved September 30, 2005, from http://www.freddiemac.com/pmms/pmms30.htm

Glaeser, E.L., Gyourko, J., & Saks, R.E. (2005). Why Have Housing Prices Gone Up?. Retrieved September 20, 2005

Greenspan, A. (2005, April). Remarks by Chairman Alan Greenspan. Retrieved October 1, 2005, from http://www.federalreserve.gov/boarddocs/speeches/2003/20030403/default.htm

Lim, Paul J. (2005). Housing's a buy? So why do execs sell?. U.S. News & World Report, 139(9), 58. Retrieved September 18, 2005 from ProQuest database

Malpezzi, S., & Wachter, M. (2000). The role of speculation in real estate cycles. Journal of Real Estate Literature, 13(2), p.143-164. Retrieved July, 5, 2005

Schiller, R.J. (2005). Irrational exuberance: Second edition. Princeton: Princeton University Press

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