Perspectives

Also see our Economic Commentary which supplements the Laufenberg Economic Quarterly and primarily focuses on more recent economic developments.

This page is designed to offer you my perspective on economic fundamentals, ranging from business cycles to yield curves. It will provide more detailed economic analysis than is generally available in the Quarterly. For the most part, the essays provided here will attempt to discuss timely fundamental issues related to the forecast but are expected to have a longer shelf life than the content on either the Quarterly or Commentary pages. I hope that over time you will consider the information on this page as a source of reference when debating economic issues in the future.

Daniel E. Laufenberg, Ph.D.
LaufenbergQuarterly.com

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House prices: the bottoming process continues
(March 8, 2012)

At a recent meeting of the Council of Economic Advisers for the State of Minnesota, I was asked what I thought house prices would do this year. My response was that I thought they would be up slightly over the twelve months of 2012. However, I failed to specify what measure of house prices I was referring to, since there are several. This oversight on my part got me thinking about the different measures of house prices that are reported every month and which measure I had in mind. After the fact, I am tempted to say that the house price measure I had in mind is the one that will go up over the next year. But for professional reasons, I feel I should identify the measure a priori.

The house price indices considered here are all based on the same methodology. That is, the two Federal Housing Finance Agency Indices—National Price Index (NPI) and Purchase Only Index (POI)—and the S&P Case-Shiller (CS) Index of house prices are all “repeat-sales price measures.” One of the problems with constructing a house price index is the issue of adjusting for quality. The idea behind the repeat sales methodology is that a house’s quality remains approximately the same over time. If this is so, then the observed change in the prices of a large number of houses sold from when they were sold the last time would provide a reasonable proxy for the change in the aggregate price of housing. The obvious issue is whether house quality actually changes from one sale to the next.1 To maintain quality, owners need to maintain their house. If the house is not maintained, it depreciates much faster than it would otherwise. In this case, the repeatsales methodology most likely underestimate the increase in the aggregate price of housing. On the hand, many owners spend time and money on home improvements. To the extent that such efforts merely maintain the quality of their home, the repeat-sales methodology is appropriate. However, to the extent that the improvements increase the quality of the house, the repeat-sales methodology overstates the increase in the aggregate price of housing.

A related issue is whether the quality of a house varies if the owners are underwater on their mortgage—where the mortgage balance exceeds the market value of the house. If owners have no equity in their houses, they are less likely to maintain them. As such, if the share of houses sold is increasingly short sales or foreclosures, which have been the case in recent years, then the repeat sales methodology would have an even greater probability of lowering the price appreciation or exacerbating the price decline.

The levels of the three repeat-sales indices mentioned above are shown in Chart 1. For the sake of comparison, I converted each index to a base period of the first quarter of 1991. This allows me to easily illustrate the relative performance of the three indices since 1991. Clearly, all three indices have followed roughly the same trajectory over the last 20 years. From 1991 to 2006, the three indices trended higher. More recently, they have trended lower.

One glaring feature of the chart is that the CS Index increased at a much faster pace than either the NPI or the OPI from 2000 to early 2006 but fell at a much faster pace from 2006 to early 2009. Since then, all three indices have declined roughly at the same pace on average. That being said, both the HPI and the POI performed slightly better than the CS Index over the last half of 2011.

chart 1 House Prices Indices

Although all three indices employ the same fundamental repeat-sales approach, there are a number of data and definition differences. These differences may go a long way to explain the differences in the indices in recent years. One major difference between the HPI and the CS Index is that the latter only uses purchase prices, while the former includes refinance appraisals. For this reason, the POI series, which is restricted to purchase prices, is included in the discussion. The HPI is the Federal Housing Finance Agency’s index that gets the media attention and is often compared to the CS Index, but the POI is the FHFA’s house price index that is more in line with the CS Index.

Nevertheless, even the POI and CS Index still are different. First, the OPI’s data are derived from conforming, conventional mortgages provided by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The CS Index uses information from county assessor and recorder offices. As such, the CS Index includes valuations of homes with all types of mortgage financing— jumbo loans as well as sub-prime loans, whereas the OPI does not. Second, the weights used to calibrate the CS Index are value based, while the weights used to calibrate the POI are equal for all properties. As such, the price trends for more expensive houses have more influence on estimated price changes in the CS Index than in the POI. This may help explain the more rapid price appreciation registered in the CS Index from 2000 to 2006 than in the POI. On the other hand, the fact that the CS Index also includes sub-prime housing valuations may help explain why this index saw a sharper decline from 2007 to 2009. There are other differences in data and definitions, but they may not be quite as important in explaining the recent disparity between the CS Index and the POI or HPI.

This gets me back to answering the question asked at the recent meeting about what I thought house prices would do this year. The three indices discussed here are only a few of the options available. As you may know, there are several others. However, the repeat-sales approach to indexing appeals to me for the purpose of calibrating an aggregate house price index, which means that my choice is one of the three discussed here. I choose the POI from the Federal Housing Finance Agency. Picking this house price index had nothing to do with the fact that it essentially was flat over the final two quarters of 2011, suggesting that house prices may have reached a bottom. Obviously, I expect this bottoming process to continue.

The reason I picked the POI is because it includes only purchase prices, making it somewhat more compatible with the CS Index. However, because every house is different, if only in location, it is extremely difficult to construct an aggregate index of house pricing. Hence, the best I can hope for is a constant-quality index of the median house. I believe that the POI is closer to such an index than the CS Index. The CS Index includes the extremes. I want to exclude the extremes, especially when the extremes (which are a minority of houses) are often weighted more heavily than other houses.

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1. Another problem with the repeat sales methodology of measuring house price changes stems from the infrequency of sales, which is referred to in the literature as “transaction bias.”    Homes that are repeatedly sold may not be representative of houses in general.  The debatable conclusion is that transaction bias caused price gains to be overstated during housing booms and understated during housing busts.

 

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


Current Perspective

2012 Economic Perspectives

House prices: the bottoming process continues
--
March 8 , 2012

Equities and the political calendar
-- February 7, 2012

2011 Economic Perspectives

Is the great American job machine finally broken?
-- December 6, 2011

Recession fear, not fact
-- September 4, 2011

Core inflation: a policy guide more than a policy target
-- May, 2011

Help not wanted?
-- Feb, 2011

Special Report: Health Care Legislation:
Essay No.1 - Costs
Essay No.2 - Revenue
Essay No.3 - Budget Deficits

2010 Economic Perspectives

Causes of the financial crisis revisited
--November, 2010

A less robust U.S. Economy longer term
--August, 2010

Greece: A test of Europe's resolve to remain united
--May, 2010

The U.S. jobs machine restarting at a slower pace
--February, 2010

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