Tuesday, July 29, 2008

Gravity and Real Estate Prices

This article in today's NYTimes gets to the heart of one key aspect of the housing crisis. Here is the key quote:
But behind the political pyrotechnics is a simple truth: Executives at IndyMac, like many people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.

This presumption forgets the truism that what goes up must come down. This is at least true when the prices of assets rise faster than rents. Apparently, many lenders forgot this, despite the fact that at least in recent years we have some good data. Robert Shiller produced this graphic, for example, in his book Irrational Exuberance, and the graph was published in the New York Times in 2005.
It is pretty apparent that real housing prices fluctuated between 100 and 125, aside from the Great Depression, for about 100 years. The recent period clearly looks like a bubble. Looking at this graph would you believe that prices never come down?

This is more apparent still when we look at house prices compared with rents. Shiller provides this in a recent working paper (gated).

Housing prices clearly grew faster than rents since 2000, and this is the hallmark of a bubble. But bubbles eventually burst. If financial institutions lend while ignoring this basic fact they can burst too.

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