Thursday, November 30, 2006

The Fed's Crystal Ball

by Osman Parvez
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John Duca, Vice President and Senior Economist at the Dallas Federal Reserve, recently published Making Sense of the U.S. Housing Slowdown. If you're wondering where real estate is heading and why the Fed is paying so much attention, pour yourself a cup of coffee and read this report.

Looking through his own real estate crystal ball, Duca had this to say about the big picture of future prices (bolding is mine)

Although the recent slowdown in home prices has been dramatic, it's still un-clear how much housing-price appreciation will decelerate from the fast pace of 2004-05. Analysts disagree about the extent to which U.S. home prices have been overvalued. A recent study by Moody'’s Economy.com maintains that more than 100 of the nation's 379 metropolitan areas, representing nearly half the value of U.S. housing stock, have a significant probability of seeing price declines by the fall of 2007. On the other hand, a Brookings Institution paper argues that there wasn't a bubble in U.S. home prices in 2005.[9]

In part, the disparate conclusions may reflect changes in supply and demand.[10] Traditional yardsticks may overstate any degree of overvaluation if land supply conditions have become more restrictive over time, especially in coastal areas, and if financial innovations have permanently boosted housing demand.[11] And differences persist over which price measures to use, as well as whether home prices should be judged, along with the user cost of housing, relative to households'’ incomes or costs of renting.[12]

Several other factors may influence home prices. The apparent greater role of speculation over the past few years, for example, may increase the likelihood of price declines. Owner occupiers directly benefit from living in a home; they also incur moving costs that speculators don'’t. As a result, owner occupiers are probably more resistant to selling at a lower price than outside investors, who have a greater incentive to sell quickly when prospects for gains diminish.

Finally, mortgage rates remain low. The impact of monetary policy on housing demand appears to have loosened in recent years, with increases in the federal funds rate not acting as quickly or forcefully on mortgage costs (see box,Interest Rates, Mortgages and the Housing Market).

Are there land supply restrictions in Boulder and the mountains? Absolutely. But that's mitigated by all the new construction to the east where land is plentiful.

What about speculation? It's hard to use primary residence as a gauge in Boulder because, as a university town, many homes are and have been rentals. Anecdotally, the vast majority of our clients have not been speculators and the grey clouds of the telecom collapse in 2001 seems to have given us a silver lining. It may have shielded us from the real estate fever that gripped places like Phoenix and created bubbles.

What about those financial innovations? It's my understanding that many of the new structures and resulting security derivatives are only now being challenged by the high volume of foreclosures in the system. These innovative, yet untested, securitized investments are frequently based on mortgages. They include CMOs, interest rate caps, and swaps in a vast sea of variation. Warren Buffet, investor extraordinaire, said they're limited only by imagination and called them "time bombs" in his 2003 annual shareholder letter (ref).

If there's a net conclusion from all of this, it's that there are many economic forces in the real estate cauldron, most of which are beyond the Fed's control. Substantial economic uncertainty lies ahead. Maybe that's why Duca mentions the word 8 times in his article.

At one point, he writes

As these uncertainties play out, analysts and policymakers will need to monitor the impact of slower home-price appreciation on U.S. consumption. ItÂ’s important to remember that recent declines in housing activity have been from high and unsustainable levels to more normal ones, marking the unwinding of some earlier speculation. A beneficial side effect may be that income could catch up with prices, making homes more affordable.

Hat tip to Calculated Risk (who in turn tips someone else)


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The ideas and strategies described in this blog are the opinion of the writer and subject to business, economic, and competitive uncertainties.   We strongly recommend conducting rigorous due diligence and obtaining professional advice before buying or selling real estate. 

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