Every month, when the S&P/Case-Shiller Home Price Indices are released, builders everywhere cringe. Another month of data these days means another month of price declines, which, in the minds of many builders, creates yet another month of price declines.
As did the media. And since journalists are always looking for objective sources, they tend to give more weight to the Case-Shiller Index than to the existing-home sales data from the National Association of Realtors (NAR), which is considered to be subjective.
So when Dr. Robert J. Shiller tells a major newspaper that he expects home values to fall by as much 30 percent–or that he thinks they could fall as far as a Great-Depression-esque 50 percent–builders go into a deep funk, and an angry one at that.
Who Is This Guy?
Shiller is a professor of finance and economics at Yale University, but don't mistake him for your garden-variety academic. He's also a businessman. He is a founder of and the chief economist for MacroMarkets, the Madison, N.J.-based firm that puts out the Case-Shiller Index with Standard & Poor's.
Options for U.S. residential real estate in partnership with the Chicago Mercantile Exchange (CME), the first exchange-traded financial products for directly investing in and hedging U.S. housing.
Shiller is an entrepreneur by birth–his father was a frustrated inventor–but he's also a professor at one of the nation's most prestigious universities. These conflicting personalities come together perfectly in Shiller. Understanding the market's inherent risks, he and Karl Case created indices that could bring order to the measurement of residential real estate's often unstable world.
Case is not involved in MacroMarkets, though he says he and Shiller remain good friends. "I had the original idea, but he fleshed [the indices] out and did a ton with them," Case says.
Shiller was introduced to risk at a young age by his father, a former Michigan Oven Co. engineer. Shiller's pére patented an industrial oven that used fluidized sand instead of hot air to distribute heat. Watching his father build the oven and then struggle with it taught him a valuable lesson.
"One thing I learned is that the business world is a very chaotic place," Shiller says. "You may have the best industrial oven, but it doesn't mean you're going to succeed. There's just so much randomness in business."
Even though Shiller's father hoped his son would follow in his footsteps, the future economist had his own ideas–even though the entrepreneurial world is exactly where he wound up. "I think I adopted his values," Shiller says. "I wanted to do my own thing and not get swept along with other people."
Shiller received his bachelor's degree from the University of Michigan at Ann Arbor, where he majored in economics. He earned his Ph.D. from the Massachusetts Institute of Technology in 1972.
Although his vocation was economics, Shiller attacked other subjects with a similar ferocity. He says he "reads everything," and, if you talk to him, that seems entirely true. In one sitting, he can launch into a dissertation on astronomy then abruptly shift to psychology, the French Revolution, and the U.S. government?the latter three, of course, being inextricably linked.
Shiller, who is married with two sons in their 20s, applies such historical lessons to his current work. "If you read about events from long ago, it's hard to imagine how that could have happened. What were people thinking? That's what you have to do to understand market movements."
Shiller also studies the role of human behavior in markets, specifically the application of psychology and sociology to the economy. "[Academia] tends to be technical in the sense that they tend to describe people as rational, optimizing, calculating when, in fact, there's a lot of craziness in people," he says. "We play on rules of thumb or hunches."
That type of human behavior is something Shiller dealt with in a series of books. In 1989's Market Volatility, he performed a mathematical and behavioral analysis of price fluctuations in speculative markets. In Irrational Exuberance, first published in 2000, he zeroed in on speculative bubbles with specific reference to the stock market and real estate.
THE REAL ESTATE EXPERIENCE
While the academic in Shiller wrote books, the entrepreneur in him looked for new ways to package information and launch companies. In 1986, he read an article by Case, who looked at the "repeat" method for determining home prices. That method collects data on single-family home resales, capturing prices to form sale pairs.
Case and Shiller soon began working together and publishing articles on repeat pricing. Allan Weiss, one of Shiller's students, joined the duo, and the newly formed trio started a research firm, Case Shiller Weiss. Their main product: indices.
"We thought there weren't any good home price indices at the time," Shiller says. "I thought these indices would be important because we would eventually be settling financial contracts based on real estate indices."
Weiss and Shiller sold the Case Shiller Weiss firm to Fiserv CSW in 2002. But Weiss and Shiller kept the rights to the indices that they developed, including Case-Shiller, and formed MacroMarkets with 12 employees. In 2006, 15 years after Case Shiller Weiss was formed, the firm hit paydirt. Shiller's group partnered with Standard & Poor's to carry its index; in May of that year, the CME added Case-Shiller. "Once we got them on our side, it really took off," Shiller says. "It was perceived as having a lot of authority."
SUDDEN INFLUENCE
While acceptance from Standard & Poor's helped the Case-Shiller Index become a success, the current housing market may have helped even more.
"Something else that boosted its popularity is [that] home prices are falling now," says Michael Moran, chief economist for Daiwa Securities America. "Everyone wants something to look at with a high degree of frequency. Case-Shiller has a high degree of frequency and high quality, so it has become a very popular index."
Paul Bishop, NAR managing director of research, acknowledges that Case-Shiller has an impact. "It gets some play in the media," says Bishop. "That's in small measure because both Case and Shiller are well known and certainly well thought of in the academic sphere."
Shiller's books also fed the popularity of Case-Shiller, according to Gary Painter, a professor at the University of Southern California Lusk Center for Real Estate in Pasadena. "It's influential, especially in a down market, because of Bob Shiller's writings about the stock market bubble and the housing market," he says.
But Daiwa's Moran cautions that just because Case-Shiller is influential doesn't mean the man on the street knows what it is. "They pick it up indirectly because the media sees this index when it comes out," he says. "There are lots of stories about home prices declining."
And therein lies the problem. The index comes out, the media picks it up, and the consumer reads the headline and not much more. Combined with other stories that report less precipitous price declines based on data such as that from NAR, the Case- Shiller stories may contribute more than their fair share to the collective notion that home prices are in freefall. That feeds a vicious cycle?buyers continue to sit on the sidelines and prices continue to erode.
"Definitely all of this stuff coming out is hurting sentiment and pushing prices down even further," says Stephen Palmer, CFO of Atlanta-based Bowen Family Homes.
Shiller doesn't deny that his data may affect consumer sentiment, but he's clear on who deserves the blame for these cycles. "I think the media are tremendous propellers of the market both ways, up and down," he says. "We didn't have speculative bubbles until we had newspapers. The newspapers kind of goaded people, and they get them excited."
And, unfortunately, even though indices from people like Case and Shiller may only be talking about resale homes, they still affect new-home buyers. For one thing, a new-home buyer may stay out of the market because the price of their existing home has fallen.
Additionally, the consumer may not be reading deep enough into the article to know that these numbers refer to resale homes rather than new. Bishop cautions that not all buyers will be affected by this data?depending on how they look at it. "A buyer in Chicago is not too concerned about the housing market in San Francisco," he says. "Hopefully, buyers are looking at it on smaller geographic levels in addition to the big picture."
Others are careful not to overestimate the data from people such as Case and Shiller and the news stories they help feed. "I think there's a little bit of an effect on psychology from all of these stories, but I think the effect on consumer spending is relatively small," Moran says.
HEDGING RISK
Shiller didn't just want his index to bring up the level of real estate pundits; he wanted to help manage risk. That's why it was so important that his real estate index fund was listed on the CME.
In fact, in his 1993 book Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, Shiller proposes a variety of new risk-management contracts, such as futures contracts in national incomes or real estate that would permit the management of risks to standards of living.
The economist admits that the desire to take some of the risk out of the industry is the result of watching his father's struggles. "[Business] has this randomness," Shiller says. "You may start the best construction firm in the country and do it at the wrong time. You could be destroyed."
The real estate business, known for its cyclical behavior, is in many ways the perfect place for Shiller to try to set a template for hedging risk. He says he's fascinated by the waves of activity in real estate, and he doesn't really understand why the building industry did not hedge itself against just such a downturn as we see today.
"In other fields outside of real estate, risk management is fundamental," Shiller says. "Futures markets are used by businesses to manage their risks. You don't put 1,000 tons of grain in a warehouse and not hedge it. You can't predict what the market will do. You see builders put tons of land in their portfolios, and they don't hedge."
In essence, Shiller is repeating a criticism voiced by many throughout the downturn. During the boom, builders not only manufactured homes, they got involved in land speculation as well. This brought on far too much risk.
"They could just take their own position in the futures market and hedge it," Shiller says. "You want to leave speculation to somebody else. Your business could be destroyed by a failure to predict the direction of the market."
Shiller also sees a way the futures market could help builders sell the homes they've already built. Right now, buyers are concerned about whether the home they buy today will be worth $20,000 less in six months. Shiller thinks builders could allay these fears by offering price warranties.
"If you're giving someone a price guarantee, you're selling them an option," Shiller says. "They're already for sale on the Chicago Mercantile Exchange. Somebody has to pay for the option. It has a cost."
The idea of guaranteeing a price has some traction in the residential building industry, but it isn't ready to adopt price warranties just yet, according to Comstock CFO Bruce Labovitz. "It scares everybody too much," he says. "The retail industry likes the idea, but, in order to get refund, you have to come back to the store. There's nothing for us to sell if you come back and ask for $50,000 back."
MARKET DYNAMICS
Shiller admits the industry is in uncharted waters, largely the result of what happened in the first half of the decade. "We've never had such a big boom before," he says, adding that it would be naïve to pin the housing run up on one factor?something he's learned from studying history. "Any market boom is a matter of history," he says. "Whenever you ask historians, who take a broad and intellectual view of history, what caused some big event, they don't have easy answers. It's usually a confluence of events."
Buyer panic about getting cut out of the market contributed to the run up, according to Shiller, but he says loose monetary policy from the Fed, mistakes in the ratings of mortgage securities, and poor regulation of lenders also contributed to real estate's fall.
So far, Shiller thinks things aren't as bad as they could have been. Of course, that could change. "This could have turned out really ugly," he says. "We've seen a freezing of our credit markets at the same time housing prices are falling. That has the potential to accelerate the decline on home prices."
Like many people, he's critical of Congress for not enacting any meaningful legislation to alleviate the housing crisis, while foreclosures keep "grinding on."
"We're not dealing with it in most rapid fashion," Shiller says. "That's why I worry that we will have a recession and things may look substantially worse in the next year."
Shiller's futures market predicts the housing situation will continue to worsen until 2009, when it will turn up. But that upswing may just equate to an increase in construction pace, not home prices.
"My suspicion is that home sales may recover, even in a market where prices are declining," he says. "As we work off the inventory, prices may still sag, yet there may still be opportunities for builders to build."
In fact, Shiller is optimistic enough to say that builders' stocks may have fallen off too much over the past few months. "Home prices are still very high," Shiller says. "That's why I think there will be a lot of opportunities to recover from this slump."
But there are also examples of markets inexplicably recovering from a decline. For instance, the London housing market fell 4 percent in 2004, but then rebounded. Of course, when the London market fell, housing markets around the world were still surging. That's no longer the case.
"What's interesting about what's happening now is that it's looking less and less local," Shiller says. "In some cities, we have no record of ever having a boom, like Phoenix and Las Vegas. They have suddenly become boom-and-bust cities."
The poster child of that phenomenon is probably Florida. Currently, Shiller's futures index sees one of its biggest drops in Miami. He sees trouble in Tampa, as well. Like many analysts, Shiller also points to California. "Somehow San Francisco has gotten the idea it's very special," Shiller says. "I've always been a skeptic as to how special the place really is."
As an example, he points to Bank of America, which relocated to Charlotte, where people can live inexpensively. "Charlotte has never boomed and has really not fallen very much," he says. "The knee-jerk reaction is that San Francisco is a very special place, but Charlotte is starting to look like a special place now, too."
Following that logic, Shiller thinks the Texas markets may be OK. "They didn't generally boom as much," he says. "The oil crisis is probably still helping Texas, too."
That's where Shiller gives his best grain of wisdom. And despite all of the research that goes into the index that bears his name, it's a fairly simple concept: "The markets that have been most volatile have been the most likely to drop."
