Yale's Shiller predicts housing prices will drop-but he says no one knows how far.

    These days the only question surrounding residential housing prices is whether they will contract on an orderly basis or crash. It's no surprise that Robert Shiller, a professor of economics at Yale University, is out sounding the same warning for real estate that he did for stocks.
    Indeed, Irrational Exuberance was the name of his prophetic book published in March 2000, just as the dotcom market peaked and began its dramatic tumble. Today, Shiller argues that the housing craze is another bubble destined to end badly, just as every other real estate boom on record has, with new data provided in a second edition of his bestseller published last year.
    Some of the data is damning. Recent figures from the National Association of Realtors shows that the number of existing single family homes on the market is up 33% on a year-over-year basis. As for co-ops and condominiums, that number is up 66%. Both figures are by far the highest in the 23 years since the association began tracking them.
    "Home prices have just shot up with no apparent reason and there's worry that they'll come back down," Shiller says. "We're going through something very similar in real estate that we did with stocks. It's driven by the same forces, the thinking that investments can't go bad, that they have the potential to make you rich, that you'll regret it if you don't get in, and that it looks expensive but is really not."
    These are typical characteristics of a bubble, he says, predicting that the future could take several forms, from a crash in prices in locally inflated markets or even nationally, to a long-term stagflation in overall housing prices. "I don't know what will happen. I don't think anyone does," he says.
Shiller's bearish view has been shared by some and disputed by others in the present debate about a housing bubble, which, depending on the expert, either exists or doesn't, will burst or won't. From Wall Street executives to economists, many say that low interest rates and a growing population are among the factors that will keep the housing market healthy, even if future increases are smaller than recent ones. And no one is predicting the leap in interest rates that would prick a bubble, if one exists. For example, Ben Bernanke, the new chairman of the Federal Reserve, in late May made his first comments about the housing market, acknowledging it was "pretty clear" that it was at long last cooling down, but that the slowdown seemed to be "orderly and moderate."
    Shiller, though not naming names, dismisses such comments as the limitations of "conventional wisdom." He believes the housing market isn't a top priority on Bernanke's agenda, though it should be. "He's not focused on the boom. He could be a major force in these markets, but he's not going to be," he says. "There's a general tendency for economists and many people beyond economists to try and think that the economy is rational, and it isn't."
    And that's why this theory of "irrational exuberance," he says, is applicable to today's housing market. There are no economic fundamentals, not even historically low interest rates, he says, to support the boom, which is larger than any other in U.S. history. His book tracks such phenomena back to the 1880s, when speculation in California sparked a land rush that went bust. "People like to talk about a land shortage or the population explosion, but these are the kinds of new-era economic thinking that's a theme in my book. These stories reappear when there's a boom."
    Shiller, whose approach to economics is combined with psychology, maintains that most experts are missing the real catalyst of the boom-human behavior. "I think people are currently underestimating the force of psychology in the current market," he says. "It seems unimaginable to them that psychology could drive the economy as much as it does."
    His analysis includes factors like investors' attention shifting from stocks to real estate as a way to make a windfall, supported by newspaper stories about runaway housing prices, particularly in glamour markets. Compounded success stories, he says, create a kind of feedback loop that keeps investors chasing returns and prices soaring, just as it drove stock prices in the dotcom era. "This high run in housing prices, particularly in spots like Miami and Los Angeles, is dominated by psychology and fed by investor excitement. I was recently in Phoenix and it didn't take much prodding to get my taxi driver to launch off about real estate. And when that excitement fades, we stand the risk of a drop in prices."
    That kind of speculation has created some worrisome trends. For one, the ascent in home prices since 1998 has been much faster than the rise in incomes. This raises concerns about the long-run stability in home values. "Obviously, housing and land in certain locations, particularly prestige areas, have acquired more value, but the question is how sustainable is it in the long term?" Shiller asks.
    A recent study by Harvard University found that over the past five years house prices have outstripped income growth by more than sixfold-the median home now costs more than four times median household income in 49 out of 145 metropolitan areas in the U.S., a record. In 14 metropolitan areas, the median house is now worth more than six times median income. Last year saw the average house price rise 9.4 %-the biggest increase since records started more than 40 years ago.
    Another disturbing trend, Shiller points out, is that more Americans have been tempted by riskier flexible-rate mortgage products, making it easier to borrow with the hopes of flipping out of a property in a hot market quickly to make a windfall. "The thinking is I can make money fast if prices just continue upwards. And people ask, why shouldn't it continue? What's different this year than last year, and there's nothing tangible."
    But these products can also cause financial strains in a housing downturn. For example, more than a third of loans last year were at adjustable rates and may rebound on their holders if interest rates continue to climb, according to the Harvard study. More reckless buyers, about 10% last year, opted for payment-option mortgages, which do not require full payment of the interest costs.
    As a result, says Shiller, the housing market is more vulnerable than ever to opposing forces, from rising interest rates to investor fickleness shifting their money-making aspirations to another asset class. In the past, he has predicted that prices could fall as much as 40% in inflation-adjusted terms over the next generation and that the end of the bubble will probably cause a recession at some point.
    But these days he confesses to some doubt. "To be honest with you, I don't know with any great accuracy what will happen. The puzzle is what is going to bring it to an end. It can't keep increasing at the rate it has been," he explains. "It no longer is. We're in a definite slowdown."
If it plays out like in 1990, the last housing downturn, then prices will start falling, though it will vary by location, he says. "The timing won't be the same everywhere." Yet he still doesn't dismiss the possibility of a significant decline in cities where real estate values have mushroomed.
    Home sales and prices are generally still at healthy levels, though showing signs of a slowdown, according to recent National Association of Realtors statistics for the first part of this year. But one key indicator, Shiller says, has shown a precipitous drop: The most recent National Association of Home Builders (NAHB) Housing Market Index, a reflection of expectations for housing starts, was down to an 11-year low in June.
    And Shiller also points to new data that suggests the U.S. market is starting to flag. The price movements in futures and options contracts launched last May on the Chicago Mercantile Exchange (CME) and based on indexes developed by Shiller and his colleague Karl Case that track house-price movements in ten U.S. cities currently predict declines in every market, varying from 1% to 7%.
    The new availability of derivatives aimed at the $26 trillion U.S. housing market, which is vast compared with the $15 trillion equities market for which there are menus of hedging instruments, are a step in the right direction for several reasons, Shiller says. Most people have a big exposure to the volatility of the housing market through home ownership alone, and no way to protect that value. Such tactics could help mitigate the negative consequences of a housing bust on personal net worth, he says. "Now if a homeowner feels overexposed to this market, they can just buy a put or take a short position in the futures market. They don' t have to reduce their exposure to zero, just bring it down a little."
    And investors are showing a healthy interest in the new instruments, says Sayee Srinivasan, a CME associate director of research and product development. Within the first two months, a couple thousand contracts are trading daily for residential real estate markets in Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, D.C. "We weren't expecting to start off doing this many contracts a day," says Srinivasan, who estimates from calls he's received that high-net-worth homeowners are major players. CME expects that as the market develops, the derivatives will attract institutional clients such as builders and mortgage investors seeking to manage their exposure to the real estate asset class, as well as more typical derivatives junkies, like hedge funds.
    Shiller is exploring the use of home-value protection products as well, such as insurance policies on home equity. He and several Yale colleagues helped launch a pilot program in Syracuse in 2002 to help people to "bubble-proof" their homes through this kind of hedging project. But it didn't incite much interest, he says, because people expected their home prices to go up, not down.
    However, he's hopeful that as the housing derivates market grows, it will extend the horizon for more financial innovation, such as exchange-traded fund spinoffs from his indexes. "The futures and options market is the first step in developing much more infrastructure for managing real estate risk," he says.