by Calculated Risk on 2/19/2008 04:35:00 PM

NAR chief economist Lawrence Yun wrote a column last week on house price indices: Competing Home Price Data — the Inside Story. Yun tries to dismiss the Case-Shiller index, however I believe he draws the wrong conclusions.

Yun wrote:

"... the Case-Shiller price index — which has been gaining more media coverage as of late — covers only 20 markets. Most of these 20 markets coincidentally tend to be located in California, Florida, and other down markets. As a result, the index shows that most of the 20 markets are experiencing price declines."

First, Case-Shiller releases a monthly index (that covers 20 cities) and a quarterly national Case-Shiller index that covers a wider geographical area. Second, the 20 cities are: Phoenix, Los Angeles, San Diego, San Francisco, Denver, Washington, Miami, Tampa, Atlanta, Chicago, Boston, Detroit, Minneapolis, Charlotte, Las Vegas, New York, Cleveland, Portland, Dallas and Seattle. Yes, these are declining price markets now, not because the cities are in California or Florida, but because most of the country is now experiencing price declines.

For an excellent review of house price indices, David Wessel at the WSJ wrote this last week: When Home Values Don't Mesh

Predicting how much worse the U.S. housing market will get is tough. The future is never certain. But when it comes to home prices, getting a clear picture of the recent past turns out to be surprisingly hard as well.

As Wessel notes, it is surprisingly hard to get a clear picture of house prices. It helps to understand the differences between the various data sources.

The NAR, DataQuick and other reports use the median house price; they take all the recent sales, and find the median price. This can be distorted by the mix of homes sold. When the bubble first burst, the median price continued to rise because fewer lower end houses were sold (the low end portion of the market with subprime loans slowed first). Now with jumbos being limited, the high end sales volume has fallen, and the median price has fallen quickly.

There is a better method, as Wessel notes:

The two best -- though far from perfect -- measures of housing prices are the Office of Federal Housing Enterprise Oversight's index and the gloomier Standard & Poor's Case/Shiller index. Both are based on a concept, developed in the 1980s by Karl Case of Wellesley College and Robert Shiller of Yale University, that looks at repeat sales of the same houses.

Using repeat sales, and adjusting for several factors (improvements, sales to family members, and more), gives a much better picture of price changes.

But Case-Shiller and OFHEO still give different results. In an earlier post, I noted the research of OFHEO economist Andrew Leventis House Prices: Comparing OFHEO vs. Case-Shiller.

Case-Shiller offers a national price index (released quarterly) and monthly price indices for 20 cities (with two composites: 10 cities and 20 cities). When comparing to OFHEO, it's important to compare similar indices.

OFHEO releases a national price index quarterly (monthly starting in March) and also provides prices for a number of cities. The OFHEO index is limited to repeat sales in the GSE database (Fannie and Freddie). This is an important difference.

When comparing the national Case-Shiller and OFHEO indices, there are a number of differences: OFHEO covers more geographical territory, OFHEO is limited to GSE loans, OFHEO uses both appraisals and sales (Case-Shiller only uses sales), and some technical differences on adjusting for the time span between sales.

OFHEO economist Andrew Leventis compared the prices in the ten major cities covered by Case-Shiller. He discovered that the main reason for the recent differences between the Case-Shiller and OFHEO indices was that prices for low end non-GSE homes declined significantly faster than homes with GSE loans. This was probably due to the lax underwriting standards on these non-GSE subprime loans.

Note that Leventis' research focused on the recent differences in the indices: he used data from Q3 2006 through Q3 2007.

This is critical. If someone believes the problems are contained to subprime, and that falling low end house prices will not impact the rest of the market, than OFHEO is probably the better index.


However I believe prices will fall across the board, and that the subprime market was just the first segment to see price declines.

Housing markets are intertwined, as this graphic indicates. Not all chain reactions start with a first time buyer using a subprime loan, but I believe the loss of a large number of subprime buyers will impact the entire chain.

I believe Case-Shiller is the better index for the 20 cities covered by the index - because it captures a wider number of sales (not just GSE) - although OFHEO is also useful because it covers a larger geographical area.

However, what everyone wants to know is what will happen in the future. As Wessel noted:

Predicting how much worse the U.S. housing market will get is tough. The future is never certain.

I have no crystal ball, but the key to house prices is supply and demand. Prices may be sticky, but they are not stuck. Prices will continue to fall until the inventory levels decline significantly. Areas with more inventory will likely see larger price declines; areas with less (especially less than 6 months of inventory) will probably see minor or no price declines.