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The housing bubble in real-time: the end of innocence

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Abstract

Market agents suffering through unanticipated boom-bust cycles would find extremely useful analytical techniques capable of serving as an early warning system. Unobserved components models and cointegration analysis are valuable in this respect. The stylized facts from unobserved components models alone do not suffice, but coupled with results from the Johansen cointegration test provided early evidence of the housing bubble and of its denouement. The paper uses real-time data vintages and shows that by 1998 the relationship between the smoothed growth rates of house prices and of per capita income was in uncharted territory. Moreover, the actual growth rates are cointegrated. This is important, as it establishes that any disequilibrium between the two becomes less tenable as its magnitude increases. By 2003, the disequilibrium was spectacular, yet it grew for another 4 years. In effect, we did not have to wait until 2008; the gruesome ending was predictable ex ante. Ironically, the greatest financial delusion of all occurred in an age that revered rationality, market efficiency, and the financial enlightenment of the TBTF actors. The empirical findings of this paper are a major problem for the rational expectations hypothesis and the remnants of the EMH.

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Notes

  1. The Case-Shiller index, unlike the HPI, is not national in coverage; it omits 13 states and has incomplete coverage for 29 other states (Leventis, 2007).

  2. The HPI began publication on January 1975, by the Office of Federal Housing Enterprise Oversight (OFHEO)—an agency that operated within the Department of Housing and Urban Development. On July 2008, the Housing and Economic Recovery Act combined OFHEO and the Federal Housing Finance Board into the new Federal Housing Finance Agency.

  3. Eventually, even the final version suffers the inevitable benchmark or methodological revisions.

  4. STMs have been used to model the behavior of exchange rates (Harvey et al. 1992); forecast consumer expenditures (Harvey and Todd, 1983); model inflation and the output gap (Kuttner 1994; Domenech and Gomez 2006; and Harvey 2008). Other examples include modeling inflation persistence (Stock and Watson 2007, and Dossche and Everaert 2005); productivity growth (Peláez 2004, and Crespo 2008); business cycles (Clark 1987), earnings per share (Peláez 2007); permanent income (Huang et al. 2008); the U.S. regional housing market (Fadiga and Wang 2009); modeling the core unemployment rate, (Harvey and Chung 2000); and testing for deterministic trends (Nyblom and Harvey 2005).

  5. Dlog(HPI) is the first-difference of the natural logarithm of HPI. Clearly, this section does not use the smoothed growth rates.

  6. If r = n, we have a contradiction of the assumption that the variables are I(1).

  7. The Schwarz Criterion and the Hannan-Quinn Criterion reached their minima for a lag length of three quarters. The finding of cointegration is robust to an unrestricted constant and to the exclusion of any intervention variables as well.

  8. The P-value is the probability of obtaining the given value of the test statistic under the null.

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Authors and Affiliations

  1. Finance Department, College of Business, University of Houston-Downtown, Houston, TX, 77002, USA

    Rolando F. Peláez

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  1. Rolando F. Peláez
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Correspondence to Rolando F. Peláez.

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Peláez, R.F. The housing bubble in real-time: the end of innocence. J Econ Finan 36, 211–225 (2012). https://doi.org/10.1007/s12197-010-9165-4

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