Monday, October 12, 2009

Monthly FHFA House Prices are Irrationally Exuberent: Headline Growth Rate Overstates Year-to-date Growth by 2.4%

On September 22nd, the Federal Housing Finance Agency (FHFA) released the July 2009 monthly housing price index with the headline “U.S. Monthly House Price Index Estimates 0.3 percent price increase from June to July.” Such headlines are fueling optimism that the housing market and the economy are turning a corner. However, in the text of the announcement we learned that the previously reported increase of 0.5% from May to June was revised down to 0.1%. Combining the two effects, house prices actually fell 0.1% relative to what was previously reported. The downward revision is not new for the FHFA monthly price index. In fact, if you only read the headline monthly growth rates, you would be under the impression that house prices have risen 2.9% so far this year through July. In fact, in the latest report, house prices had only risen 0.5%. In other words, the headline monthly house price growth gives the impression that house prices have grown 2.4% more this year than they actually have.

The FHFA monthly house price index is new, only having been reported for 20 months. In the FHFA’s original analysis of the potential revisions to their monthly index (reported in the second quarter 2007 release) they stated the initial monthly estimate `would not be reliable’ and did not bother to even report the magnitude of the revisions in their analysis. This unreliable estimate is now the headline of their monthly release. We should not overly criticize the FHFA. The initial monthly index does provide information, explaining roughly 84% of the movements in house prices (in an R-squared sense).

To put the revisions in context, suppose instead that the FHFA was a stock broker handling your million dollar portfolio, and he called you up to tell you the news on your portfolio for July. The conversation could have played out like this:

BROKER: Great news, your portfolio is up 0.3% June to July.

YOU: Great, combined with the 0.5% from May to June, I’ve earned $8,000 the past two months. Maybe I’ll start thinking about getting the deck redone on my house.

BROKER: Yes, about that 0.5%, we re-estimated the increase from May to June to be only 0.1%, so that you actually have only earned $4,000 the last two months. Sorry.

I think most people with a million dollar portfolio would not like to frequently have such conversations with their stock broker. However, for the past twenty months that the FHFA (formerly OFHEO) has been reporting the monthly house price index, the FHFA has been regularly having just such conversations with Americans regarding their houses.

I do research using the quarterly house price index from FHFA. I know that this index states that house prices are down for the year, but it seemed to me that the monthly index had been reporting prices increases from month to month. I went back and checked the headline growth rates, here they are, stating the date reported along with the relevant period for the index:

  • March 24: “1.7% increase from December to January”
  • April 22: “0.7% increase from January to February”
  • May 27: no headline, part of quarterly report. Reported change from February to March is 1.1% decrease
  • June 23: “0.1% decline from March to April”
  • July 22: “0.9% increase from April to May”
  • August 25: no headline, part of quarterly report, in the text the FHFA states that the “monthly index for June rose 0.5%”
  • September 22: “0.3% increase from June to July”

If you add up all of the growth rates, you arrive at a year-to-date growth of 2.9%. In fact, prices have only rise 0.5%. Furthermore, the 0.5% is most likely overstated as the 0.3% reported from June to July is likely to be revised down. Figure one plots the perceived series for house prices relative to December 2008 if one accepts the headline growth rates as the truth, showing an increase of 2.9%. Figure one also reports the current path for house prices relative to December 2008. Clearly the headline growth rate overstates the actual growth. So far, the overstatement has been 2.4% for 2009.

To put the FHFA’s revisions back into the context of a stock broker managing a million dollar portfolio, if you just looked at the headline growth (maybe in the subject line of a monthly e-mail) you would think that you had earned $29,000 so far this year. You could be thinking about making a large transaction such as renovating a bathroom. However, when you actually looked at your most recent statement, you’d see that you were in fact only up $5,000 so far this year.

The FHFA only started reporting the monthly house price index on February 26, 2008 as part of the report for the 4th quarter of 2007, giving us an observation for December 2007. Since then, we have received 20 observations in total (including Dec 07). Figure two plots the initial estimated price growth along with the current estimate for price growth. There is a clear bias down in the revision. Figure three plots the error in the initial estimate, given by the difference between the initial and the current. Once again there is a clear bias in the revision. Not including the latest observation, the initial estimate overstates the growth rate of house prices by 0.22% on average. This amounts to an annual overstatement of 2.68%.

Before the FHFA started reporting the monthly price index, in their Second Quarter 2007 report, released on August 30 2008, they performed an analysis of revisions. In their analysis they state (see page 11 of the report):

“A primary concern with the construction of monthly price indexes is that revisions will tend to be large. …the most recent monthly price measures would seem to be particularly susceptible to later revision. A June index estimate and the corresponding May-June appreciation rate estimate would be prone to the greatest revision, and a review of the evidence suggests that the estimates would not be reliable.”

To analyze the revisions, they compare their estimate in the second quarter 2007 release with an estimate only using date through the first quarter of 2007. When they do this analysis they do not show the error for March 2007! They leave it out, stating “the line only extends through February 2007 because the data submission only included data through March, and—as indicated above—the index point for the latest month (March) is not deemed to be reliable.”

In other words, from their analysis they deemed the first estimate unreliable and not worth even making an analysis of the size of the revisions. This estimate that `would not be reliable’ is the estimate that they currently report in their monthly release. But not only do they report it, they make it their headline!

Before we overly criticize the FHFA, they have put out many warnings in the text of their announcements. When the monthly house price index was first released as part of the fourth quarter 2007 report (release on Feb. 26, 2008) they warned “index users should recognize that, while OFHEO’s initial review suggests that revisions may be reasonably small, this is no guarantee that future revisions cannot be significant.” They also made a warning for the January 2009 report—which ended up being the largest revision to date—stating that due to a low sample size that “the estimation imprecision associated with the January estimate is relatively large and subsequent revisions … could be significant.”

The initial monthly estimate does provide information. As the then OFHEO director James B. Lockhart stated in the release with the first monthly index “Given the recent turmoil in the housing markets we thought it would be helpful to provide a greater amount of information about price trends.” The FHFA has succeeded along this dimension. Inspection of figure 2 shows that, although there is a bias in the initial estimate, it does provide information about the final estimate. The R-squared of the fit of initial to the final (through June 2009) is 0.84. Therefore, the initial does provide more information about the price trends in the housing market.

Last, there have only been 20 observations of the initial monthly estimate. In addition, theses twenty observations have covered a period of unprecedented falling house prices and very low level of sales, especially considering that the FHFA’s data only starts in 1991. With such a small sample over observations that are so unprecedented, it is difficult to say definitively that the initial estimated is biased. Furthermore, large revisions consistently in one direction are not surprising.

The main problem with the overstatement in the initial monthly estimate is that the FHFA is using the initial estimate as their headline. Given that the FHFA stated in their own analysis that this estimate ‘would not be reliable’, they may want to think about not using this observation as their headline. Instead they could go with the change in the year-over-year or use a more descriptive headline like they use for the quarterly report.

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