Mortgage and Housing Markets

David's professional interest in UK housing and mortgage markets began in the early 1970s, when he and Gordon Anderson were modelling building societies—the British analogue of US savings and loans associations.

David's interest in the housing market arose from a forecasting puzzle. During 1972, UK house prices rose dramatically in response to a major increase in mortgage lending by building societies. David later checked how well his house-price model would have forecast through that period. When forecasting a few quarters after the then largest-ever increase in UK house prices, the model predicted a fall in prices, while prices actually continued to rise substantially. Nevertheless, coefficients estimated over the pre-forecast period were almost identical to those estimated over the whole sample, and the whole-sample residuals were homoscedastic, so there appeared to be little evidence of parameter nonconstancy.

David finally resolved this conundrum over a decade later, when he and Mike Clements were developing the general theory of forecasting. That theory distinguishes between “internal breaks” (shifts in the model's param­eters) and “external breaks” (shifts in the unmodelled included variables). A change in multicollinearity among the model's variables leaves estimated coefficients almost unchanged but can greatly increase MSFEs, contrasting with the irrelevance of multicollinearity to forecast uncertainty when mul­ticollinearity is constant. This problem with multicollinearity cannot be solved by orthogonalising the model's variables or by eliminating relevant multicollinear variables. The latter can lead to even worse forecasts. However, updating parameter estimates with new data can reduce MSFEs.

Model nonlinearities proved central to explaining house-price bubbles. Through David's interest in the natural sciences, he had learned that Van der Pol's cubic differential equation could describe heartbeats and that heartbeats could manifest sudden surges. Changes in UK house prices seemed rather like heartbeats so, in his model, he included the cube of the excess demand for housing, as represented by the cube of lagged house-price inflation. As Hendry (1984a) showed, the cube was significant. The formulation had difficulties, though. It predicted some large jumps in house prices that did not materialise. Also, it implied that large changes in house prices were explosive. In practice, though, once the market was far from equilibrium, excessively high or low house-price-to-income ratios drove the market back towards equilibrium, as followed after the UK housing bubble in the late 1980s. Richard and Zhang (1996) improved on David's nonlinear formulation by using a cubic in the observed deviation from the long-run equilibrium rather than the cube of house-price inflation.

In related research, Ericsson and Hendry (1985) showed that the price of new housing piggybacked on the price of existing houses in an equilibrium correction framework that also accounted for construction costs, housing units still under construction, and the cost of financing. Hendry (1986c) modelled the construction sector, focusing on the determination of starts and completions of houses.

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