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Is there a housing bubble about to be burst?
To be meaningful, bubble bursting predictions must also predict when they will happen. Price volatility, especially rising prices, offers opportunity to investors in the period leading up to an anticipated bubble burst. Also, it would be meaningful to know the extent to which prices will collapse.
The stock market bubble should not necessarily be likened to the current inflation of housing prices. The stock market bubble burst in a relatively short period of time considering the extent to which prices collapsed (the NASQDAQ shrank about 76% from March 2000 to October 2002). The market for housing assets does not behave as efficiently. Large transaction costs, the fact that people actually live in houses, localized conditions, pre-determined costs of servicing fixed mortgages, etc. tend to make price deflation not as steep though more prolonged (for example, in California prices lost about a quarter of their value and bottomed out in the mid-90's from the heights of the late eighties).
Similar to the way in which earnings and projected earnings momentum sustains a stock climb, low interest rates, low unemployment rates, and tight local supply and demand conditions sustain housing prices. Housing prices have been rising in many regions of the country because the power of very low interest rates is overwhelming relatively higher unemployment rates. Also, in these regions short run housing supply is relatively inelastic. "Short-run" conditions can last several years in some areas (such as heavily regulated California).
The rise in prices is exacerbated by expectations that prices will rise further, and speculators enter the market, leading to a vicious cycle. Speculation does not mean a bust is around the corner. Speculators will speed up the rise in prices to a new level where demand matches supply.
Historically, housing prices have been benchmarked against the inflation rate, household income, or the cost of owning versus renting. However, historical relations do not have to hold in the future. As examples, health care and college tuition costs are rising disproportionately, with no likelihood of a price implosion. With respect to income, the household income, worth and willingness of the last buyer to absorb a higher price sets the market price, not the income of current owners. We may also be witnessing a historical shift in favor of owning rather than renting, which would explain why rental rates are not appreciating.
The divergence from historically benchmarked measures can be interpreted as a positive shift in the preference for housing (over other assets such as stocks), just as higher Price/Earning ratios for stocks are tolerated today as opposed to a generation ago.
A number of factors are contriving to keep a lid on low and even negative real interest rates. Capital and labor markets are underemployed, leading to low CPI rate increases. Foreigners are counteracting the budget and trade deficits and the declining dollar by buying up US treasuries. Moreover, the Fed does not have a policy of raising rates to tame asset price inflation. With little pressure on interest rates housing prices can continue to rise or keep high. These circumstances may persist for some time as long as Asian countries view the US as their major export market and peg their currencies to the US dollars.
In these circumstances the Fed can patiently support accommodative monetary policy. The downside is that with rising housing prices and little or no wage increases household indebtedness is rising (currently, mortgage indebtedness is about 90% of GDP). However, this is not necessarily a cause for concern. Homeowners can compensate by willing to work harder to service their high debt levels, which are generally being serviced at locked-in rates.
However, economic shifts occur over time, and critical to averting a bubble is the progression by which current circumstances transition to a new state. If the deficits are not contained before foreigners stop purchasing US treasuries, or inflation rears its head too soon, interest rates will rise sharply. A sharp rise in interest rates will have a deleterious impact on housing prices, since they will not allow buyers and sellers to adjust to price changes in gradual steps. To offset the risk of an overnight tumble in asset prices, the Fed must raise rates gradually long before the anticipated change in condition.
On the other hand, if the economy improves markedly with low inflation, rising employment and wages will help reduce the budget deficit and soften the impact of potentially higher interest rates and keep housing prices propped up. This is the sunny scenario the Fed has placed all its bets on.
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"A well researched & excellently written piece that was informative, alarming & downright scary for those of us who own real estate! " -- RAM, usa.
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© 2004 Sean Mann
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