Housing Bubble
Brian Trumbore
President/Editor, StocksandNews.com

In my "Week in Review" column I have written extensively about the U.S. housing market and over the past five years or so I personally saw it as being in a bubble mode, though I have tempered this view recently in touting more of a flat pricing environment for the foreseeable future.

That's just one man's opinion, of course, so I thought I'd give you the view of two economists at the Federal Reserve Bank of New York, Jonathan McCarthy and Richard W. Peach, who combined on a report, released December 2004, that I just had a chance to peruse.

Titled "Are Home Prices the Next 'Bubble'?" the document is rather dry, due to the preponderance of data and equations, and I've attempted to pick out the more readable sections. Also, not to insult anyone's intelligence but I thought I should supply some basic definitions for terms that will pop up.

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Elastic: Pertaining to the demand for a good or service when quantity purchased varies significantly in response to price changes in the good or service. For example, if there are many competing brands, a small increase in price of your favorite may cause you to look elsewhere for a substitute.

Inelastic: Pertaining to the demand for a good or service when quantity purchased varies little in response to price changes in the good or service. For example, medical services?few options.

Nominal interest rate: The stated rate of interest.

Real interest rate: Nominal rate less rate of inflation. [5% coupon in time of 3% inflation is a real interest rate of 2%.]

Following are direct quotes from the Fed report, unless otherwise noted.

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Before discussing the existence of a bubble, we need to define the term. We subscribe to the definition from (Joseph) Stiglitz (1990):

'If the reason the price is high today is only because investors believe that the selling price will be high tomorrow - when "fundamental" factors do not seem to justify such a price - then a bubble exists.'

Accordingly, the key features of a bubble are that the level of prices has been bid up beyond what is consistent with underlying fundamentals and that buyers of the asset do so with the expectation of future price increases.

Although some press accounts treat the rapid rate of increase in national home price series as prima facie evidence of a bubble, our definition dictates that such increases alone are necessary but not sufficient evidence. Additional evidence that relates current home prices to their fundamental determinants is required to solidify any claim of a bubble. Two such measures that have been widely used to support claims of a bubble are home prices relative to household income and home prices relative to rents.

The ratio of the median home price to median household income is one frequently employed measure of home ownership affordability. If this ratio is relatively high, then households should find both down payments and monthly mortgage payments more difficult to meet, which should reduce demand and lead to downward pressure on home prices. In fact, the median home price?is now about three times median household income, surpassing the previous peak in the late 1970s and early 1980s, when there was arguably a bubble in the housing market. Moreover, and of relevance to our analysis, home prices experienced a sizable decline in real terms over the few years following that previous peak.

Another common way to evaluate home price fundamentals is to compare them with the implicit rents that homeowners receive from owning their homes. Implicit rent, or owners' equivalent rent, is defined as the rent a homeowner would have to pay to rent a housing unit similar to his home, or equivalently, the rent a homeowner could receive if she rented her home to a tenant. As such, implicit rent is a return to the homeowner from owning her home, much like a dividend is a return to the stockholder from owning stock in a company?.

The two measures of home price fundamentals presented above both support the notion of a home price bubble and suggest that home prices are likely to fall, at least in real terms, in the near future. However, these measures have flaws that call into question these conclusions.

First, neither measure takes interest rates into account. Clearly, interest rates should matter in assessing the existence of a bubble because they influence home ownership affordability and because they represent the yield on a competing asset in a household's portfolio. The downward trend in nominal mortgage interest rates - a major feature of the housing market over the past decade - thus has significant implications for home ownership affordability and for the equilibrium return on housing (the rent-to-price ratio). Accounting for this trend in interest rates in the analysis casts doubt on the existence of a bubble.

Second, the particular home price index used to calculate these ratios can have an impact on the conclusions derived from them. Again, when the appropriate index is used in calculating the ratios, doubt is cast on the evidence of a bubble.

The secular decline of nominal interest rates over the 1990s had a dramatic impact on the size of the mortgage that could be carried with the median family income. In 1990, the average nominal interest rate on a 30-year, fixed-rate conventional mortgage was a little more than 10 percent. By 2003, that interest rate had declined to around 5 ? percent. Combined with the roughly 50 percent increase in the median family income from 1990 to 2003, this decline in interest rates resulted in a nearly 130 percent increase in the maximum mortgage amount that a family with the median income could qualify for under standard underwriting criteria. Over the same period, the OFHEO (Office of Federal Housing Enterprise Oversight) home price index rose 72 percent. Perhaps we should be asking why home prices did not rise even more under the circumstances?..

Our analysis indicates that a home price bubble does not exist. Nonetheless, home prices could fall because of deteriorating fundamentals, and thus it is useful to gauge the magnitude of previous declines. Nationally, nominal price declines have been rare. [Ed. Peter Lynch likes to say that nationwide since the Depression, there hasn't been a single year where home prices declined.] Moreover, real price declines - an important consideration during this period of low inflation - have been mild. For example, the early 1980s and early 1990s featured weak fundamentals - slow income growth and high nominal interest rates and unemployment - yet real home prices declined only about 5 percent.

One reason for the moderate volatility of national home prices is that the housing market comprises many heterogeneous regional markets. In the past, some regions experienced wide swings in real home prices that were not apparent in the aggregate statistics. For example, real home prices in California and Massachusetts have been much more volatile historically than those for the nation as a whole. [Ed. 5-12 percent declines have occurred in both states, periodically, since 1980.] These wide regional swings may have been influenced by fluctuations in population and income growth that would not occur at the national level.

For most states, income and home prices have historically been closely related?.The areas of rapid home price appreciation tend to be areas of rapid personal income growth, as one would expect. However, there are several states with equally high growth of personal income but much lower home price appreciation. Therefore, the recent regional patterns of home price appreciation do not just reflect faster versus slower growing states, but also other factors.

One such factor is the ease of increasing supply. Over the 1999- 2003 period, home price appreciation was highest in states such as California, Massachusetts, New Hampshire, New York, and New Jersey, and in Washington, D.C. Some recent research suggests that, because of population density and building restrictions, the supply of new housing units is likely to be relatively inelastic in these areas. In contrast, states with comparable growth of income but relatively low home price appreciation were Utah, New Mexico, Idaho, and North Dakota, where supply probably is more elastic?.

Conclusion

Our analysis of the U.S. housing market in recent years finds little evidence to support the existence of a national home price bubble. Rather, it appears that home prices have risen in line with increases in personal income and declines in nominal interest rates. Moreover, expectations of rapid price appreciation do not appear to be a major factor behind the strong housing market.

Our observations also suggest that home prices are not likely to plunge in response to deteriorating fundamentals to the extent envisioned by some analysts. Real home prices have been less volatile than other asset prices, such as equity prices. Several reasons have been cited for the lower volatility, including the cost to speculate in the housing market. However, there have been examples of extreme home price volatility where it presumably has been costly to speculate, such as in Japan in the late 1980s and the 1990s. Therefore, we prefer instead to emphasize that the lower volatility of national home prices likely stems from the disjointed nature of the U.S. housing market.

Furthermore, our state-level analysis of home prices finds that while prices have risen much faster recently for some states than for the nation, the supply of housing in those states appears to be inelastic, making prices there more volatile. We therefore conclude that much of the volatility at the state level is the result of changing fundamentals rather than regional bubbles. Nevertheless, weaker fundamentals have caused home price declines in those areas with inelastic supply. If the past is any guide, however, that phenomenon is unlikely to plunge the U.S. economy into a recession.

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Source: Federal Reserve Bank of New York [ny.frb.org]

Brian Trumbore