September 2003
By ROBERT PEGG
Homeownership rates are at record levels because easy credit and historically low interest rates have increased people's ability to buy a house. As a result, the value of homesÑand the mortgage debt that has been incurred to buy themÑhave been rising.
According to the Federal Reserve, homes in the U.S. are worth $13.6 trillion, 92 percent more than a decade ago; mortgage debt now totals over $6 trillion, more than double the total of a decade ago. The rapid home price appreciation in many parts of the U.S. has clearly alarmed some housing experts and economists, because its continued unabated rise is unsustainable and a crash would have serious negative consequences for the economy. On the other hand, other economists, including Alan Greenspan, chairman of the Federal Reserve Board, dismiss the idea of a national housing bubble that could harm the economy if it bursts.
In a recent study of housing conditions in the U.S. by the Wharton School of the University of Pennsylvania, two economists argue that housing markets are prone to bubbles and this one is no exception. This conclusion arises for three reasons, according to the professors. First, the supply of residential real estate is fixed in the short term, so that increased demand from a few buyers can easily push prices up. Since no one sells a house "short," such as investors do with stocks in the stock market, prices are continually driven up, all else being equal. Second, new properties take years to complete. The housing market is not efficient (or far less efficient than the stock market) and lags behind the general economy. Because of these lags, housing supply for a given period may continue to increase even as prices decline, eventually pushing prices even lower. Thus, these supply-demand imbalances encourage a boom bust cycle.
Third, banks have an incentive to lend as much as possible when property values are rising, but to pull out quickly when housing prices fall, exacerbating the boom or bust. Rising home prices lift the market value of collateral on banks' existing loans, so they are only willing to lend more, pushing prices even higher. Higher prices also lift the value of bank-owned property holdings (and hence their capital), encouraging them to relax their lending standards. If housing prices fall, the process goes sharply into reverse and a credit crunch may develop, intensifying the effect of falling prices. Property cycles tend to be linked more with credit cycles than stock market cycles.
In the U.S., the economy has held up in part because rising housing prices have offset the loss of equity wealth and have helped to support consumer spending. Many housing experts insist that a housing bubble will be avoided. Nonetheless, housing prices have considerably outpaced the more general rate of inflation, which is at its lowest level in 50 years. As a result, housing prices cannot regain their long-term equilibrium level unless inflation catches up or housing prices fall significantly. Moreover, the surge in home prices has been accompanied by a surge in household debt. Not only are new homebuyers taking out ever larger mortgages as a percentage of their purchase price, but existing owners have taken advantage of rising home prices to increase their mortgages and convert some of their capital gains into cash.
A fall in housing prices, if one occurs, will be a blow to prospective retirees. Their pensions and 401ks already have been reduced by the stock market downturn and if they were planning to supplement their nest egg by selling their home, they will be disappointed. A fall in housing prices also would lead to increased mortgage defaults. In the past, the biggest victims of a housing bubble, other than the borrowers, were the banks and savings institutions. Today, American banks sell mortgages in the secondary market mostly to Fannie Mae and Freddie Mac, which finances their purchases by issuing bonds or by pooling mortgages and selling them as mortgage-backed securities. This has allowed American banks to make even more loans, fueling a potential housing bubble.
For now, potential housing bubbles threaten only markets on the East and West Coasts, particularly around Boston, New York City and San Francisco. The good news is that most economists still foresee a reduction in the double-digit increases in home appreciation in these areas; they do not however, predict a downturn in housing prices, especially in an improving economy. As a result, the general advice is to keep your house, enjoy it, but don't chase the next one.
About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.