Separating the Boom from the Bubble
The current discussion about the housing bubble has been largely based on data that is only partially appropriate, ignoring more important data and leading to more confusion than necessary.
Like many discussions about bubbles they overly rely on tracking rapidly rising prices. Rising prices may provide some initial warning signs but they are not sufficient for identifying a bubble.
Let’s address the fundamental question directly: We need to determine whether the growth in housing prices is due to a boom or a bubble.
A boom is based on rising prices based on growing investment opportunities that eventually level off. A bubble is based on an unsustainable rise in prices due to a cascade of bad investment decisions and/or speculative betting leading to a crash.
The data most frequently sited to warn that there is a housing bubble is the record high ratio of average home prices to average income.
This is used to argue that people cannot afford their homes given their income. However, mortgage interest rates are extremely low. As a result, home-buyers can afford homes that have far higher sticker prices because low interest rates make the monthly payments more affordable. It may take owners longer to payoff their mortgage, but that is a minor issue.
The price data alone cannot determine whether homebuyers are making bad or speculative buying decisions on housing that is not sustainable.
What we want to know is whether home buyers are purchasing homes that they cannot afford and at some point they will be confronted with this reality and prices will have to crash to come more in line with what the market can bear.
Homeownesrhip Burden Near Record High Stretching Homebuyers. The Federal Reserve Bank collects data that helps see this distinction. The Homeownership Burden calculates payments on mortgage debt, homeowners' insurance, and property taxes as a percentage of disposable income. Importantly, the focus then is on the actual payments homeowners need to make compared to what they can afford. This adjusts for the low interest rates.
At 9.86 percent, the Homeownership Burden is approaching the highest levels since data was first tabulated in 1980.
This reveals that from an historical perspective homebuyers are increasingly stretching themselves to buy a new home. It is not yet clear whether buyers have reached their limit. However, there are some substantial dangers ahead.
Adjusted Rate Mortgages at Record High in Rising Interest Rate Environment. Perhaps most worrying is that vast numbers of new mortgages being done as adjustable rate mortgages during this period of rising interest rates. Thus, the debt burden which has been increasing since 1998 due to high home prices, will now also start increasing even faster for homeowners due to rising interest rates.
If nothing else, these home buyers are taking on a lot of interest rate risk- especially because rates may rise faster than buyers anticipate.
Decline of Discipline. Some might expect that loan officers would play an important role in determining whether homebuyers can afford to carry their loans and would include the expected impact of rising rates. However, bubbles create intense competitive pressures to “win the deal,” and loan officers are not exempt from this pressure. In hot markets, loan officers that are not demonstrating high performance can be penalized.
The Federal Reserve conducts a survey of senior loan officers and asks them whether they are loosening or tightening their credit standards for mortgages to individuals.
Over the course of 2004, the Federal Reserve has reported that lenders have been substantially loosening their credit standards. In fact, a near record percentage of loan officers reported they were loosening their credit standards.
Speculative Activity Distorts Market Pricing and Accelerates Liquidity. There are also growing signs of speculative activity in the market. In the December FOMC meeting, the Federal Reserve noted this directly. Reports in California, Florida and other parts of the country indicate that as much as 70 percent of condominium buying and 15-20 percent of single family homes are being done by speculators who never intend to occupy their new homes.
Facilitating this speculative activity is the explosion of real estate investment clubs around the country and best selling books aimed at teaching individuals how to buy and sell homes.
The speculative activity alters two key factors in the market. First, it shifts the marketing pricing process from one where buyers are viewing homes as places to live and judging prices based on what they can afford to one where buyers are guessing how much others are willing to pay for them down the line in a hot market.
Second, speculative activity that brings in the general public adds vast amounts of capital to the market further adding to the inflationary pressures.
Given the pace of rising prices potential homebuyers increasingly fear that they may soon be priced out of homeownership altogether. Even if they believe that the market is a bubble, they may not be willing to take the risk that they are wrong and are jumping into the market. The psychological fear of rising prices is a classic cause of hyperinflation.
The perception of rising prices itself becomes self fulfilling prophecy. As more and more people buy now with the perception that they are avoiding higher prices later, they in fact they are causing higher prices. Buying now, appears to be buying at a substantial discount compared to the future when prices may 25-30 percent higher in one year. Correcting a hyperinflation syndrome is very difficult and usually ends in a significant crash.