Fed’s Rate Raises May Pop the Housing Bubble

As the Federal Reserve moves to raise short-term interest rates once again, flags are being raised about the impact on housing prices. With housing being the largest household asset – and one that has risen sharply over the last several years – a downturn in housing prices akin to the fall in stock prices since 2000 would be devastating to families and the economy.According to the latest Federal Reserve data, American households owned $16.6 trillion in real estate in the third quarter of 2004, up $2.2 trillion in the last year, an increase of 15.4%. By contrast, they owned just $9.4 trillion in corporate equities and mutual funds, which rose $923 billion over the same period, an increase of just 10.9%.The Office of Federal Housing Enterprise Oversight reports that home prices rose 13% in the past year, almost 5% in just the last quarter. This is a very large increase by historical standards. However, some areas have seen much larger increases. Housing prices in Nevada are up 36% in the last year. During the last 5 years, prices are up 107% in the District of Columbia, versus 48% nationally. Since 1980, homeowners in Massachusetts have seen a 566% rise. The national figure is 234%.One worry is that mortgage lenders have been too easy about granting mortgage loans. However, service on mortgage debt was only 9.86% of disposable personal income in the third quarter, up from a recent low of 9.08% in the fourth quarter of 1998, but down from a high of 10.41% in the third quarter of 1991.A key concern is that mortgage lenders now often lend to homebuyers with no money down. Until recently, lenders have usually demanded a 10% to 20% down payment before one could obtain a mortgage, to protect them from housing downturns. Furthermore, many home buyers now have adjustable-rate mortgages, which rise automatically when interest rates rise, rather than fixed-rate mortgages, which remain the same no matter what happens to interest rates.A number of economists have warned lately that housing prices have increased far more than economic fundamentals would seem to justify, at least in some important markets. Economists at UCLA have concluded that California’s housing market is in a bubble, and economist Stephen Roach of Morgan Stanley thinks much of the rest of the country is also experiencing a housing bubble.Economists at the Federal Reserve Bank of San Francisco point out that one can get some idea of whether housing prices are out of line with fundamentals by comparing them to rents. This yields a ratio akin to the price/earnings ratio that investors use to gauge stock prices. On that basis, home prices are at historically high levels that appear unsustainable.Other economists are less apprehensive. Those at the Federal Reserve Bank of New York think that fundamentals are mainly responsible for the recent rise in housing prices. They point to rising family incomes and historically low interest rates. Moreover, they note than even if interest rates were to rise, experience shows that this tends to slow housing prices increases rather than leading to a generalized fall in prices.Federal Reserve Board Chairman Alan Greenspan also appears sanguine about the existence of a housing bubble. It is worth noting that housing prices aren’t just rising here, they are rising worldwide. According to The Economist magazine, housing prices rose 65% in America between 1997 and 2004, but they increased 112% in Australia, 139% in Britain, 149% in Spain, 187% in Ireland, and 227% in South Africa.The rise in housing prices, here and elsewhere, is not surprising, given the decline in interest rates. Housing prices are, to a certain extent, like bond prices. When interest rates fall, bond prices rise. But, when interest rates rise, bond prices fall. Therefore, the critical question is what will happen when interest rates inevitably rise from their current, historically low levels?Economist Arnold Kling points out that much depends on whether market rates rise due to inflationary expectations or because real rates are rising because of an increased demand for credit. If it is the former, then housing prices can continue to rise even as interest rates rise. But if real rates – the market rate less the inflation rate – rise sharply, then all asset prices are likely to fall.Prudence suggests that it would be unwise to buy a house in the expectation of future price increases like those we have seen. However, those planning to stay put for a few years should not suffer. In any event, all homeowners would be well advised to get out of ARM’s and refinance into fixed rate mortgages as soon as possible.

Fed’s Rate Raises May Pop the Housing Bubble

Fed’s Rate Raises May Pop the Housing Bubble

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