Wednesday, June 1, 2005

previous entry | main | next entry | TrackBack (1)

The housing market: foam or no foam?

I don't normally blog about the housing market (see here for an exception), but since everyone from Alan Greenspan to Brad Setser has been talking about whether the U.S. is experiencing a housing bubble right now, I thought it might be useful to link to this Chicago Fed Letter by Richard Rosen that suggests the answer is no. The highlights:

Some believe that the rapid increase in housing prices is a sign of a bubble. In this Chicago Fed Letter, I document changes in the median sale price of a house in the United States and
for major markets in the Seventh Federal Reserve District. I show that the increase in housing prices in most areas, including the Seventh District, can be largely explained by falling mortgage interest rates and changes in household income.

Do note the big caveats in the article, namely:

1) Rosen assumes all homebuyers will use fixed-rate mortgages;

2) Housing is not purchased for investment purposes.

For a summary of the report, see this Chicago Tribune story.

posted by Dan on 06.01.05 at 11:44 AM


Those are some fairly hefty caveats. They may be sufficiently hefty to torpedo Rosen's argument. The heavy use of variable rate and interest only mortagages during the recent boom has been well documented, and in certain areas of the country, speculative real estate transactions are beginning to approach 35% of the total.

I'm not certain if we are wintessing a national bubble, regional mini-bubbles, or none of the above, but any analysis should look at the facts on the ground, not a fantasy land based on plainly false assumptions.

posted by: pslade on 06.01.05 at 11:44 AM [permalink]

Also worth looking at, esp. in California, is that housing prices are beginning to climb out of the reach for first-time homebuyers. An article--in the Economist, I believe--pointed out that much CA's housing market was now among those who already owned a home, and those wishing to buy for the first time were shut out. That said, I believe the same article pointed out that areas like CA were not the norm for the whole country, and that it is a better idea to think of regional bubbles rather than a national one.

posted by: CMC on 06.01.05 at 11:44 AM [permalink]

Its also worth considering that housing prices were in a slump in many markets when this boom started, so some of the gains are a bit less spectacular than they may seem. Secondly you have to seperate real estate speculation (which has always been a dangerous game) from the housing market. A house is a great investment, you have to live somewhere and you get the tax break on top of that. Further the decision on when to sell can usually be dictated by the state of the market which is not always true with real estate speculation (its too expensive to hang onto indefinately, certainly for your middle class investor). There does seem to be a bubble, but the bursting is going to hurt the rich investor class much more than the middle class. Certainly it will hurt less than the stock market bubble that hit so many 401ks and pensions. Conclusion: not worth worrying about for 98% of us.

posted by: Mark Buehner on 06.01.05 at 11:44 AM [permalink]

One important note: My understanding is that the Chicago area market has been stable, but not giddy, maybe thats why Rosen doesn't see a big bubble in that district. Its not SoCal or Washington DC area. So this may not hold for the coasts.

I count the start of the speculative bubble to be around 2001 in most markets. This is just the time that a lot of investors gave up on the NASDAQ as the generator of instant wealth.

Mark -- some markets were slumping before 2001 (SoCal being one), but in many other markets (New York metro for one), there had been solid growth even before then. So some of the gains are justified, others appear to be most definitively froth-driven. Also, the general interest rate favorability and the like holds all over the country -- why then are some markets (Texas) still in a bust ? Colorado has already seen a mini collapse.

Logic details that the impact of 911 should have been a slight downturn in the property markets in the major metro areas, as people adjust for the real possibility of a major terror attack in these cities (especially NYC and Washington). The threat existed before, but it was not recognized, and the market should have discounted for that after 911. Instead, we got an even greater boom.

Also, yes, the bubbles are local, but when NYC, Washington DC, Cal are considered, they account for half the real estate capitalization in the US.

Will speculators be the only ones hurt ? I don't know. I do know that the wealth effect has led to people spending lots of money more than they would have. People are willing to buy more house or take bigger mortgages than they should simply because they believe that it doesn't matter if they buy a more expensive house -- it will just go up in price more. Some of the new mortgage products are extremely speculative. I think the bubble in many areas is getting worse as prices go up each quarter. The bubble in many such areas will indeed burst -- at some point even the banks will find themsleves unable to lend that much even with new products. When ? Aha, thats the big question. It could be this year, it could be the next, or the next. I predict no steep drop, but a slow decline or staganation for a period. There may well be bargains to pick up in a year or two, so keep your powder dry.

One more thing to consider: What if the yield curve becomes inverted with short term rates higher than long term rates ? Will banks still be willing to lend as much ?

Conclusion: No bubble in Chicago. None in much of the Midwest, Texas etc. Big bubble in the Washington DC area, unsupported by income growth. Bubble in SoCal. Bubble in NYC metro.

posted by: erg on 06.01.05 at 11:44 AM [permalink]

Oh no- the big weakness might be caveat number two.

Greed. One way to tell how much speculation went into a local market is how many rentals are available. In certain areas realtors bought houses on speculation and there were families on wait lists that found other options. The pent up demand can perhaps be assessed by the rental market. However I think that varies by locality-an aging baby boomer population might prop up more temperate realty markets for awhile but then when does that bust?

posted by: madawaskan on 06.01.05 at 11:44 AM [permalink]

In the SF Bay Area, it is without QUESTION a bubble. If one bought a condo next to my apartment (same size, same floorplan, same amenities), it would be $450,000 to $480,000, compared with $1300 a month in rent.

I made a spreadsheet. If I consider JUST interest (10% down, 30 year, 6% fixed), property tax, homeowners association, maintinence, and insurance, AFTER subtracting out the tax savings, it is still $500/month MORE than what I'm paying in rent.

Thus if someone bought the condo and rented it out, they would be $500/month in the hole in real money. Even assuming 3% inflation in rent, it would be ~8-10 years before the net cost would balance.

Since you would naturally expect the tax-neutral nonsavings cost to be less than rent (how else are landlords supposed to make money?), this clearly says that either rents are unnaturally low, or house prices are horribly high.

Given the nontrivial rent, the natural conclusion is house prices in the SF Bay Area are completely bubbled.

And remember, a raise in the ARM rate from 4% to 6% would require a substantial (15%+) drop in the sale price for the buyer to be paying the same amount/month (what the buyer looks at). Thus if interest rates go up 2%, that alone will have a huge impact on price.

posted by: Nicholas Weaver on 06.01.05 at 11:44 AM [permalink]

Rosen's paper makes about as much sense as "Here's my review of the gallery's paintings, with the caveat that I'm blind."

posted by: KipEsquire on 06.01.05 at 11:44 AM [permalink]

For those who assume there is a bubble, the question is whether it will fall into a holding pattern, gradually deflate or burst. I have heard some convincing arguments that a bursting bubble is the most likely scenario. I live in DC where housing prices have doubled in six years. One reason home buyers and those taking out second mortgages are willing to take on so much debt is that they are convinced that in six years, their homes will be worth twice as much again. If the trend stalls and homebuyers cannot count on a 15% annual return on their investment, not only will they not be willing to pay 15% more every year, they may not be willing to pay what are already astronomical prices.
As for being safe if you are paying a fixed rate, this may be the case for some who have secure incomes. However, if the housing market stalls, this will almost certainly lead to an economic downturn. If too many homeowners have to take a pay cut or a job that doesn't pay as well, they may find themselves unable to pay their half million dollar mortgage even at historically low interest rates. It there is a wave of foreclosed properties going on the market, the bubble will burst.

posted by: Ken on 06.01.05 at 11:44 AM [permalink]

My hypothesis:

Interest rates jump and the market just freezes: Buyers demand a huge drop in costs to be worth buying (at the same outrageous cost/month, not even demanding a lower cost), while sellers refuse to sell: simply because buyers look at monthly cost, sellers look at bottom-line price, and an interest rate increase separates the two.

Now a frozen market IMO is the best scenario. But what I fear will happen is that with all the interest only ARMs, regular ARMs, etc, the (possible) sellers are going to be feeling a huge pain as the rates rise. After a while, you get some forced-sales, and the market collapses as the bubble assumption goes away.

Combine this with the economic hit caused by no longer having the refinance/bubble money driving a good section of the economy, and we are looking at plausible world-o-hurt.

Of course, this is just my gut feeling as a non-economist. Couch it up in fancier mathematics and you could say either the same thing or the exact opposite.

posted by: Nicholas Weaver on 06.01.05 at 11:44 AM [permalink]

What pslade said. Speculation is indeed rife in the most overheated markets. This is partly because rental rates have not kept up with PMIs, which means that renting is relatively more attractive than buying for first-time would-be homebuyer yuppies, thus creating a very strong market for renting houses.

The other factor that no one seems to have studied is the (probably large and rising) amount of offshore capital invested in housing markets, especially on the West Coast and in Manhattan and South Florida. I only have anecdotal evidence here, but I suspect that much of the housing price bubble in these markets is due to speculative investment by Asian individuals primarily and, in Miami, Latin flight capital. As overheated as the market seems to us, given Chinese or latin risk premiums, US real estate still offers better risk/return characteristics than re-investing your profits in Shanghai or Sao Paolo. Especially if you know that you have utterly no problem renting it out and generating steady cashflow.

posted by: thibaud on 06.01.05 at 11:44 AM [permalink]

What bubble? We live near Chicago and the 'presumed
value' of our house is rising at an astounding rate.

I guess it must be due to the new lawn mower blade
we installed this spring. :-}

Let's see:
the local school districts are in the red
traffic is worse than ever
parking almost unavailable in local downtowns
high paying jobs tough to come across
energy prices soaring

What a great time to overpay for a house!

posted by: Ted on 06.01.05 at 11:44 AM [permalink]

Okay, the housing 'bubble' is most severe where? Manhattan, California, South Florida . Now, think ....think.... what do these areas have in common.

Maybe they have massive immigration in common. When you have a state that is half desert (California), with a population growing at a rate faster than Bangladesh's, it's no wonder housing prices are going through the roof in the areas in which it is actually pleasant to live. What's the control group--well mortgage rates are nationwide, but immigration hits some area harder than others. I've no doubt the correlation between insane housing prices and immigration impact is there.

' Course, its all the native-born's fault, kvetching about having to move 45 miles from work to find a decent place to live. If they would just be willing to share a house with three of four families, like those hard working, frugal immigrants, they could save themselves a big commute.

posted by: Mitchell Young on 06.01.05 at 11:44 AM [permalink]

Consider also that the housing market is a great way to launder drug money.

There is certainly a pattern in California of several families of Mexican immigrants, some of them doubtless illegal immigrants, living together in a single-family zoned detached home which they purchased with cash (no loan).

Enforcement of the single-family residence laws common in most California cities has pretty much ceased.

posted by: Tom Holsinger on 06.01.05 at 11:44 AM [permalink]

The fixed-rate caveat is a bit surprising, given that Greenspan has been talking up ARM mortgages for a while.

posted by: Jon H on 06.01.05 at 11:44 AM [permalink]

The pinheads who run this country and the pinheads who advise them think all civilization is in states that touch an ocean.

Here in Ohio the only boom is in foreclosures.

I hope we don't make too much national policy based on what is happening in Manhattan and San Francisco.

posted by: save_the_rustbelt on 06.01.05 at 11:44 AM [permalink]

"I hope we don't make too much national policy based on what is happening in Manhattan and San Francisco."

I think Las Vegas has been having a real estate boom, and I wouldn't be surprised if trendy resort areas in the Rocky Mountain region are also having a boom.

posted by: Jon H on 06.01.05 at 11:44 AM [permalink]

"-the local school districts are in the red
-traffic is worse than ever
-parking almost unavailable in local downtowns
-high paying jobs tough to come across
-energy prices soaring"

Sounds like Raleigh, NC with the exception that our school district (which has no taxing authority) is extremely short of money, but not yet in the red.

I agree with the above posts that note that the caveats are too large. I would only add that it is not only the ARMS that are causing problems, but also the very low down payments that are now required to buy a home.

posted by: Russell on 06.01.05 at 11:44 AM [permalink]

Post a Comment:


Email Address:



Remember your info?