Wall Street History

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Wall Street History

01/28/2005

Housing Bubble?

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]

Wall Street History returns February 4 Albert Lasker.

Brian Trumbore

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