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Trouble With The Bubble Theory
Home prices, while high, are backed by sound fundamentals.


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David Malpass

The U.S. moved into a healthy, sustainable recovery in 2002 once the dollar’s value weakened enough to stop the deflation. Since then, however, there has been a lot of concern over the durability of the expansion. Looking back, the worriers had it wrong. Gross domestic product has grown each quarter since December 2001, including 3 percent growth for the second quarter of this year.

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That’s not to say the economy does not have its obstacles and drags: Rising inflation, expensive oil, terrorism, and capacity constraints in an increasing number of sectors are valid concerns. But many of today’s fragile-recovery arguments — among them a debt-induced consumption slump, a “jobless recovery,” excess capacity, and a U.S. housing crash — are ill-founded.

Let’s look closely at housing. Interest rates (and mortgage rates) have been kept low, but the housing market is not in a bubble — at least not yet. Federal Reserve chairman Alan Greenspan has noted that bubbles are difficult to identify. He’s right. And in the case of housing — unlike equities or commodities — markets are heavily influenced by local factors which create local excesses.

May and June of 2004 saw record sales of 1.3 million new homes and nearly 7 million existing homes (both at annual rates). Some of the increase in new-home sales reflects the increasing U.S. population. On a per capita basis, the rate of new-home sales has been steadier.

Along with sales volume, house prices have also hit record highs. This is seen by some analysts as a bubble. Speculation is certainly a factor in the housing market, especially in some local areas. But at the national level, there appear to be sound fundamental factors causing much of the current rise in home prices.

To begin, the 1997 cut in the capital-gains tax rate on houses added substantially to the value of homes, just as the 2003 cut in the capital-gains tax rate on equities increased the value of equities. House prices had also lagged the economy and equity market in the mid-1990s, so some of the gains were part of a catch-up process.

Strong demographics are also playing a critical role. Increased immigration and the formation of households by the children of baby boomers are providing a firm foundation for increased housing demand.

Then there’s the long-term decline in the U.S. unemployment rate. This has added to the value of land and houses in the U.S. Similarly, the decline in the U.K. unemployment rate and the country’s avoidance of a recession in 2001 added to the value of land and houses there. This defended strong house-price gains in the face of high interest rates and mostly floating-rate mortgages.

Another argument against the bubble theory is that housing remains affordable in the U.S. While home prices have increased, mortgage interest rates have been low while real disposable income has been solid. The most recent data show that median income in the U.S. is 24 percent above that required to qualify for an 80 percent mortgage to purchase the median-priced home.

In a rough sensitivity test, the housing affordability index, now at 124, would decline to roughly 110 at the end of 2005, assuming mortgage rates rise to 7.3 percent from 6 percent. Median home prices, meanwhile, would slow to 3 percent from 5 percent, and median income growth rates would rise at a 4 percent rate versus 3 percent now. If incomes grow slower than that, median home prices would likely also rise less than assumed, offsetting the impact on affordability. And if home prices rise slower than these assumptions, the affordability index would be higher. However, if mortgage rates rise more than assumed, then the affordability index would be further depressed.

A key factor behind the rise in house prices has come from the supply-side. In previous episodes of sharply rising home prices in the past 30 years, the increase in price has led to overbuilding. Once inventories of unsold homes reached a critical mass, prices tumbled. The current episode has been different. Home builders have not built heavily ahead of sales — inventories of unsold homes are fluctuating around their all-time lows. With fundamentals pushing up demand and inventories remaining lean, it is hard to see how the current rise in home prices can be termed a “bubble.”

A key premise of the housing-bubble theory is that consumers have adopted risky practices in financing their homes, which will destabilize the market if prices soften. But the percentage of fixed-rate mortgages has remained at a high 80 percent level. (Due to fast turnover, an increasing number of new mortgages have had adjustable rates in response to the steep yield curve, but the stock of fixed-rate mortgages has stayed relatively stable as mortgagers prepare for higher rates.) The aggregate equity in homes has also remained relatively stable at 55 percent of home sales.

As mortgage rates rise in the coming quarters, U.S. home prices should show localized weakness. This would slow the gains in median home prices, but would not cause a decline in nationwide median prices. This would not be a crash, although some local areas could see sharp-enough declines to be characterized as mini-bubbles.

Separately, as mortgage rates rise and affordability declines, there should be some slowdown in new-home sales and in the residential construction component of GDP. Consumers may become satisfied with the quantity of their housing, shifting the focus of their consumption elsewhere.

– David Malpass is the chief economist for Bear Stearns.



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