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Housing bubble may be illusion, but choices are real

Either the United States is inside a colossal housing bubble that's about to pop, or there's little to worry about. It depends on whom you ask.
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The debate over the existence of a housing bubble has been going on for at least two years. A "bubble" happens when frenzied buyers bid up prices artificially high. Eventually, the bubble bursts and prices plummet. Believers in a real estate bubble worry that years of low interest rates have inflated home prices beyond reason. They warn that the inevitable rise in mortgage rates could cause a coast-to-coast plunge in values that would have hideous effects on the economy.

The debate over the existence of a bubble is important because most homeowners have to choose whether to protect themselves from rising home prices or from falling home prices. Home buyers make that choice, whether they realize it or not, when they decide how much of a down payment to make and what type of loan to get.

Playing bubble jeopardy
Many buyers nowadays borrow 90 percent or more of a home's price just so they can buy a place before even the least-expensive houses in their areas are out of reach. They figure they can move up to a better house in a few years. Some of these buyers get adjustable-rate or interest-only mortgages. They stretch their finances to protect themselves from further increases in home prices, but that makes them vulnerable to dramatic drops in values.

By most accounts, fewer buyers are doing the opposite: protecting themselves from a bubble. The best bubble-protection strategies consist of saving up for a hefty down payment (of 20 percent or more), avoiding bidding wars for houses in hot markets, shunning interest-only loans and buying houses for the long term.

People who warn of a housing bubble say that home prices have risen dramatically in the past eight years, faster than the overall rate of inflation, while rents have not kept pace. They acknowledge that real estate markets are local, and that all real estate bubbles in the past were local. But they say the past few years' rapid run-up in home prices has been national and unprecedented, so a nationwide drop in values is possible.

The rate-price link
Stephen Roach, chief economist for Morgan Stanley, believes that low mortgage rates are driving up house prices artificially. He compares what's happening in residential real estate today with the dot-com bubble of the 1990s, and has urged the Federal Reserve to raise short-term interest rates now, to deflate the bubble before it gets bigger.

Dean Baker, an economist and co-director of the Center for Economic Policy and Research, agrees with Roach that low mortgage rates have inflated a bubble. He says the fad for cash-out refinances, equity lines of credit and high loan-to-value mortgages are signs of a bubble. Baker believes so confidently in a housing bubble that he sponsored a $1,000 essay contest to solicit the most-convincing argument for the other side.

Experts disagree on bubble's existence
The winning essayist, Hilary Croke, is a researcher for the Federal Reserve. Expressing her personal views and not those of the Fed, she argues in the essay that the steep rise in prices in recent years is nothing new, that demand for housing is high and supply is low and that houses are bigger and better than they used to be. All of these factors push up prices.

She adds that home prices have risen much faster than rents because the "benefits of homeownership together with easier access to credit has made rental accommodation less attractive."

-- Posted: April 22, 2004




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