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Housing-bubble theory full of hot air

Doug Duncan, senior staff vice president/chief economist at the Mortgage Bankers Association of America, wrote this commentary for

Ever since the NASDAQ meltdown some folks have been waiting for the next big bad equity story. Since most equity is found in peoples' homes, that's where pundits have been focusing. They face disappointment however as they watch and wait for the "house-price bubble" to burst.

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It's not going to happen -- there isn't one.

There has not been a single year since World War II in which house prices across the United States have declined; local markets, yes, but the whole United States, no (see chart). Homeowners know this intuitively and view housing as a solid, if conservative, investment. After all, you get to live in your house, you can't live in your stock portfolio, and you do have to live somewhere. Since there are more and more of us living in the good old United States, we will need more and more places to live. And the number of us is growing faster than the number of houses. Ergo, no bubble!

OK, let's look at the issue a bit more systematically to see why from the economist's point of view the issue is overblown. I work for the Mortgage Bankers Association whose members make about 70 percent of all the home loans in the country, so it is important that you see the logic in the argument against the "price bubble" to overcome any suspicions of an inherent bias based on who I work for.

Trouble with the bubble
First, let's define the term bubble. The Oxford English dictionary defines it as "a gas-filled cavity in liquid or in solidified liquid." One might say it has form but no substance -- the outward appearance of something substantial, but once the outside is pierced it is revealed to be based on a false impression. In the case of home prices, the interpretation would be that current home prices or price increases will be revealed to have been based on a false impression and when the surface is pierced we will see a substantial fall in prices.

About the only way an economist can find agreement with that argument is by discussing the role of expectations in decision making by consumers and investors. That is to say, consumers and investors might engage in speculation that prices will continue to rise as they have been (50 percent over the past six years), thus bidding house prices above the level indicated by the current supply-and-demand fundamentals. This speculative bidding would be for the purpose of capturing gains unrelated to their need for housing. To confirm that this is happening, there would need to be evidence that there was a growth in the number or share of residential home sales that were sold to purchasers not intending to live in them. It is difficult to find any confirmation of such a trend in the current market.

Another way an economist would accommodate your thought that home prices might unexpectedly fall is if you argue that interest rates will rise rapidly and far enough to make people stop buying houses. The economist would call this an affordability issue, not a price bubble. Roughly nine out of 10 people who buy a house do so by borrowing money. When interest rates rise, the monthly payment on a given amount of borrowed money rises also and can exceed the maximum size payment the family budget can support. This can change the balance between the cost to rent and the cost to buy. The attached chart shows the recent relationship between average monthly rent and average monthly after-tax mortgage payments and gives a good picture of why people are buying homes.

Outsmart rising mortgage rates
Several strategies can offset the effects of rising interest rates and keep the housing markets strong. People can use adjustable-rate mortgages that typically have lower interest rates than fixed-rate mortgages and therefore lower monthly payments. Another mortgage product that assists in overcoming the affordability problem is the interest-only mortgage. Also, the family can adjust the kind or size of house they are buying or the amount of down payment they are making.

That said, if interest rates were to rise above 8 percent in the near term there would definitely be at least a temporary slowing in home sales and price appreciation though the economist wouldn't call it a price bubble, but rather an affordability problem.

It is exceedingly hard to tear an economist away from the concepts of supply and demand when discussing price changes whether you are discussing houses or oranges. To really convince the economist that there is a house-price bubble, you will have to convince him or her that somehow price has decoupled from the intersection of supply and demand.

More demand than supply
Housing supply in the United States is growing slower than housing demand. That means prices will rise; not in every individual market but across the whole national market.

Supply is growing more slowly because it is constrained by local growth control ordinances, increased environmental cost, time requirements for land development and by the fact that construction lenders have been more conservative recently in lending terms. In addition, a higher percentage of homes are being built by companies who are owned by stockholders, which makes them more conservative in attempting to prevent oversupply.

Demand will grow faster because demographic factors like population growth, household formation rates, immigration, employment growth and income growth are all going to push demand forward more rapidly.

Contrary to the view of some observers the "boomers aren't yet done buying." Also, there were 11 million immigrants to the United States over the past decade that will create 4 million new home buyers over the next two decades. Recent gains in the economy's rate of productivity mean that income growth will be strong for probably the next decade. When placed in the context of conservative supply growth, this is a recipe for real price increases, not collapse.

Can prices fall?
Yes, there will almost certainly be some communities in which they will, perhaps because the biggest employer in the town closes down thus reducing jobs and demand. Is there any evidence that is will happen across the United States as a whole? None. The equity in their home is the single largest source of wealth for the median income family in the U.S and it will remain so for the foreseeable future. No fear where bubbles are concerned.

Doug DuncanDouglas G. Duncan is senior staff vice president/chief economist at the Mortgage Bankers Association of America (MBA). Since joining MBA in 1992, Duncan has served as director and senior director of MBA's research group.Prior to joining MBA, Duncan, served as a LEGIS fellow with the U.S. House of Representatives Committee on Banking, Finance, and Urban Affairs under Representative Bill McCollum (R-FL). He has also served as an economist with the Department of Agriculture's Economic Research Service.

-- Posted: Sept. 18, 2003




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