May 23, 2005
Lots of fretting about house prices in the blogosphere today.
On Economist’s View, Tim Duy assumes a bubble, and asks what the Fed can do about it:
Bubbles pose significant challenges for policymakers. They are economic distortions that lead to inefficient resource allocation, and tend to have nasty unexpected consequences when they pop. But to what extent, if any, should they be a focus of central bank policy? I think conventional wisdom at the Fed is that you should keep your eye on the ball, and the ball is price stability. To deviate from this objective pulls you into the uncertain world of bubble analysis. It is possible that you may not be able to conclusively identify whether a bubble exists until it is far too late to do anything about it. Moreover, the Fed is not charged with maintaining stability within any one sector of the economy, just as they cannot set monetary policy with a focus on California. The Fed will instead focus on cleaning up after the bubble pops (some will argue that this entails creating a new bubble somewhere else in the economy).
Duy also thinks Greenspan is now in CYA mode:
[G]iven the lack of attractive policy options, or the ineffectiveness of these options, why the very public shift in concern at the Fed? I propose a very simple answer: The Fed is trying to protect its reputation. In the past, Greenspan has clearly downplayed the existence and impact of a housing bubble, even going so far as praising ARMs. It is getting harder to make those arguments, and consequently I suspect that Greenspan does not want to be blamed for being the cheerleader behind another bubble…
I’d guess he’s also reluctant to be the one who bursts the bubble and finds himself single-handedly responsible for stopping consumer spending in its tracks.
Surging housing demand appears to be continuing to reduce demand for rental units, weighing on the OER component of the CPI. Strength in housing demand is apparent in the recent data on mortgage applications for home purchases, wherein the four-week moving average is now at a record high, as well as the National Association of Homebuilders’ latest housing market index, which in May reached its second-highest reading in five years. Meanwhile, rental income has fallen to about $147.8 billion from the peak of $186.6 billion in April 2002. When the housing market weakens, it will result in increased demand for rental units, hence boosting the OER portion of the CPI.
TBP notes that because housing rental costs make up 30% of the core CPI, the inflationary effects of the housing bubble will be masked by falling rents. Perhaps, but what Crescenzi is seeing definitely doesn’t reflect the situation in my (undoubtedly bubbling) neck of the woods. Here, rents are soaring along with housing prices—not keeping pace, but staying pretty close. The crunch will come when the bubble does burst, and thousands of over-leveraged and unsellable properties are dumped on the rental market. That’s when rents will implode.
It’s the structural change in house financing that worries me most. As I wrote in a previous post, a recent report from the Federal Deposit Insurance Corporation describes how the housing boom is being accompanied by a fundamental shift toward riskier forms of lending. In particular, it notes that sub-prime mortgage originations surged to almost 20% of all mortgage originations in 2004, up from just under 9%in 2003; that adjustable-rate mortgages accounted for almost 46% of the value of new mortgages, up from 29% in 2003; and that interest-only mortgages accounted for 23% of the value of non-agency mortgage securitizations. All of which suggests there is an increasing number of marginal (i.e., stretched) borrowers in the market. A lengthy article in today’s Wall Street Journal paints a troubling picture:
Five years into a housing boom that has boosted U.S. home values an average of 50% and added an estimated $5.5 trillion to the total market value of residential real estate, many Americans no longer think of their home as just a place to live. Instead, it’s a cash machine that can be used to rapidly build wealth. To that end, a growing number of people are tapping into their home equity to invest in more real estate.
That’s a lot like using a margin account – a line of credit backed by securities in an investor’s portfolio – to buy stocks. During the 1990s, many investors used such accounts to buy shares in fast-rising tech stocks. When the dot-com bubble burst, the value of the shares bought on credit cratered and investors’ borrowing worsened their losses. Economists say today’s debt-fueled investment binge in real estate is fanning the flames of an already overheated housing market, and making demand from people who actually need houses to live in seem stronger than it truly is.
Which is why, for me, the truly scary paragraph in the FDIC report is this:
Data from Loan Performance indicate that 9 percent of U.S. mortgages in 2004 were taken out by investors, up from just under 6 percent in 2000. Furthermore, this share is significantly higher in local markets that are experiencing the strongest home price appreciation. In some of these markets, it is estimated that the investor share of new mortgage originations is as high as 19 percent.
As I've said before, investors in residential property are less loss-averse than owner-occupants, and therefore more willing to sell precipitously if the market declines. That would make the bang much louder when the bubble bursts.
And if speculators really do account for one-fifth of new mortgages in the frothiest markets, it’s gonna burst sooner rather than later.
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