Surveying my neighborhood, outside Washington, D.C., I wonder how there could not be a bubble. Homes fetch 30, 50 or even 100 percent more than they did a few years ago. We live in a hot real estate market (median-priced homes in the Washington area rose 14 percent in 2003 to $286,000 and are up 57 percent since 2000), but we aren’t all that different. Since 2000, the national median price for existing homes has increased 23 percent to $170,000, and many gains are much larger: 31 percent in Boston to $413,000; 64 percent in Los Angeles to $355,000; 32 percent in Minneapolis-St. Paul to $200,000; and 74 percent in West Palm Beach-Boca Raton to $241,000 (all figures from the National Association of Realtors).
Speculative fever also shows up in a widespread euphoria about future prices. Economists Robert Shiller of Yale and Karl Case of Wellesley surveyed recent home buyers in four cities. In the next decade, these home buyers think real estate values will rise from 11.7 percent annually (Milwaukee) to 15.7 percent annually (San Francisco). These expectations are absurd, as Shiller and Case say. Even annual gains of 11.7 percent would triple prices in a decade–far beyond any plausible income gains. Who’d buy those homes? But if people believe, they’ll borrow more against homes, and torrents of credit will temporarily bolster prices. Sure enough, home borrowing has surged. In 2003, homeowners’ equity (the amount not covered by loans) was only 55 percent of home value, a record low. In 1990, the figure was 61 percent; in 1945 it was 86 percent.
Still, Shiller and Case doubt there’s a big bubble–and they could be right. Lawrence Yun of the National Association of Realtors points out that since World War II median national home prices have never declined from one year to the next. At worst, there have been localized “bubbles.” In Houston, home prices dropped 23 percent over five years after oil prices collapsed in the mid-1980s, he says. In Los Angeles, home prices declined 21 percent over seven years in the early 1990s. Lower prices usually reflected weak local economies and ample supplies of homes. Similar conditions (it’s said) don’t apply now.
Up to a point, that’s true. Over the past two decades, homeowners have benefited from two trends. One is falling inflation and interest rates. On 30-year fixed rate mortgages, the peak occurred in Oct. 1981 at about 18.5 percent. Lower rates mean that borrowers can–on the same income–afford larger loans and costlier homes. Consider a family with $50,000 in disposable income that spends 28 percent ($1,167 a month) on its mortgage, says Yun. With interest rates at 8 percent, it can afford a $159,000 loan; at 6 percent, that jumps 23 percent to $195,000. Interestingly, those changes roughly mirror what’s actually happened nationally to interest rates and home prices since 2000.
The other favorable trend has been a transformation of the mortgage industry. To get a loan 20 years ago, you usually went to a local bank or savings association, which approved the application and provided the money. Now, the mortgage business is mostly national. You may still go to a local bank or mortgage broker, but most loans are packaged and sold to national lenders (led by Fannie Mae and Freddie Mac) and serviced by major corporations (Wells Fargo, Chase). They’ve cut costs by computerizing much of the process. In 1980, high fees and closing costs made mortgage refinancing attractive only if interest rates dropped two percentage points (say, from 8 percent to 6 percent), says Forrest Pafenberg of the Office of Federal Housing Enterprise Oversight. Now, the threshold for refinancing is as low as 40 basis points (say, from 8 percent to 7.6 percent), estimates Douglas Duncan of the Mortgage Bankers Association.
All this has made housing an economic cocktail. People have repeatedly refinanced. They’ve traded up. They’ve borrowed against higher prices, spent some cash or consolidated high-rate credit-care debt into lower-rate mortgages. The Fed’s low overnight rate (1 percent) helped keep mortgage rates low. Higher home values buoyed confidence. If more jobs signal a stronger economy and slightly higher rates, what’s the worry? Home prices may stabilize, and even if declines occur in some frenzied markets, there won’t be a widespread collapse of either prices or psychology. “It’s not a bubble because it’s not coast to coast,” says Mark Zandi of economy.com. Sounds reasonable, but wandering around my neighborhood–where many prices seem totally crazy–I’m waiting for the proof.
