August 2004
By ROBERT PEGG
U.S. housing prices have risen significantly over the past several years. Median prices for homes in the U.S. at the end of 2003 were up 15 percent from two years earlier. However, in the New York region, far stronger gains in housing prices have been noted in markets on Long Island, in Westchester and in parts of New Jersey. In some of these areas, house appreciation has been triple the national average.
Growth in home price appreciation, fueled by low mortgage rates, has easily outpaced growth in disposable income. The housing boom has raised concerns among many analysts about the possibility of a home price bubble and the fear that home prices may suddenly collapse.
Collapsing home prices would not be without precedent. While reliable price histories do not exist, it is recognized by economists that home prices fell greatly in many areas of the nation during the Great Depression. Although median prices in the U.S. have never experienced even a yearly decline since World War II, there have been localized bubbles in parts of the nation. In Houston, for example, home prices dropped 23 percent over a five-year period after oil prices collapsed in the mid 1980s. In Los Angeles, home prices declined 21 percent over seven years in the early 1990s. Even on Long Island, prices were very soft in the early to mid 1990s. Usually, declines in housing prices are coincident with weak local economies, job losses, or an ample supply of homes. Although such conditions do not presently exist in many of the nation's cities, they have in the past.
On the surface, the performance of the housing market in recent years appears similar to an asset bubble. Housing is considered a leveraged asset, similar to purchasing a stock on margin. Here there is considerable risk because an investor-homeowner can potentially owe more on the asset than it might get if resold at the prevailing market price. However, the analogy stops there. There are several reasons why owner-occupied housing is less prone to price bubbles than stocks. For one, homeowners cannot sell their housing asset short and there is no potential for a margin call demanding additional funds when prices drop below the outstanding mortgage balance. In addition, trading volume in the housing market is a fraction of financial asset markets.
Nonetheless, the concern about housing speculation persists. Over the past two decades, homeowners have benefited from several major economic trends, falling inflation and lower interest rates. In October 1981, 30-year fixed-rate mortgages were 18.5 percent. Today, fixed-rate mortgages can be easily obtained for one-third the amount and adjustable rate mortgages, for even less. Another important trend has been the transformation of the mortgage industry. In order to obtain a loan in the early 1980's, one would go to a local bank or saving association, which approved the application and provided money. Today, the mortgage industry is national. One can still go to a local bank or broker, but most loans are then sold to national lenders and serviced by major corporations. Computerizing much of the process has reduced costs.
In 1980, high fees and closing costs made mortgage refinancing attractive only if interest rates dropped about two percentage points. Now the threshold is about 40 basis points. As a result, homeowners have repeatedly refinanced. They have traded their houses up, borrowed more against higher prices, spent some of it, and even consolidated high-rate credit card debt into lower rate mortgages. The Federal Reserve's low interest rate policy has kept mortgage rates low and allowed for this kind of activity.
The consensus is however, that a full-fledged home price bubble in the U.S. is unlikely. The history of U.S. home prices suggests a potential for home prices to decline in individual markets, particularly in cities that have shown wide price swings in the past and where prices have risen dramatically. However, the same history suggests that home prices, even though they may be high, are unlikely to fall dramatically across the entire nation, even if rising interest rates and the cost of mortgage borrowing reduces housing affordability. History shows that a sharp price decline does not inevitably follow a sharp rise in local home prices. In many cases, the aftermath of a housing boom has been characterized by slower sales and price stability, until the underlying fundamental economics have caught up.
About the author: Mr. Pegg is managing director of Tocqueville Asset Management LP, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.