Running Out of Bubbles - New York Times
Remember the stock market bubble? With everything that's happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.
I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.
In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. "There is room," he wrote, "for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing."
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Many home purchases are speculative; the National Association of Realtors estimates that 23 percent of the homes sold last year were bought for investment, not to live in. According to Business Week, 31 percent of new mortgages are interest only, a sign that people are stretching to their financial limits.
The important point to remember is that the bursting of the stock market bubble hurt lots of people - not just those who bought stocks near their peak. By the summer of 2003, private-sector employment was three million below its 2001 peak. And the job losses would have been much worse if the stock bubble hadn't been quickly replaced with a housing bubble.
So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it's hard to imagine what that might be. After all, the Fed's ability to manage the economy mainly comes from its ability to create booms and busts in the housing market. If housing enters a post-bubble slump, what's left?
Mr. Roach believes that the Fed's apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he's wrong. But the Fed does seem to be running out of bubbles.
Paul Krugman | Morgan Stanley
The New York Times
May 27, 2005
Running Out of Bubbles
By PAUL KRUGMAN
Remember the stock market bubble? With everything that's happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.
I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.
In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. "There is room," he wrote, "for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing."
As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.
Now the question is what can replace the housing bubble.
Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.
But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession.
That's why it's so ominous to see signs that America's housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.
Some analysts still insist that housing prices aren't out of line. But someone will always come up with reasons why seemingly absurd asset prices make sense. Remember "Dow 36,000"? Robert Shiller, who argued against such rationalizations and correctly called the stock bubble in his book "Irrational Exuberance," has added an ominous analysis of the housing market to the new edition, and says the housing bubble "may be the biggest bubble in U.S. history"
In parts of the country there's a speculative fever among people who shouldn't be speculators that seems all too familiar from past bubbles - the shoeshine boys with stock tips in the 1920's, the beer-and-pizza joints showing CNBC, not ESPN, on their TV sets in the 1990's.
Even Alan Greenspan now admits that we have "characteristics of bubbles" in the housing market, but only "in certain areas." And it's true that the craziest scenes are concentrated in a few regions, like coastal Florida and California.
But these aren't tiny regions; they're big and wealthy, so that the national housing market as a whole looks pretty bubbly. Many home purchases are speculative; the National Association of Realtors estimates that 23 percent of the homes sold last year were bought for investment, not to live in. According to Business Week, 31 percent of new mortgages are interest only, a sign that people are stretching to their financial limits.
The important point to remember is that the bursting of the stock market bubble hurt lots of people - not just those who bought stocks near their peak. By the summer of 2003, private-sector employment was three million below its 2001 peak. And the job losses would have been much worse if the stock bubble hadn't been quickly replaced with a housing bubble.
So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it's hard to imagine what that might be. After all, the Fed's ability to manage the economy mainly comes from its ability to create booms and busts in the housing market. If housing enters a post-bubble slump, what's left?
Mr. Roach believes that the Fed's apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he's wrong. But the Fed does seem to be running out of bubbles.
E-mail: krugman@nytimes.com
* Copyright 2005 The New York Times Company
Housing Bubble Metrics
Richard Berner and Michael Marschoun (New York)
Concern about a US housing bubble is now reaching a fever pitch. Front page stories and thoughtful columnists in the Wall Street Journal and the Financial Times are sounding the tocsin. Googling ‘housing bubble’ instantly produces 2.4 million references. The Federal Deposit Insurance Corporation (FDIC) notes that a record 55 markets saw real price gains of 30% or more in the past three years. Fed officials are evincing concern: At their May 3 meeting they observed that “a number of local [housing] markets were still regarded as `hot' with signs of possible speculative excess." For his part, Fed Chairman Greenspan recently described tell-tale signs of market excess, noting that “there's a little froth in this market.†Two years ago we were convinced that the bubble enthusiasts were wrong, but even we switched to the ‘froth’ camp three months ago (see “Housing: Bubbly?†Global Economic Forum, February 28, 2005). That some markets are frothy is now obvious to even the most casual observer.
Yet, casual observation of the metrics often cited as proof of a housing bubble can be misleading. Here, we examine four such gauges: Price indexes themselves, the investor share of sales, housing turnover, and the terms of mortgage lending. As we see it, all four suggest froth but not a bubble. What’s the difference? We agree that some markets are frothy and show classic signs of speculative activity, especially buying homes for investment purposes in the apparent belief that the recent trend in appreciation will continue. But in many other markets — even in some large markets where home price appreciation has run at twice the national average — those signs are absent.
As a result, we stubbornly stick to the view that home prices will rust, not bust. Among the reasons: Housing has become less affordable with the runup in prices, and pent-up demand has ebbed. Favorable demographic trends are starting to fade: The immigration boom has cooled since 9/11, and the growth in households of prime home-buying age has slowed. But none of these trends has reversed. Indeed, in our view nationwide housing ‘valuations’ have only risen a bit above neutral from being undervalued. A valuation metric we developed a few years ago — a crude ‘price-earnings’ ratio for housing — corroborates that view (for details, see “Bubble Trouble?†Global Economic Forum, June 4, 2004).
Let’s examine the four bubble metrics. Home prices have soared at a pace last seen in the inflationary 1970s — 11.2% in the past year and 49.7% in the past five, measured by the OFHEO nationwide price index. But even this and other so-called ‘matched sample’ popular price gauges — which track repeat sales of the same single-family properties — may overstate ‘pure’ price appreciation in housing, because they don’t take remodeling into account. That is, owners added to the value of the property by investing in additions and alterations, but the index (which is designed for housing intermediaries Fannie Mae and Freddie Mac, not for economic analysis) isn’t adjusted for such increases in ‘quality.’ The difference can be substantial: The Census Bureau’s index of median new home prices rose by 37.8% in the past five years, while a similar index adjusted for quality rose by one quarter less than that pace, or 29.4%.
Some other, commonly-cited pricing metrics are meaningless, in our view, when looked at over periods less than two years. Shifts in the composition of sales affect the just-mentioned single family median price measure (not adjusted for quality); a shift to sales of more expensive houses will boost the index with no change in price. The index of median prices for sales of existing homes is similarly flawed. That partly explains why the former rose by 3.8% from a year ago in April, while the latter jumped by 15.1% over the same period. That’s too big a discrepancy to explain by fundamental factors.
Another indicator — the share of home sales that are for investment —hints strongly at a pickup in speculative activity. A National Association of Realtors survey claims that a record 23% of all homes purchased in 2004 were for investment, while another 13% were vacation homes. That non-occupant buyers are fueling the rise in home prices suggests less attachment to the home and more speculation. But we think such surveys can mislead. The NAR surveyors canvassed by email, got a low response rate (which is a typical problem with surveys) and have no basis for comparison; the survey is the first and only one. We suspect that the investor share in this survey is inflated; we believe that the email addresses were collected from loan closing documents and that real estate investors are more likely to provide email addresses and to use email than is the typical owner/occupant homeowner.
In contrast, HMDA (Home Mortgage Disclosure Act) data in our view measure the proportion of investor sales (including vacation homes) more accurately, and indicate a substantially lower proportion — closer to 13-15%. We believe that the HMDA data are more accurate because the data come directly from loan closing documents, are comprehensive, thoroughly audited and have been in use for many years. FDIC lending data corroborate the lower share, with investors comprising 9% of originations in 2004. HMDA data show that some local markets have extremely high investor shares (Las Vegas 24%, Orlando 19%) and those venues are clearly ‘hot’, but other fast growing markets have below-average investor shares (Los Angeles 8%, San Diego 10%), and thus are probably less susceptible to outright price declines.
Two other measures — housing turnover and lending terms — do suggest froth and speculation abetted by lenders in housing markets. Sales of existing homes in relation to the housing stock approached 5% recently, or double the share a decade ago, when home price appreciation began to quicken. Somewhat ominously, that turnover ratio peaked at a similar level in 1978, and that marked the crest of the 1970s housing boom. Then, of course, mortgage rates rose by more than 100 basis points over the course of that year, and 400 bp subsequently as the Fed crushed inflation.
Regarding the terms of lending today, to quote Mr. Greenspan: “There is a major move in mortgage originations now to interest-only and another [to ] all sorts of adjustable rate mortgages with very hybrid, very imaginative constructions. People are reaching to be able to pay the prices to move into a home…†Clearly the Fed Chairman is referring among others to so-called ‘negative-am’ ARMS which defer the increase in payments for a while when rates go up by adding it to the principal. Bank regulators are warning lenders about the risks in high loan-to-value, limited documentation and no documentation interest-only, and third-party generated home-equity loans. However, for the borrowers, it will be three years or more before the first interest rate reset on most hybrid ARMS, so rising rates won’t affect such borrowers for a while. In contrast, in the late 1980s and early 1990, most ARMs had one year resets.
The outcome of the housing bubble debate is important for financial markets in at least two respects. First, while many suspect that frothy housing markets will stay the Fed’s hand for fear of popping a bubble that would undermine economic growth, we believe that the housing situation will encourage officials to be transparent about their goals and keep tightening monetary policy at a gradual pace. Fixed income markets that increasingly are romancing a pause or an end to Fed tightening will have to reckon with that reality.
Second, we believe that housing and other consumer lenders are more at risk to deflating or just rusting home prices than are consumers themselves. For the consumer, a source of wealth will fade, which will promote slower growth in spending and increased saving. And such consumers will be more vulnerable to other shocks. But the lenders, some of whom have mispriced the options embedded in the loans they ‘sold’ to consumers, will likely lose both income and possibly principal.
There is clearly downside risk to the rate of growth of home prices nationwide, and to the level of prices in some frothy markets, and such declines will doubtless create fears of collateral damage to the consumer. But with income, compensation, and job growth improving, there are also upside risks to consumer spending and unit labor costs and to the level of interest rates consistent with today’s economic and financial setting.
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