This paper examines some of the risks and possible ramifications of a slowdown in the US Housing Market in 2006.
What is a housing bubble? One definition of an asset bubble is: “If the reason that the price is high today is only because investors believe that the selling price is high tomorrow - when ‘fundamental’ factors do not seem to justify such a price – then a bubble exists. At least in the short run, the high price of the asset is merited, because it yields a return (capital gain plus dividend) equal to that on alternative assets.” The ‘dividend’ portion of the return from owning a house comes from the rent the owner saves by living in the house rent-free and the capital gains come from house price appreciation over time. A housing bubble can be thought of as driven by homebuyers who are willing to pay inflated prices for houses today because they expect unrealistically high housing appreciation in the future [Himmerberg, p. 68].
Three major measures are commonly used to assess whether house prices are unsustainably high: house price growth, price-to-rent ratio and price-to-income ratio.
A widely-quoted measure of housing prices is the Office of Federal Housing Enterprise Oversight (OFHEO), a single-family house price index. This index provides data on over 100 metropolitan areas since 1980. A major drawback is that the index only covers so-called “conventional” mortgages that have been purchased by Fannie Mae and Freddie Mac, which in 2005 has a maximum limit of $359,650 and therefore high-priced houses are underrepresented in the OFHEO index.
Price-to-rent ratio is a similar measure to a price-to-earnings multiple for stocks. It is intended to reflect the relative cost of owning vs renting. In theory, when house prices are too high relative to rents, potential homebuyers will instead choose to rent, thus reducing the demand for houses and causing house prices fall until they are once more in line with rents. If this ratio remains high for a prolonged period then it must be because prices are being sustained by unrealistic expectations of future price gains instead of fundamental rental value. i.e. bubble.
Historically, the price-to-rent ratio for the nation as a whole has had many ups and downs, but over time it has tended to return to its long-run average. Thus, when the price-to-rent ratio is high, housing prices tend to grow more slowly or fall for a time, and when the ratio is low, prices tend to rise more rapidly.
Currently the ratio for the country is higher than at any time since data became available in 1970 - about 32% above its long-run average. Of course, the results vary widely from place to place. For
The fact that the ratios for the nation and many areas of the country are higher than normal doesn’t necessarily prove that there’s a bubble. House prices could be high for some good reasons that affect their fundamental value. The most obvious reason is the low level of mortgage rates. This stems both from very stimulative monetary policy, which I discuss in more detail below.
The fact remains, however, housing prices have risen very fast for a historically long sustained period of time in many countries, it is easier to get credit than at other times and there is a glut of investment worldwide.
According to estimates by THE ECONOMIST, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries' combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1990s (an increase over 5 years of 80% of GDP) or
The global boom in house prices has been driven largely by historically low interest rates and low returns in the equities market in recent years.
Analysis of the
Housing Market US
In recent years the percentage of home ownership in the
At the end of 2005 the
The savings rate has been negative for an entire year only twice before - in 1932 and 1933 - two years when Americans had to deplete savings to cope with the massive job layoffs and business failures caused by the Great Depression.
This time Americans are spending all their incomes and more because they feel wealthier because of soaring value of their homes, which for many Americans is the largest investment they own. A rebound in stock prices after the 2000 market collapse has also increased consumer confidence.
A ‘traditional’ housing loan could be defined historically as 20% down payment and a fixed interest rate.
There’s been a huge rise in subprime, zero-down and interest-only loans in recent years. People who have had trouble getting loans in past decades because of poor credit or lack of a down payment are now eagerly sought after, while those with more solid finances are urged to stretch further and further to buy ever more lavish homes. This could be putting some real estate markets more at risk than they’ve ever been.
New, riskier forms of mortgage finance also allow buyers to borrow more money than they would have in the past. According to the NAR, 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase in 2004.
Nearly 9% of the mortgages made in 2003 were 'subprime' (made to people with troubled credit or uncertain finances). That’s up from 4.5% in 1994. In terms of volume, $388 billion in subprime-mortgage loans were originated in the first nine months of 2004 - more than triple the amount made in the eight years before that.
Zero-down loans totaled more than $80 billion in 2003. They were virtually nonexistent a decade ago. Another relatively recent phenomenon is the 125% loan. It allows people to borrow more than their homes are worth.
A record number of homeowners have taken out Adjustable Rate Mortgages (ARMs). From 2001-2003 ARMs made up fewer than 20% of all new mortgages, a rate that is lower than all but one year in the 1990s. However, ARMs rose to 34% of new mortgages in 2004. [Himmelberg] ARMs expose consumers to more risk, because their payments can rise along with interest rates.
Interest-only mortgages require buyers to make only interest payments for a period of time. After that, the rate adjusts, requiring principal payments as well. The loans were designed for people who wanted to preserve their cash flow for other investments or who receive a lot of their compensation in lump sums, such as big annual bonuses. Interest-only loans were, until 2000, almost exclusively a product for the wealthy, who had plenty of real estate exposure in their portfolio. Now they’re being pushed as a viable alternative for the average homebuyer - who is probably underestimating the potential risk he’s taking on. In 2004 about 18% of the $1.8 trillion in securitized mortgages were interest-only.
A major trend to emerge in recent years is for home owners to extract equity from their existing homes and use it for additional consumer spending. The equity is extracted via cash-out refinancing, home equity borrowing and housing turnover. Goldman Sachs [GS137] refers to this as Mortgage Equity Withdrawal (MEW) and they speculate that this extracted equity has a statistically significant and large effect on consumer spending. Between 50% and 62% of such equity is used for consumer spending, flowing into consumption or home improvement.
TODO: MEW spending is fine as long as house prices continue to rise. If there is a housing slowdown, however, MEW funds are very likely to dry up quickly.
The inflated prices of real estate have given rise to the ‘flipper’ phenomena, which in turn inflates the real estate prices further. A study by the National Association of Realtors (NAR) found that 23% of all US houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes. “Flippers” buy and sell new properties even before they are built in the hope of a large gain. In Miami as many as half of the original buyers resell new apartments in this way; many properties change hands two or three times before somebody moves in.[ICW]
Investment banks and other firms have been buying mortgage loans from lenders and packaging them into securities for sale to investors since the 1980s. But investor demand has surged in recent years, largely because in an era of low returns, mortgage-backed securities offer yield-starved investors much higher returns than government bonds.
Investors' strong demand for mortgage debt, besides allowing lenders to offer many borrowers better terms, has also made it easier to offer mortgages to borrowers who might not easily qualify for a loan. The growth of the mortgage markets spreads the risks around. But some mortgage-industry analysts say lenders have become less stringent in their loan terms because they can sell almost any type of loan to those who package mortgage securities for investors.
In a world of low interest rates, the market for mortgage securities is simply too big and profitable for many investors to ignore. Investors can earn about 5.5% on mortgage securities whose payments are guaranteed by Fannie Mae or Freddie Mac, government-sponsored companies. Those who can stomach greater risk can buy subprime mortgage securities, which come with no guarantee but can yield as much as 15%, according to Bear Stearns. Typically pays 0.75 to 1.15 percentage points more than US treasuries.
The buyers of mortgage-backed securities include
While Asian investors have largely focused on triple-A-rated bonds, other investors are buying lower-rated debt. These bonds, which are created when bankers carve up pools of mortgages, offer higher yields, but also bear the first risk of losses should borrowers default. Investors who buy these bonds in effect set the standards for which mortgages are made by deciding how much extra yield they need to compensate for the added risks of lower-quality loans. They include real-estate investment trusts, hedge funds and investors from
Strong investor interest has also made loans available to borrowers with poor credit and many other people who might otherwise have trouble getting a mortgage. Subprime loans included in mortgage securities totaled $401.5 billion last year, nearly double the total for 2003, according to Standard & Poor's. Meanwhile, loans with less than full documentation of the borrower's income and assets accounted for 70% of mortgage securities rated by Standard & Poor's in this year's first half, double the level recorded in 2000.
Also of concern is the amount of derivatives in "insured" commercial bank portfolios. The commercial banks, or course, do much of the lending to the housing sector. The amount increased by $2.6 trillion in the third quarter of 2005, to a whopping $98.8 trillion. 98% of these are concentrated in 5 banks. Total assets of these top 5 banks is $3.3 trillion. [OCC]
Most of the $570 trillion in derivatives are held by overseas investors.
After the biggest boom in US history the housing market has started to slow. Inventories of unsold homes are rising, homebuilding sentiment is falling and prices have fallen significantly in recent months.
There are two ways for the housing bubble to ‘correct’ itself (i.e. return to normal trends): either incomes rise or housing prices drop - or a combination of both.
There are two important questions for the economy as a whole: Will the slowdown be gradual or will prices crash? And, how large will the impact on GDP be?
Goldman Sachs [GS137] predict the following:
At the national level house prices will stagnate in coming years. At mortgage rates of around 6% Goldman Sachs estimate prices are 15% overvalued, with a range of 0%-50% across regions. (Regions such as
Residential investment is expected to 15%-30% over the next couple of years. This is likely to trigger a significant drop in constructions employment, whose share of total payrolls is the highest in 50 years.
In terms of GDP the direct and indirect effects of a housing slowdown is expected to cut 1.5 percentage points from real GDP growth in 2007. Even allowing for a boost from net trade this could push growth from the above-trend 3.5% pace of the past two years to a below-trend 2.5%.
The direct hit to growth is likely to come from normalization in residential investment, which is likely to cut 0.75% from annualized GDP growth. The indirect hit will come from a sharp drop in Mortgage Equity Withdrawal (MEW), which is expected to cut a further 0.75% off annualized GDP.
Core inflation appears to be contained and should remain contained during a housing slowdown.
A Bernanke-controlled Federal Reserve Bank is expected to react to the slowdown by cutting its federal funds rate target by about 100 basis points in 2007.
Similarly, in order for the price-to-rent ratio to return to long-term norms, either rents must rise sharply or prices must fall. However, the Federal Reserve Bank cannot allow rents to rise sharply as this would feed into inflation. Rents directly or indirectly account for 29% of
What’s the likely effect if national house prices did fall by 25%, enough to bring the price-to-rent ratio back to its historical average? With housing wealth nearing $18 trillion today, such a drop in house prices would extinguish about $4.5 trillion of household wealth - equal to about 38 % of GDP. Standard estimates suggest that for each dollar of wealth lost, households tend to cut back on spending by around 3.5 cents. This amounts to a decrease in consumer spending of about 1.25% of GDP. To get some perspective on how big the effect would be, it’s worth comparing it with the stock market decline that began in early 2000. In that episode, the extinction of wealth was much greater - stock market wealth fell by $8.5 trillion from March 2000 to the end of 2002. This suggests that if house prices were to drop by 25%, the impact on the economy might be about half what it was when the stock market turned down a few years ago.
Wealth effects - positive or negative - tend to affect spending with fairly long lags. Therefore, a drop in house price probably would lead to a gradual cutback in spending, giving the Fed time to respond by lowering short-term interest rates and keeping the economy steady.
Faced with higher payments, homeowners who have drained all the equity in their home or who didn’t put anything down to begin with are much more likely to simply walk away. The same is true for those with troubled credit. The serious delinquency rate, where borrowers are 90 days overdue or in foreclosure, is 1 in 12 for the subprime market, versus about 1 in 100 for the prime. Delinquencies tend to peak two to three years after subprime loans are originated, said Glenn Costello, an analyst at Fitch Ratings in
So far, the mortgage-backed market has generated cash and profits galore. Someday, however, someone will lose money. No one knows who, when or how much because housing has never been so frothy, risky mortgages so common or the market in which they trade so vast. Also unknowable is the quality of lenders' and investors' hedges, the complex investing strategies that are supposed to cover losses in the event of turmoil, like a default-inducing spike in interest rates. Many of the players in this market are not subject to government regulation, and those that are haven't exactly been under the microscope.
While there is some debate about whether there is a
However, US economic fundamentals appear to be strong and worldwide markets appear strong, so the likely outcome would be a slowdown on a similar scale to previous slowdowns – a 3-5 year dip with a 1.5% drop in GDP.
[BLOOM] Bloomberg.com, “Housing Bubble Bursts in
[GS137]. Jan Hatzius. February 2006. Goldman Sachs Global Economics Paper No. 137. https://portal.gs.com
[Himmelberg] Himmelberg, Charles, Chrostopher Mayer and Todd Sinai. 2005. “Assessing High House Prices: Bubbles, Fundamentals and Misperceptions”. Journal of Economic Perspectives – Volume 19, Number 4 – Fall 2005
[ICW] The Economist, “In Come the Waves”,
[OCC] OCC Bank Derivatives Report Third Quarter 2005
Comptroller of the Currency Administrator of National Banks
[REJ] RealEstateJournal.com, “Housing-Bubble Talk
Doesn't Scare Foreigners”,
[SWB] The Economist, “Still Want to Buy?”,