Currencies

[thepennyking]

Fannie Mae's Thoughts On 'Housing Bubble' Stories

August 23, 2002

Often when the housing sector is strong and growing at a steady, healthy pace, as it has and will continue to do, stories appear warning of a "housing bubble." But as Federal Reserve Chairman Greenspan said in Congressional testimony, it is very difficult for a housing bubble to occur on a national basis because unlike stocks and bonds, investors cannot move in and out of housing as they can financial instruments. In the past quarter century, home values nationwide have never fallen on an annual basis. In fact, home values nationwide have risen every year, even during severe recessions like 1981-82 when the unemployment rate jumped to nearly 11 percent, and during the "mild" recession of 1990-91.

Certainly, housing may cool from its record pace, but recent stories of weakness usually refer to the high-end market. It is not the case that more moderately priced homes which we fund are showing price weakness. For much of the 1990's income outpaced home price appreciation. It has only been recently that home prices have caught up.

Following are facts that give us confidence in the health of the housing market:
On a national average basis, annual home prices have not declined since the Great Depression. Even during severe recessions (such as 1981-82, when the economy had double digit unemployment rates and mortgage rates over 18 percent), home prices increased. To be sure, there have been regional declines (such as in the "oil patch" in the mid-1980s, and California and New England in the early 1990s), but even these did not bring national prices down.

The causes of the regional home price downturns do not appear to be in place today. The oil patch home price decline came as a result of a regional recession that was even worse than the national recession of 1981-82 -- it was, in effect, a regional depression. It would take a U.S. downturn approaching that magnitude to bring national home prices down -- something that seems extremely unlikely.

The regional downturns in California and New England in the early 1990s stemmed largely from excess housing supply in the face of steeply rising prices -- resulting in a sharp increase in unsold home inventories. This exhibited many of the characteristics of a speculative bubble. The supply-demand situation is very different today -- with strong demand being met with constrained supply (as an increasing number of communities have made development more difficult as a result of concerns about sprawl and the environment). As a result, unsold inventories of new homes today are near record lows, while existing home inventories are below average -- putting upward pressure on home prices.

Some have argued that home price gains have outstripped income growth, making housing less affordable. These arguments are incorrect for two reasons. First, over the 1990s, median household income growth and home values both increased at a 3.5 percent pace (while disposable personal income growth increased by 5.2 percent) -- so home price gains were no more than income growth over this long-run period. Second, these arguments fail to account for interest rates -- the most important factor in home affordability. Low inflation over the past decade, and a weak economy more recently, are responsible for bringing mortgage rates down and boosting affordability. Today, yields on 30-year fixed-rate mortgages are at or near the lowest levels since the mid-1960s. As a result, affordability is at high levels despite strong home price gains. It is true that home price gains have outpaced income growth over the past couple of years, suggesting that the recent rapid gains in home prices won't continue (unless mortgage rates fall still more). The unsold home inventory situation indicates that home price increases will moderate to be more in line with income growth, however, rather than falling. Over the past two years disposable personal income growth has averaged 4.9 percent.

Some have argued that home price gains have outstripped the general rate of inflation, and therefore they will have to fall to come back into line with the general price level. This argument is also incorrect. There is no necessity for changes in the price of a particular good or service to equal the overall inflation rate -- either in the short run or the long run. For example, personal computer prices have been falling for decades, yet no one expects PC prices to suddenly jump in order to bring PC inflation back into line with overall inflation. Because housing is something that people historically have wanted to spend more on as their wealth and income rise, demand has shifted toward owner-occupied housing and away from other goods and services as the real economy has grown over time. This shift in relative demand has pushed up home prices faster than the average rate of inflation. There is no specific long run relationship between home price inflation and general inflation other than home price gains should continue to outpace general inflation.

Over the long run, strong productivity growth should allow nominal GDP growth (and thus disposable personal income) to grow by 5.5-6.0 percent this decade. This would, in turn, support home price gains in the range of 5.0-5.5 percent with no additional declines in mortgage rates.

While home price gains have been strong in recent years, increases in the strongest markets are less than they were in the late-1980s (the last time home price inflation was very strong). For example, home values in California (those funded by conforming loans) have risen by 11.5 percent over the past two years (compound annual rate) -- compared with an 18.0 percent increase in 1988-90. In Massachusetts, home values are up by 12.0 percent -- versus 23.0 percent in 1985-87.

In regional home price declines, the proximate cause has always been a downturn in the (regional) economy. The recession of 2001 is over (even if economic growth is only modest today) and most analysts expect stronger economic growth in the year ahead than in the previous year -- both nationally and regionally. There are only a handful of states still in recession, and the economic environment should improve for them -- rather than worsen -- over the next year. Moreover, housing demand is expected to continue to grow at a healthy pace over the next decade. This is due to strong demographic and economic drivers led by household growth, baby boomers moving into their peak homeownership years, immigration, low inflation, and strong productivity gains.

While there is little prospect of a national home price decline, there are a handful of markets around the country that are at risk of a drop in home prices. These are areas where home prices have increased sharply in recent years while new supply has grown strongly -- resulting in a rise in unsold inventories of new homes. Weakness in certain employment sectors (e.g., high-tech manufacturing, telecommunications, airlines and aircraft, and hotels/tourism) could pop prices in those markets. Fortunately, the number of at-risk markets appears to be small.

Federal Reserve Board Chairman Alan Greenspan recently said, "The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect ... Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole." When he testified before Congress on July 17, 2002, Greenspan added, "The type of underlying conditions that create bubbles are very difficult to initiate in the housing market. It is not an issue on the table at the moment." Greenspan also added that the diversity of housing markets in the United States and the high transaction costs involved in selling a home made a bubble "most unlikely."

We expect the housing market to slow modestly over the coming year from the record pace of the past year. Moreover, the recent pace of home price gains is unsustainable if mortgage rates don't continue to decline (which we do not expect). These points do not lead to the conclusion that home prices will drop. Instead, home price gains are likely to slow over the next few years -- but continued strong income growth, strong underlying housing demand, and continued supply restraints on new housing will keep prices moving upward (probably in the range of 4.0-5.5 percent).

Consider the Source

http://www.fanniemae.com/ir/issues/creditrisk/082302.jhtml?s=Current+Issues&t=Credit+Risk+Manage...