Phillip Spears  /  Getty Images file
By Martin Wolk
updated 4/12/2004 4:09:36 PM ET 2004-04-12T20:09:36

The government’s report of a surge in hiring last month already has driven up mortgage interest rates, reviving speculation about a national housing bubble that could pop with devastating consequences. But try telling that to Joel Hawk, a real estate agent in San Diego, one of the nation’s hottest housing markets.

A 1,000-square-foot home Hawk recently listed in the city’s rapidly growing Mira Mesa community drew 12 offers on the first day, including 10 above the asking price of $375,000. The house sold for $391,000, he said. A similar home with a pool nearby sold in one day for the asking price of $425,000, he said.

“This market is just so heated -- it is just incredible,” Hawk said. “Buyers have to make decisions on the fly. In the past they had a couple of days to think things through. Today they are much more educated. … They go in with their eyes wide open, and they understand what the market is.”

To skeptics, this is exactly the sort of anecdote that justifies concerns about a home-buying mania comparable to the tech-stock bubble of the late 1990s. In this view, a mortgage rate increase of less than two percentage points could be enough to trigger a downturn in which home values could fall 15 to 20 percent -– far more in overheated coastal metro markets.

“The fact that there has been an unprecedented run-up in home prices over the last eight years creates the possibility for an unprecedented decline in the years ahead -- just as the spurt in the Nasdaq at the end of the ’90s created the basis for its plunge after March of 2000,” said Dean Baker, co-director of the Center for Economic and Policy Research, in an essay on the think tank’s Web site.

Low rates, little inventory
Baker and others have worried publicly for years about the emergence of a housing bubble, but an extraordinary period of low interest rates has allowed the market to defy gravity -– despite the loss of more than 2 million jobs over the past three years.

The median price for an existing home rose to $170,000 in 2003, up 15 percent from just two years earlier. Yet housing actually grew more affordable during that period as the typical mortgage rate fell to 5.74 percent from over 7 percent. The average monthly payment on a median-priced home was 17.8 percent of median family income in 2003, down from 18.4 percent in 2001, according to the National Association of Realtors.

“Right now the markets are working -- the fundamentals are very good in housing,” said David Lereah, chief economist for the Realtors.

He pointed out that nationally there is a little more than four months’ worth of housing inventory on the market, compared with more than nine months’ in 1989-90, the last time the market went bust.

With the economy once again creating jobs, even at a relatively slow pace, many industry experts and economists believe that a soft landing is the most likely scenario for the housing market as a whole. But as mortgage rates rise, nasty price declines could whipsaw some local markets.

“Our own sense is there will be a slowing of price appreciation but no widespread price corrections,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies. “Absent widespread job losses that would essentially force sales, the underlying fundamentals would argue for a sustainable rate of growth.”

Major Market Indices

Retsinas and others have been surprised that home prices have continued to rise at a steady clip through the recent recession and early stages of recovery. A government report issued last month startled many analysts, showing that home prices rose in the fourth quarter at an annualized rate of more than 14 percent, the biggest one-quarter jump in nearly 25 years.

“To me, that was a little bit of a concern,” said Doug Duncan, chief economist for the Mortgage Bankers Association.

For the full year, home prices rose 8 percent on average, with increases seen in all 220 metropolitan areas, ranging from 21 percent in Fresno, Calif., to about 1 percent in Austin, Texas, according to the federal House Price Index.

“I think there are some places where prices will fall,” said Duncan, who believes overheated coastal markets are the most vulnerable.

Other options for buyers
Even though the supply of homes is relatively scarce in many metropolitan areas in the Northeast and West Coast, the situation could turn around quickly if mortgage rates were to rise. The national apartment vacancy rate is at a record 10.2 percent, meaning many would-be home buyers would have plenty of attractive options if  monthly mortgage payments were to become unaffordable.

Still, even if fundamental factors turn against the housing market, home prices rarely decline because homeowners are extremely reluctant to sell at a loss, Retsinas and other experts said. “You don’t day-trade housing,” Retsinas noted.

The more likely result is that sales would slow substantially, as happened in the early 1980s when long-term mortgage rates peaked at 18 percent. Although average home prices continued to rise – at least before adjusting for inflation – sales bottomed out at 2.4 million units in 1982, compared with a record 7.2 million last year.

A slowdown in sales would no doubt be damaging to the economy, affecting a wide range of industries from construction to financial services, but it would not be the same as a bubble deflating the biggest financial asset held by tens of millions of American families.

“People who follow the industry closely are watchful, but I don’t know that anyone is deeply concerned,” said Duncan.

Perhaps the biggest concern is that a sharp increase in delinquencies and foreclosures would force banks to take a harder look at potential buyers and clamp down on lending standards. A cover story in the current Washington Monthly magazine contends that banks have all but abandoned their responsibility to independently verify home values because they are able to eliminate any risk by quickly selling mortgages on the secondary market created by Fannie Mae and Freddie Mac.

“What is going to end this thing is rising interest rates and affordability issues and qualifying questions and concern on the part of banks,” said Ed Leamer, director of the UCLA Anderson Business Forecast.

He said the most likely trigger would be a sharp rise in interest rates caused by Chinese and Japanese investors pulling back from the market for Treasury securities to shore up their own currencies.

“It’s hard to see in 2004, but in 2005 I think there is a substantial risk we are going to have a nationwide macroeconomic problem precipitated by problems in the housing market,” Leamer said.

Needless to say, housing industry officials disagree.

Even after a quarter-point spike in interest rates since the strong employment report April 2, the average 30-year fixed-rate mortgage is still well under 6 percent -- virtually the same place it was a year ago.

David Seiders, chief economist for the National Association of Home Builders, predicts sales will drop only 2 percent this year from last year’s 7.2 million, which was a third straight record year.

“At the moment,” he said, “this feels like a pretty conservative place to be.”

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