San Francisco home
Jeff Chiu  /  AP file
A home for sale in San Francisco, considered one of the least affordable housing markets in the nation. The median price for a home in the San Francisco Bay area is currently about $689,000, up 35 percent since 2002.
By Martin Wolk
msnbc.com
updated 7/11/2005 5:02:58 PM ET 2005-07-11T21:02:58

When we first began writing about the possibility of a housing bubble nearly three years ago, economists who sketched a grim scenario of downward spiraling prices largely were dismissed as overly pessimistic cranks.

So far, their harsh projections have failed to materialize. But even the most optimistic housing industry boosters are beginning to worry, to wonder and to wish out loud for a cooling-off period.

There are growing signs that federal regulators would like to rein in some of the worst excesses of the current boom, including the increasing dependence on interest-only loans and other non-traditional lending products that can leave borrowers overextended, especially if interest rates rise or housing values drop.

What's all the fuss about? Consider:

  • In California, the median price for an existing home has surged past $500,000 to the current $523,000, double the $262,000 median of just four years ago. In the hottest markets near the California coast, where two-bedroom cottages often go for more than $600,000, the asking price is often little more than a starting point for a bidding war. Nationally, home prices rose 12.5 percent over the past year, according to the most reliable federal figures.
  • A study by the National Association of Realtors found that more than 35 percent of all home sales were for investment purposes or as second homes. And even with fixed mortgage rates near 40-year lows, more than one-third of borrowers took out adjustable-rate mortgages last year.
  • Ten states and the District of Columbia have seen prices rise more than 70 percent over the past five years, and prices have more than doubled in 23 markets in California, Florida and Massachusetts, according to federal figures. In the same time frame, ordinary consumer prices have risen just 13 percent, and personal income has risen 23 percent.
  • A cover story in the Economist magazine this month calls the global rise in housing prices “the biggest bubble in history” and warns of economic pain to follow. Declining prices in formerly red-hot markets of Britain and Australia offer a cautionary tale for what could happen in the United States, the magazine's editors argue.

Federal Reserve Chairman Alan Greenspan, who as recently as last year dismissed talk of a speculative housing bubble, now acknowledges that there are “a lot of local bubbles” in the housing market, although he sees nothing along the lines of a NASDAQ-type asset bubble that could deflate suddenly with national economic consequences.

In May, the Fed and four other regulatory agencies issued an unusual joint statement, warning that financial institutions  “may not be fully recognizing the risk” inherent in aggressive lending secured by rapidly rising home values. These home equity loans and cash-out refinancing deals have been a major engine for consumer spending in an economy characterized by relatively slow job and income growth.

Regulators are working on additional guidelines for non-traditional loans issued by primary mortgage lenders, a spokesman for the Federal Deposit Insurance Corp. said.

The proliferation of interest-only, "negative amortization" and various hybrid loan products is capturing the attention of regulators because they rely heavily on rapidly increasing home values and appeal to buyers who otherwise would not be able to afford a home.

Because borrowers who get these loans pay no principal — and often put little or no money down — they easily could find themselves "underwater" if home prices decline, meaning they owe the bank more than the home is worth.

Richard Brown, chief economist for the FDIC, said he worries that the easy availability of such mortgages is contributing to the rapid rise in housing prices.

“The broadening (of the housing boom) in 2004 was remarkable and pretty unprecedented,” said Brown, "It does add some concerns if credit conditions are pushing prices up.”

A study by the FDIC, which insures bank deposits, found that inflation-adjusted housing prices rose by 30 percent from 2001 to 2004 in 55 metropolitan markets. That was up from 33 markets in the 2000-2003 period.

History argues that market busts are fairly rare and generally caused by local economic distress, Brown said. But he acknowledges that history “may not be a perfect guide” this time around, in part because of the proliferation of what Greenspan has described as “exotic” loan options.

The banking sector is in far better shape than it was when at the time of the savings and loan crisis in the 1980s, and so far loan loss rates have remained extremely low. Only about 1 percent of mortgage loans are currently in foreclosure, according to the Mortgage Bankers Association, a rate that has fallen slightly over the past year.

The concern is that loan losses could rise if home prices level off or even decline, and that aggressive interest-only loans could create a vicious cycle of declining prices as homeowners scramble to get their equity out before a foreclosure.

“I think the case is circumstantial but it’s well accepted there is a link” between rising housing prices and non-traditional lending practices, Brown said. “Certainly some households could be using those innovative credit structures to qualify for homes that they really can't afford. For those households there could be a day of reckoning down the road.”

While there is growing concern about housing prices, there is little agreement on precisely what would happen if the air were to come out of the bubble. But the term "bubble" probably is an unfortunate choice, because a housing bust would bear little resemblance to the collapse of the dot-com bubble several years ago, which saw many stocks lose 90 percent or more of their value.

"It is a bubble, and it will pop but it’s not prices that pop — it’s market activity that pops," said Christopher Thornberg, an economist at UCLA's Anderson business school. "Prices just go down glacially, but market transactions collapse."

Thornberg speculated that housing prices in a typically overheated market could go down 20 percent for two years and then rise slowly, by 5 percent a year. Or prices could stay flat for six years. In either case, inflation-adjusted housing values would be far lower in six years than they are today.

If the prospect of flat housing prices seems insignificant compared to a stock market bust, consider the range of industries that would be affected by a slowdown in housing activity, including construction workers, material suppliers, brokers and mortgage bankers. All told, the industry accounts for about 16 percent of the nation's economic activity. And that is not counting the billions of dollars spent on furniture, appliances, paint and carpeting in the first few years after a home is purchased.

In addition, when the rise value of homes is translated into consumer spending fairly quickly through a well-known "wealth effect." For every dollar of increased value, homeowners spend about 5.5 cents that they otherwise would not have spent, according to one recent study. That translates to $1,100 in spending on a home that rises in value by $20,000.

"You don’t have to have prices fall for the wealth effect to have a bite," said Thornberg, of UCLA. "If houses stop appreciating, then that consumer spending goes away. The very process of prices going flat is sufficient to have a real impact."

Ethan Harris, chief U.S. economist at Lehman Bros., agrees that even a regional bust in the most overheated markets could slow the nation’s economy.

“I don’t think it requires that prices fall nationally,” he said in MSNBC.com’s midyear economic roundtable . “I think what is important is that enough major regions experience price declines that it really hurts those local economies and then it filters into the national economy.”

“We’ve never had this kind of leverage in the housing sector,” he said. “It’s very hard to know what the other side of the bubble is going to look like, but we certainly should be on the alert for uglier scenarios."

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