Tuesday, November 16, 2004

Leaky bubble? : Housing is heading for a fall

By Dr. Irwin Kellner, CBS MarketWatch
Last Update: 10:33 AM ET Nov. 16, 2004

HEMPSTEAD, N.Y. (CBS.MW) -- If Alan Greenspan really believes his rhetoric, housing is headed for a fall.

Time and again, the Fed head has said that fears of a speculative bubble in housing prices were exaggerated. Unlike the stock market, real estate is local, and, besides, most people buy houses to live in them - not to flip them.

Thus the Federal Reserve has not hesitated to double its key short-term lending rate, the federal funds rate, in little more than four months. The Fed wants to keep the overall rate of inflation from accelerating, but doing so runs the risk of deflating the housing bubble.

At the moment, housing remains strong. Short-term rates are still relatively low, while long-term rates have actually fallen a tad since last June.

These low interest rates make housing more affordable, thus increasing demand. In turn, this pushes up home prices, since the housing supply does not respond all that quickly.

In the past five years alone housing prices have nearly doubled in many parts of the country - a much faster jump than the rise in family incomes. This has pushed the ratio of home prices to incomes to record levels.

Going back even further, three decades ago, when home sales were last at today's levels, housing prices generally equaled little more than two years of the average family's income. Today, housing prices in most areas are more like four times median family incomes.

Keep in mind that mortgage rates three decades ago were as much as two points higher than they are today. They also were fixed - not adjustable.

Today, half or more of all new mortgages carry an interest rate that adjusts with market rates. Meanwhile, when homeowners refinance their existing mortgages, they generally assume an adjustable rate as well.

The share of all mortgages that carry an adjustable rate today has risen to about a third.

As long as short-term rates remain below long-term rates and rates in general remain low, the housing market will remain strong and prices firm. But rates are going up, thus putting housing at risk.

Besides the Fed's stated intentions to keep raising short-term interest rates, market rates will be pushed higher by what is shaping up to be a perfect storm of increased demand for funds and reduced supplies.

The federal government's borrowing is increasing because of its soaring budget deficit. And if President Bush has his way and Social Security is privatized, Washington's financing needs will jump even more, since it will need additional funds to pay today's retirees (see my column of Oct. 19).

Meanwhile, Corporate America has concluded that the time has come to lock in the cost of money, so many businesses are converting short-term to long-term debt.

On the supply side, the sinking dollar may well cause foreigners to lose their appetite for Treasury securities. And if China and Japan allow their currencies to float upward, they won't be recycling as many dollars back into the U.S. as they do now.

Rising interest rates will puncture the housing bubble - the only question is when.

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