Friday, December 17, 2004

Housing bubble is real, report says

Bank predicts a 'hard landing' by mid-2005. And regulators say too many homeowners are cashing out their equity to play the market.

By Reuters/MSNBC

Economists at HSBC have waded into the debate over whether the U.S. housing market is overinflated, declaring a bubble exists, something the Federal Reserve has long been reluctant to do.

Only days after the Federal Reserve Bank of New York said there was little evidence of a nationwide housing bubble, HSBC, a giant bank and financial services company, issued its assessment of the situation with a report titled, "The U.S. Housing Bubble -- The case for a home-brewed hangover." The bank insists that a bubble exists and prices are likely to deflate gradually over a few years, triggered by Federal Reserve interest rate rises.

"This bubble-psychology has manifested itself in very rich valuations,'' HSBC chief U.S. economist Ian Morris wrote.

House prices relative to income, rent, replacement-cost and home-equity have all set new highs, Morris said.

"Expectations of future house price appreciation are spectacularly, and unrealistically, high,'' he said.

The debate over whether a housing bubble exists has raged in recent years as prices have surged. But the Federal Reserve has often said it does not see a bubble.

Over the four years to the first quarter of 2004, official figures show house prices rose 33% nationally. Over the same period, prices in Washington, D.C., were up 70%, in California 60% and in New York and Florida 50%.

Cashing out to play the market
If anything, the trend has sped up. The Office of Federal Housing Enterprise and Oversight reported that prices as of Sept. 30 were 13% higher than a year earlier. Just weeks later, though, Federal Reserve Chairman Alan Greenspan sought to reassure lenders that the ride wasn't over.

"Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities," Greenspan told America's Community Bankers.

Stock brokers are apparently reaching out, too. Wednesday, the regulatory agency NASD warned that too many house-rich Americans are borrowing money against their homes to play the stock market.

In an alert to brokers who may be encouraging the trend, the NASD reminded Wall Street that it has a responsibility to steer investors away from unsuitable financial strategies.

About 11% of gains from mortgage refinancings were plowed into the stock market and other financial investments in 2001 through mid-2002, up from less than 2% in 1998 through mid-1999, a recent Federal Reserve study showed.

A hard landing ahead
The New York Fed has said the decline in interest rates in recent years justified the price increases.

Its 12-page Fed said the rapid increase in home prices was itself not evidence of a bubble. "Rather, it appears that home prices have risen in line with increases in personal income and declines in nominal interest rates,'' it said.

Some economists worry that the run-up in housing prices in recent years has created a bubble similar to the stock market excesses of the late 1990s and could jeopardize the entire U.S. economy if prices fall sharply.

The 47-page HSBC report, issued in late June, said a "hard landing'' is typical after a housing bust because the wealth effects -- which can affect consumer spending -- from real estate are more powerful than from stocks.

"Prices are 10 to 20% too high and can overshoot on the way down,'' HSBC's Morris said, most likely deflating gradually over a few years rather than crashing like stocks.

"We think the party stops by mid-2005. A series of rate hikes will cause a reassessment of likely future house price risks and its associated debt, thereby triggering housing's fall.''

Morris said that as the hangover hits around the middle of next year, he expects relief in the form of renewed Fed easing will be required.

Much of the difference in how HSBC views the run-up in prices compared with the Fed's assessment stems from a debate over which price measures are used.

The New York Fed said it was important to adjust for quality improvements due to renovations and extensions. Unfortunately, such a price index does not exist, so the Fed uses a quality-adjusted "new'' home price index.

HSBC's Morris argued that this approach has pitfalls because the existing stock of housing does not improve in quality by anywhere near as much as the improvement in new homes.


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