Friday, February 18, 2005

Greenspan And His Bubble

Dan Ackman

With Alan Greenspan in the witness chair yesterday, U.S. Rep. Scott Garrett, R-N.J., took the opportunity to ask the Federal Reserve chairman for some personal financial advice. Garrett told Greenspan he is buying a house in Washington, D.C., one of many areas on the East and West coasts where home prices have skyrocketed well past any increase in home-buyer incomes.

"The bubble is about to burst as soon as I buy my house down here," Garrett complained to the Fed chairman, as quoted in The Washington Times. Greenspan didn't address Garrett's particular situation, but he did offer some reassurance, albeit qualified, that if there is a housing bubble, and if it does burst, it would cause no great harm.

"I think we're running into certain problems in certain localized areas. We do have characteristics of bubbles in certain areas but not, as best I can judge, nationwide," Greenspan told the House Financial Services Committee. He added: "I don't expect that we will run into anything resembling a collapsing bubble," though it's "conceivable that we will get some reduction in overall prices as we've had in the past, but that is not a particular problem."

Of course, the Fed chairman cannot be expected to sound loud alarms. He is by nature a soothsayer. The question is, should his words be taken as a warning--and was that warning loud enough?

The numbers are fairly dramatic, even nationwide. In the last year, home buyers paid 9% more for the average existing home and 11% more for the average new home than they would have paid one year earlier, according to a report by David Kelly, an economist for Putnam. The demand spurred builders into starting 1.95 million new housing

units, up 5% from a booming 2003. In all, the number of homes being constructed in the United States is increasing at nearly twice the rate as the number of households. At the same time, the share prices of home builders like Toll Brothers (nyse: TOL - news - people ), Centex (nyse: CTX - news - people ), D.R. Horton (nyse: DHI - news - people ) and Pulte Homes (nyse: PHM - news - people ) are all up by 25% to 100% in the last six months.

While the price increases nationally are fast enough, in many areas home price inflation is running at two or three times the national rate, according to a recent report by the National Association of Realtors. In certain regions, prices have doubled in the past five years, particularly up and down the East Coast, in Las Vegas and in California. Kelly adds, "In these areas, there are many anecdotal accounts of people buying properties just to flip them, buying housing with virtually no money down, or using interest-only or negative amortization loans."

While Greenspan calls the bubble a localized phenomenon, the localities tend to be the largest in the country, such as southern California, New York, Massachusetts and the particularly overheated Las Vegas market. "It's not as if there's a bubble in Des Moines, Iowa," says Peter Schiff, a financial adviser for Euro-Pacific Capital and a persistent critic of the Fed chairman.

The question Garrett and many others want answered: Is a sharp decline in home prices inevitable, or will the prices flatten or just keep rising?

Here the chairman was cryptic. "Remember that there's a very significant buffer in home equities at this stage," he said. Most home buyers have put down deposits of 20%; they can weather a potential drop in home values, Greenspan implied. Even for home buyers who put nothing down, the recent price surges will offer a cushion against decline, he suggested. He added, though, that some home buyers, perhaps 20% of the total, face some real risk.

Kelly agrees that most home owners are fairly safe, especially those who bought their homes with the intention of living there for awhile. He does point out that there is a substantial minority of home buyers who have bought for speculative reasons, and he compares some of the housing market to the not-too-long-ago market for Internet stocks. "Irrational exuberance has not gone away, it's just wearing a different coat."

Schiff thinks the chairman is sugarcoating the story. He points out that home-mortgage borrowing has nearly tripled nationwide since 2000, which is even faster than the increase in home purchases or house prices. Despite the rise in short-term interest rates, mortgage rates are still near historic lows. Rental vacancies are at just over 10%--that's as high as they have ever been since the Census Bureau started measuring the phenomenon in the 1950s.

In short, to answer Garrett's question, Kelly would tell the congressman to consider his political future, and if he's a D.C. lifer, perhaps he should buy that house. Schiff, on the other hand, would say, don't do it; but if you must do it, avoid adjustable-rate mortgages, and make sure your debt payments are fixed.