“SOME artefact or some development, seemingly new and desirable — tulips in Holland, gold in Louisiana, real estate in Florida . . . captures the financial mind. The price of the object of speculation goes up . . . This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted . . .” So wrote the economist John Kenneth Galbraith in his Short History of Financial Euphoria.
Many observers worry that those words describe America’s housing market. Stories of people buying condominiums in the morning and selling them at a substantial profit later in the day enliven the financial press. Cocktail parties are made merrier by the game of “whose-house-has-increased-the-most-in-value”. Are we witnessing the final stages of a house-price bubble?
Well, maybe not. Perhaps we are seeing only “a little froth in the market”, to borrow the phrase used by Alan Greenspan, the Federal Reserve Board chairman, in his recent speech to the Economic Club of New York.
The man who is famous for saying that “if anyone understands what I am saying, I must have mis-spoken”, handed down this model of clarity: “Without calling the overall national issue a bubble, it’s pretty clear that it’s an unsustainable underlying pattern.” Froth, it seems, consists of “a lot of local bubbles”. Meaning that in some areas house prices will come down, but there will be no nationwide collapse.
So spoke the man who finds it a “conundrum” that his repeated increases in short-term interest rates have failed to prevent rates on 30-year mortgages from falling from 6.3% to 5.71% in the past year. Or to cool what everyone is now calling a “red-hot housing market”.
Last month, sales of existing homes rose by 4.5%, and single-family homes commanded a median price of $206,800 (£113,600), a jump of 15% in the past year. That’s the fastest rate at which prices have increased since 1979.
New homes are also selling at a torrid pace. Sales in April were 13.3% higher than last year and the median price rose by 3.8%. Little wonder that builders increased privately owned housing starts by 11% in April compared with March, and stepped up their applications for permits.
What worries some analysts is not only the speed with which prices have been rising, but the way in which Americans have suddenly begun financing their purchases. Until recently, the typical buyer sought a fixed-rate 30-year mortgage that set total monthly payments at an unchanging, predictable and affordable level.
But times have changed. More Americans — two-thirds of new buyers, by one estimate — are opting for variable-rate mortgages or choosing to pay only the interest in the early years, leaving repayment of the loan till later.
This stores up two kinds of trouble. First, if interest rates rise, so will the monthly payments. Second, after five years, the borrower must start to repay the principal, which just about doubles his monthly payments. Unless, of course, an increase in his house’s value allows him to obtain a new interest-only mortgage.
More worrying to those who see a bubble in America’s future is the willingness of homeowners who have built up equity in their homes to borrow against that equity, either to finance a spending spree or to invest in more property. Economy.com estimates that Americans borrowed $705 billion against their homes last year, compared with $266 billion in 1999.
But before deciding that America’s housing market is another example of the bubbles scattered through history — tulip bulbs in the 17th century, John Law’s Louisiana land scheme and the South Sea bubble in the 18th century, share prices in America in 1929 — consider this. House prices have not fallen in any year since the Great Depression.
There is a reason for this. Despite the emergence of some investors who have become the equivalent of day-traders in shares, most homeowners live in the properties they buy.
When prices ease, there is no mass dash for the exit, as with tulips and shares. So a fall in prices does not result in a sudden increase of the supply on the market.
Furthermore, and despite an increased flow of funds into markets by investors rather than by occupiers, many property markets are local.
A fall in the market for Florida condominiums, where speculators are active, need not affect house prices in rapidly growing Nevada. And hard times for investment bankers have in the past caused a lull in the upward movement of prices in New York without affecting property values in Phoenix, Arizona.
Perhaps most important is the strength of the underlying demand for houses. Newcomers to America are providing a boost to demand at the starter-home level. More affluent Americans are buying second homes. The job market has created new employment for 23 months in succession and, equally important, worker income rose at an annual rate of 6.9% in the first quarter.
Does this mean that perpetual double-digit increases in prices are assured? Certainly not. Does it mean prices might never decline? Of course not: they will go down when mortgage rates rise significantly. Will some homeowners who are over-extended find themselves in financial difficulty and face foreclosure? Very likely.
But for most homeowners, a decline in the value of their homes would only reduce the gains they have made since purchase, and perhaps make them rein in their borrowing as they feel less rich.
They will still have the same place in which to live, and if they plan to trade up, or down, will find that although they may get less for their house, they will pay less for the house they buy.
In short, there is life even after a bubble. After all, the dotcom bubble burst, but we still have the internet.
Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute
