On May 2, the Federal Deposit Insurance Corporation released a report title
US Home Prices: Does Bust Always Follow Boom? The report studied the real estate market, and concluded we are experiencing a real estate bubble, but the possibility of a hard bust cycle may be overblown. However,
there may be sufficient differencies between this boom and previous booms to warrant an additional level of caution.
Let me spare you the suspense and show the conclusion up front.
Mortgage lenders and borrowers encountered a great deal more distress in the 21 episodes of U.S. metro-area housing busts identified between 1978 and 1998. Fortunately,
based on the criteria we use to define a housing bust, such an outcome can be characterized as relatively rare. In fact, only 17 percent of the housing booms identified during this period led to a subsequent bust, and where busts occurred they were typically preceded by significant distress in the local economy. To the extent that local factors continue to determine home price trends, the expectation would be that metro-area home price busts will continue to be relatively rare.
However, the broadening of the U.S. housing boom during 2004 may imply a growing role for national factors-including mortgage credit conditions-in explaining recent home price trends. More research is needed to establish exactly what role, if any, changes in the cost and availability of mortgage credit played in the expansion of the U.S. housing boom in 2004. But to the extent that credit conditions are driving home price trends, the implication would be that a reversal in mortgage market conditions-where interest rates rise and lenders tighten their standards-could contribute to an end of the housing boom. While our analysis shows that boom does not necessarily lead to bust, it remains to be seen to what degree the current situation might differ from our previous experience in U.S. housing markets.
The report defined a "boom period" as "as one in which inflation-adjusted prices rose by at least 30 percent in a three-year period and a "bust period" as "markets in which home prices had declined by at least 15 percent (in nominal terms) over a five-year span." I should note that definitions such as these are by definition arbitrary. Based on different criteria, the results would obviously be very different. But, these numbers appear to me to be pretty fair.
The report continues, by noting "Based on this definition, some 63 cities had experienced a boom at some point in the last 30 years, and 33 cities were experiencing a boom as of the end of 2003...While 21 housing busts have occurred since 1978 under this definition, only nine of them have occurred on the heels of a housing boom."
So far so good. These figures indicate that concern over the current situation is warranted, but should not lead to mass panic and alarmist rhetoric.
But, there are some disturbing trends to the current boom that may make it different from previous booms.
The first primary difference is the use of new, non-traditional mortgage products such as high debt-equity loans and interest only loans. A high debt-equity loan involves the little initial capital from the purchaser, who instead relies almost exclusively on debt financing to purchase the home. With an interest only loan, the purchaser only pays interest. A traditional mortgage payment comprises a percentage of interest and a percentage of principal with each payment. This is how the homeowner starts to build equity -- his own personal interest or ownership in the home. Interest only loans accounted for 23% of non-agency mortgage securitizations in 2004. In addtion, these loans are increasingly used for high-risk borrowers.
The second change is the increased use of ARMS or adjustable rate mortgages. The report notes: "According to the Mortgage Bankers Association, ARMs accounted for almost 46 percent of the value of new mortgages in 2004 and 32 percent of all applications. Both figures were up sharply from their 2003 levels of 29 percent and 19 percent, respectively...Furthermore, data from the Federal Housing Finance Board indicate that the ARM share is high and rising in several of our boom markets. Taken together, these trends suggest that highly-leveraged borrowers are increasingly taking on interest-rate risk as they stretch to afford high-cost housing....A large share of ARMs originated in recent years featured initial fixed-rate periods that could last up to ten years."
These comments on the ARMs market lead to 3 conclusions. First, the initial indexing feature could ameliorate the effects of an interest rate spike should an economic shock hit the US economy. Secondly, the effects ARM loans could be long-lasting, depending on the number of indexing loans used. Homeowners could experience financial difficulty if their indexing period is 10 years and the US experiences an interest rate spike in 11 years. Third, the increased use of ARMs at a time when fixed mortgage financing is still fairly cheap by historical standards may indicate lenders are counting on the rising income stream from ARMs to offset a loss of income from a large number of fixed mortgages in a rising rate environment. If a lender has all of his loans at 6%, and the prevailing rate rises to 8%, the lender is losing 200 basis points of income. However, if the lender's outstanding loans are indexed to rates, the lender's income rises with rates.
The final change the report notes is the new effect national factors are having in the real estate market. In previous expansions, booms were primarily caused by local factors such as a new industry developing or an area suddenly becoming more attractive causing migration. However, the report notes "The number of individual markets that met the boom criteria increased by 72 percent in 2004, to 55 metro areas."
In conclusion, there is a low probability the current boom cycle in real estate will be followed by a bust. However, there are sufficient new factors in this cycle to separate this cycle from previous booms.
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