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|  | Riccardo Sorrentino, born in 1964, has worked at Il Sole-24 Ore since 1992. In the past years, he has attended several international summits, including the Palermo G-7 of Finance Ministers and Central Bankers in 2001, and the WTO conferences of Cancun (2003) and Hong Kong (2005) and he has covered several G-10 central bank meetings at the BIS and ECB press conferences. As a special correspondent, he has been in The Netherlands; in the US; in Iceland, in Hungary, in Singapore, in Indonesia, in India, in Norway, in Thailand, in Pakistan, in Armenia. In the 2003-2004 winter and in the 2006 summer, he worked at Il Sole 24 Ore's North American bureau in New York. |
| | riccardo.sorrentino@ilsole24ore.com |
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| If the Fed says: there is not a housing bubble |
| October 25, 2007 |
There has been a housing bubble in United States? After the subprime crisis, burst when home prices stopped rallying, the Federal Reserve says: maybe, but there are some doubts. In the past, when prices were going up very quickly, it was silent or argued: there is no speculative mania, everything is ok, in line with fundamentals.
FEAR...
In 2003 many economists put everybody on the alert: there is a bubble or, better, many local housing bubbles in many States or cities. «The popular press is full of speculation that we are in a "housing bubble" that is about to burst. Barrons, Money Magazine and The Economist have all run recent feature stories about the irrational runup in prices and the potential for a crash in home prices. The Economist has had a series of articles with titles like "Castles in Hot Air" "House of Cards" "Bubble Trouble," "Betting the House." These accounts have necessarily raised a lot of concerns among the general public. But, how do we know if the housing market is in a bubble?», asked Karl E. Case at Wellesley College and Robert J. Shiller at Yale University.
...AND REASON
In order to answer this question, their paper ("Is There a Bubble in the Housing Market? An Analysis") used many tools, including surveys, and reached an important conclusion: «Clearly, one can construct an argument that home price increases nationally since 1995 have been driven by fundamentals. For more than 40 states, income growth alone explains virtually all housing price increases, and falling interest rates have reduced financing cost sufficiently to keep the ratio of annual mortgage payments to income from rising even in the boom states of Massachusetts and California. In the vast majority of states housing is actually more affordable that was the case in 1995. Nonetheless, our analysis indicates that there are elements of a speculative bubble in single family home prices in some cities: the strong investment motive, the high expectations for future price increases and the strong word of mouth». After that paper, home prices went up more and more, and many economists went on to warn the risks of a housing bubble.
GREENSPAN'S FROTH
The Fed tried, instead, to reassure markets: Alan Greenspan spoke about a froth in housing market, and nothing more. In 2004 the chairman argued even that a "speculative mania" on houses is a very unlikely development: «Housing price bubbles presuppose an ability of market participants to trade properties as they speculate about the future. But upon sale of a house, homeowners must move and live elsewhere. This necessity, as well as large transaction costs, are significant impediments to speculative trading and an important restraint on the development of price bubbles», he said on October 24th, 2004. Did he forget the bubbles in the 70s and in the early 80s?
GLOCAL SPECULATIONS
In the same occasion, Greenspan admitted the link between a loose monetary policy and higher home prices. Even so - and interest rates were very low at that moment - his views were quite optimistic. «We can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of homebuilding and home turnover and the steep climb in home prices. Indeed, home prices have been rising sharply in many countries around the world. In the United States, signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels. It is still too early to judge whether the froth will become evident on a widening geographic scale, or whether recent indications of some easing of speculative pressures signal the onset of a moderating trend. The housing market in the United States is quite heterogeneous, and it does not facilitate the easy diffusion of local excesses». The message was: monitor the housing sector developments, but don't worry.
IN LINE WITH FUNDAMENTALS
It wasn't a simply policy statement aimed to forge expectations. The team of economists at Federal Reserve argued in a scientific fashion, that there was not a bubble, and that the price upsurge was in line with fundamentals. In research written in 2006 Jonas D. N. Fisher and Saad Quayyum, both at the Federal Reserve Bank of Chicago, said that their «findings point toward the high prices being driven by fundamentals».
ABSOLVED
The two economists began with a question mark: «Monetary policy has been traditionally viewed as having a strong influence over new home construction. Have the high levels of residential investment been driven by unusually loose monetary policy?» According their analysis, the answer is no, even if «residential investment is particularly sensitive to a monetary policy shock».
A TECHNOLOGICAL PROCESS?
Another factor - they wrote - was more important: «High rates of technological progress» in the economy as a whole and in the financial sector. «The dramatic rise in residential investment and homeownership - they wrote - has coincided with equally dramatic developments in the mortgage market. Over the past ten years to 15 years, the mortgage market has developed substantially in four areas. First, technological progress has reduced the cost of approving a mortgage under a standardized set of lending guidelines, in part by allowing more precise measurement of a borrower's credit risk. Second, mirroring developments in financial markets more generally, many new kinds of mortgages have become available. Third, the secondary mortgage market has grown and matured so that many kinds of mortgages can now be packaged and sold as mortgage-backed securities. Fourth, the mortgage market has become more specialized, as firms concentrate on different pieces of the market, including origination, servicing, and securitization». The second development, namely the «new kinds of mortgages [THAT]have become available», is the most important for supporting their argument.
SIGN OF A BUBBLE...
More important is, maybe, a research written in December 2004 and updated one year later by Jonathan McCarthy and Richard W. Peach, both at the Federal Reserve Bank of New York. The results are striking. «The median home prices, based on the OFHEO (the Office of Federal Housing Enterprise Oversight) index, is now about three times median household income, surpassing the previous peak in the late 1970s and early 1980s, when there were arguably a bubble in the housing market», wrote the authors who, speaking about the rent-to price ratio - the equivalent of the dividend-to-price ratio for a stock in a company, added that «this homeowner's ratio reached an historic low. The last time the ratio fell below its long-run average - the late 1980s - real home prices subsequently declined significantly».
... MAYBE NOT
There was a bubble, therefore. No, argued McCarthy and Peach, «these measure [the median home prices and the rent-to-price ratio] have flaws that call into question these conclusions». Why? Because «neither measures takes interest rates into account». According to the two economists, low interest rates, which actually were the cause of the bubble, changed the fundamentals in such a way that they could conclude: «There is no bubble». Lower the rates - their argument goes - higher are the "equilibrium" home prices. Lower the rates - says instead the common sense in economics - higher the prices and the probabilities to inflate a bubble: «Home prices have risen - actually wrote McCarthy and Peach - in line with declines in mortgage interest rates and increases in median family income. Both of these conclusions argue against the existence of a home price bubble». Both? Really?
WHAT IS A "SPECULATIVE MANIA"
This research is even more interesting because it reminds a scientific definition of bubble. It is from Joseph Stiglitz and its existence negates an argument always subscribed by the Federal reserve: «It is very hard for monetary authorities - argues for instance Frederic Mishkin, member of the Federal reserve board - to identify that a bubble has actually developed. To assume that they can is to assume that the monetary authorities have better information and predictive ability than the private sector. If the central bank has no informational advantage, then if it knows that a bubble has developed that will eventually crash, then the market knows this too and then the bubble would unravel and thus would be unlikely to develop». Very self-serving... But a scientific definition of bubble exists: «If the reason the price is high today - wrote instead Joseph Stiglitz - is only because investors believe that the selling price will be high tomorrow - when "fundamental" factors do not seem to justify such a price - then a bubble exists».
THE ROLE OF EXPECTATIONS
So McCarthy e Peach tried to demonstrate that «the current housing market is not characterized by widespread expectations of rapid future price appreciation», using the same approach adopted to explain why prices were in line with fundamentals. And, naturally, they succeed. Still the real world was different. In «Money for Nothing and Checks for Free», John Kiff and Paul Mills, both at the International Monetary Fund, wrote that «Recent subprime lending growth was boosted by more highly leveraged lending against a background of rapidly rising house prices» adding that «speculative borrowers obtained loans on the basis of expected collateral appreciation [italics added] with little account taken of their ability to make the requisite mortgage payments».
EVERYTHING OK
The final remarks, in McCarthy and Peach's paper, were consistent with its assumptions: «It appears that home prices have risen in line with increases in personal income and declines in nominal interest rates». So everything was ok? Yes, was the answer: the housing market is very segmented: «While prices have risen much faster recently for some states than for the nation, the supply of housing in those states appears to be inelastic, making prices there volatile». Even this «volatility at the state level is the result of changing fundamentals rather than regional bubbles». And «if the past is any guide, however, that phenomenon is unlikely to plunge the U.S. economy into a recession».
ONE YEAR LATER...
Even more surprising was the update of that paper. «Since the completion of [THE PREVIOUS] study, home price indices, particularly the commonly-used OFHEO repeat sales index, have risen at even faster rates than they did in the 1995-2003 period. For those analysts that were convinced there was a bubble at the time of our earlier study, the recent sharp rise indicates that prices are even more out of line with fundamentals. Moreover, the rise has prompted other analysts to become convinced that there may be a bubble».
Only 300%...
In their new paper McCarthy and Peach compared several home prices indexes: «Even though there are noticeable differences in their short- and medium-term behaviour - they explained - the two median sales price series and the two repeat sales indices have behave quite similarly over the 1979-2005 period as all of these have risen about 400 percent». But, they warned: «In contrast, the constant-quality index, which uses hedonic methods to control for changing quality, has risen only about 300 percent during this period, and the gap between it and the other indices has widened considerably over recent years». Only 300 per cent, but it is nevertheless a strong growth.
NEW SIGNS...
The two economists went even further: «The rent-price ratio - they wrote - has fallen steadily since 2000, with particularly steep drops in the past two years. Its current level is well below its historic levels. This would indicate that prices are considerably out of line with rents, which would be consistent with a bubble in the housing market and would suggest home prices may decline in the future».
...MISLEADING
Obviously, even those indicators were «misleading». Applying the same approach used in the 2004 paper, the two economists concluded that there was «little evidence to support the existence of a national home price bubble, as prices have yet to rise out of line with fundamentals. Even so, with the strong rise in home prices, the current level of home prices is more expensive relative to fundamentals than they were just a couple of years ago». Again the same message: monitor, but don't worry.
ANOTHER BUBBLE?
Still there is a very strange caveat in this paper: «Of course, this conclusion is reliant on interest rate remaining low: if for some reason long-term interest rates rise significantly, e.g., because there is a bubble in bond markets as some have argued, then it would be harder to justify current home prices based on fundamentals». What assumption!... So, let's hope there is no bubble on the Bond market: today the policy rate, an overnight, is at 4,75% and yields on 10-years T-Bond - normally higher than Fed Funds rates - are at 4,32%. Who knows? But don't ask the Federal Reserve: in the past it was a conundrum or the effect a saving glut and now... maybe just expectations. |
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