Part II
CONTINUED
Of course, this is all an extreme generalization. Adjustable and interest-only mortgages, as they become a bigger part of the mix, increase the supply of cheap money and drive up prices even faster, for example. Demographic trends increase prices faster than average in areas with more jobs, for example, or where cheap land lets builders construct new housing for the country's growing population of retired (or semiretired) workers.
But you get the idea: cheap money drives up housing prices.
Reverse the process and you get the logic of bursting bubbles. If interest rates rise, putting an end to the supply of cheap money, prices will fall. If the fall in prices gathers enough speed, the bubble will not simply gradually deflate but, instead, pop all at once.
Based on past history, at least, a modest rise in mortgage rates won't do the trick. Average interest rates for a 30-year fixed mortgage rose to 6.3% in May 2004 from 5.5% in May 2003 without sending housing prices sliding quickly lower. Based on the projections from the National Association of Home Builders, a future climb in mortgage rates from 5.8% in 2004 to 6.6% in 2006 wouldn't have a huge effect on sales of either new or existing homes. As mortgage rates climbed 0.8 percentage points, new-home sales would fall by 6.5% from 2004 to 2006, and sales of existing homes would decline by 5%. At worst, that's air gently escaping from any housing bubble.
And if you want a glimpse of what today's lower rates might do to the housing market if they're sustained for a year, take a look at the projections released by the National Association of Realtors on June 8. The group's economists now expect existing-home sales to climb 3% from 2004 and new-home sales to rise 2%. Total home sales will hit a record 8.13 million in 2005, up 2% from 2004, thanks to the current low mortgage rates. Back in February, when it looked like mortgage rates would go higher instead of lower, the group projected a 2% decline in existing-home sales in 2005 and a 6% drop in new-home sales.
The role of consumer debt
Of course, these are all just projections, and it might be different this time. In fact, those who see a bubble and predict its bursting, argue strongly that it is. The consumer is more indebted now than when mortgage rates climbed in 2003-2004, and thanks to the heavy use of adjustable rate and interest-only mortgages, home buyers are so stretched that even a relatively slight rise in interest rates will be enough to create a cascade of mortgage defaults.
It's certainly true that today's consumer is carrying more debt than the consumers of 10 years ago. But thanks to low interest rates, the monthly burden of that debt is remarkably unchanged over the last few years. The Federal Reserve's DSR ratio, which measures the ratio of disposable income to total mortgage and consumer debt, stood at 11.17 in the fourth quarter of 1994 and at 13.26 in the fourth quarter of 2004. That's an almost 20% increase in the weight of the average family's monthly debt payments in 10 years. But the ratio has been remarkably stable since 2001 and actually shows a slight decline from 13.3 in the fourth quarter of 2001.
To make that monthly debt burden onerous enough to trigger a burst in a housing bubble, you have to look for a big drop in family income so that while monthly debt payments remain the same, they take up a bigger chunk of a diminished family income. That would require not just a further slowdown in economic growth, but an actual recession. Although I think growth will continue to slow this year, I don't think a national recession is in the cards in 2005 or even 2006.
The other trigger would be a big increase in interest rates that would push the monthly debt burden up on average and would strike especially hard at those home buyers who used an adjustable or no-interest mortgage to buy more house than they could really afford.
And that too, oddly, doesn't look like it's in the cards in 2005 for interest rates for 10-year Treasury notes, the part of the bond market that mortgage rates pay attention to. Nobody knows exactly why, but despite eight interest-rate increases that have taken the short-term rate target of the Federal Reserve to 3% now from 1% in June 2004, the yield on the 10-year Treasury has actually tumbled to 3.9% today from 4.7% in June 2004.
Since no one, including Fed chairman Alan Greenspan (who refers to the decline in 10-year yields as a "conundrum") knows why interest rates are behaving this way, it's tough to predict where 10-year rates will be in a year or two. History, however, does show that interest rates usually don't rise when economic growth slows. So if we're headed into even a modest slowdown in growth in 2005 and 2006 from 2004 levels in the United States, Europe and Asia, as now looks likely, then interest rates are unlikely to rise for the 10-year Treasury note in that time period.
Look for refinancing fever -- again
What to me looks most likely to happen now, and I readily admit I didn't expect this in 2005, is another outburst of refinancing fever. At 5.1%, the lowest rates on 30-year fixed mortgages are now about a full percentage point below the average rate on outstanding mortgages. That's a level that, in the past, has produced a wave of refinancing as homeowners figure that the drop in their monthly payments -- about $720 a year on a $100,000 30-year fixed-rate mortgage -- more than offsets the costs and hassle of refinancing.
A refinancing wave, or even a wavelet, would put off any day of reckoning in the real estate market even further.
None of this means that the housing market can go up forever, or that we won't have a day of reckoning someday. And I think any sensible person should use the current drop in interest rates as an opportunity to get his or her own financial house in order. It would be unwise to expect that another, and then another, of these refinancing opportunities will come along in the future.
It's just that those who are predicting a housing bubble and its bursting may have much longer to wait than they expect right now.