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The US housing market is buoyant, but is it a bubble? Contrary to most published opinions, James Ferguson can’t find any compelling evidence that it is.
For some years now US economic growth has appeared persistently strong, inflation has remained curiously subdued and interest rates have been at post-war lows. The result has a been a boom in residential property prices: houses across the nation cost 50% more than they did five years ago, last year alone prices rose 13%, the fastest rate of growth since the 1970s, and housing starts rose 4.7% in January to a 20-year high.
But is this boom now turning into a bubble? Certainly an increasing number of analysts seem to think so. The FT’s Stephen Schurr warns us, for example, that the 700% gain in the S&P 500 homebuilder’s index over the last five years dwarfs the Nasdaq gain of 529% in the five years preceding the dotcom peak. And under the heading: “US housing - bubbly?” Morgan Stanley’s Richard Berner argues “activity is likely to decline over 2005”. The house price sell off now spreading across Britain and Australia will soon hit the US, say the bears. I’m not convinced.
American houses aren’t expensive
Analysts automatically assume that the soaring prices of the last few years have made housing less affordable, especially for the first-time homebuyer. But that simply isn’t the case. According to the National Association of Realtors (NAR), affordability for first-time buyers has remained essentially unchanged over the last five years. This is because, although house prices have gone up 48.5% in this time, mortgage interest rates have fallen from 8% to 5.8%, a 27% decline. As a consequence, typical monthly mortgage payments (principal and interest) have risen only a little over 10% since the boom started. This increase is only a bit less than the increase in average wages. Thus real net housing costs have remained essentially flat for the last five years, and in fact since as far back as 1998.
How can this be so, you might well ask, when base interest rates have clearly now been rising for months in America? The answer is that, unlike in the UK and the rest of the world, where mortgage rates are determined by short-term interest rates, in the US the majority of homeowners enjoy very long-term (often 30-year) fixed-rate mortgages. These are largely backed by the government-formed institutional oddities known as Fannie Mae and Freddie Mac. Fannie and Freddie not only provide long-dated mortgages to the public, they buy long-term mortgage risk from other financial institutions.
This has allowed US homeowners to lock in 30-year low mortgage rates for the life of their loans. What's more, this mortgage refinancing activity - or ‘refi’, as the Americans call it - is still going on because although short-term interest rates may be rising, long-term rates are not. The yield on 10-year Treasury debt is marginally higher than it was a year ago at 4.37% but is still well down on last summer’s peaks. Likewise, yields on 30-year Treasuries are currently about 4.7% and have also been falling over the nine months since last May, when they peaked at 5.56%. So even as Alan Greenspan has been raising the headline short-term rate, long-term rates have been falling. That means it still makes sense for homeowners to refinance outstanding mortgages at ever lower rates.
This is unlike the UK where the rising base rate makes our own ‘refi’, which we call mortgage equity withdrawal (MEW), no longer attractive. This key difference helps explain why the US debt-fuelled consumer is still going strong, whereas UK consumption is slowing and last Christmas was, according to some, the worst on the high street since 1979. “Consumer spending remained the main driver of US growth (in the fourth quarter),” writes Christopher Swan in the FT, “rising by an annualised 4.2%. Overall consumer spending grew 3.8% last year, the most since 2000, after rising 3.3% in 2003.”
The dollar is the danger
The greenback has fallen about 27.5% since its 2002 peak, bringing it back to the levels it traded at in the mid-1990s. Moreover, should America’s twin (current account and government) deficits spark a further significant decline from here, it seems unfeasible that foreigners wouldn’t start demanding higher yields from their US assets. At such a time, even if the Fed cut short-term rates, long-term rates would surely rise. Then the cost of housing would rise too. But a weak dollar may not be the obvious one-way bet that some commentators would have us believe. For starters, foreigners are still buying with enthusiasm. “Treasury data showed the US attracted net portfolio inflows of $61.3bn in December,” writes Steve Johnson in the FT, “better than expected and enough to finance the monthly trade deficit.” Furthermore, “the quality of the flows was high, with private sector investors largely taking up the baton from Asian central banks”.
There’s another reason not to be wholly negative on the dollar’s prospects too. Economists have for a long time noted that correcting a trade imbalance with currency weakness has a perverse initial effect on that country’s deficit. Because it takes time for new exporters to set up and because the trade flow is meantime priced in a depreciating currency, a weaker currency leads (initially) to an increase in the trade deficit. Only later does the bigger, structural improvement kick-in (so a chart of the deficit over several years will curve like a letter ‘J’). The dollar has been falling in pretty much a straight line for three years now, so a trade deficit that only seems to be getting worse might well be expected.
The real bubble’s in the UK
But even if rates were to be forced up by a falling dollar, house prices might not fall. Asset bubbles can only be said to have occurred when an extremely large price move can’t be justified by the fundamentals. In the case of the US housing market - localised distortions aside - California for example - a rise of nearly 50% over five years is not only a fairly restrained move by both historical and international standards, but also appears wholly justified by lower bond yields and higher wages over the period.
To see what a real bubble looks like, compare the US to a housing market much closer to home. Whereas US house prices haven’t even risen by as much as 50% over the last five years, UK prices have more than doubled over the same period, and homes now costs three times what they did just nine years ago. The US financial weekly, Barron’s, notes that “the (US) home-price-to-income ratio at 3.35 is a record high”, yet here in the UK homes sell for over six times average incomes - nearly twice as much. Seen in that light, it is perhaps not surprising that (according to David Rosenberg of Merrill Lynch) the share of US households convinced this is still the time to buy a house jumped to 22% in January, double the percentage a scant 15 months ago.
Conclusion
The real difference between the UK and the US housing markets is the response of borrowers to cheaper rates. In the UK we seem to like keeping the proportion of our income that goes on debt service costs steady over time (at around 10%). As mortgage repayment rates have in effect halved since the early 1990s, we have found that if we keep paying the same amount, we could borrow twice as much - so we do. This has facilitated a spectacular surge in house prices but now that rates are rising, the debt service burden is approaching record high levels. It would appear we have no option now but to cut back on debt - and that spells lower house prices.
The US experience has been different. Since mid-1989, the effective mortgage rate has fallen 45%. However, households have been more circumspect about raising the size of their loans. As a consequence, typical mortgage repayments (interest and principal) adjusted for average incomes, have fallen by more than a third. This is even though house prices have been rising at a double-digit rate. This means that should Treasury yields (and thus mortgage rates) rise in the near future, US house-buyers would not necessarily have to flee the market. Unlike us, they could still afford to let debt service costs rise instead. American house prices are not about to crash. If you want to fear a housing post-bubble crash, there’s no need to look as far afield as America.
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James Ferguson
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