Why there is no housing bubble
The sky is not falling. Yes, home prices are sky-high, but we really don't have a housing bubble that is anywhere near bursting. Here's why.
By Jim Jubak
Housing bubble? What housing bubble?
With the 10-year U.S. Treasury bond yielding below 4% and 30-year mortgages available at 5.1%, there isn’t a housing bubble
Mind you, I'm not saying that U.S. consumers don't have too much debt, or that the U.S. economy isn't dangerously dependent on the housing sector for growth, or that all the money sloshing around the globe isn't encouraging dangerous speculation.
But those are different problems from the one getting all the headline attention at the moment.
It's just that, for all the teeth-gnashing and pundit-moralizing, we really don't have a housing bubble that's anywhere near bursting. Current 10-year interest rates are just too low. And I certainly don't see interest rates rising enough in the next year or so to burst a bubble, either.
Mortgage money is cheap
Oh, I'll grant you that housing prices are high. They're at nosebleed levels in some areas of the country, and still they keep climbing. According to the Federal Reserve Bank of Boston, national median home prices have climbed at an annualized rate of 8.2% from the fourth quarter of 2001 to the fourth quarter of 2004. See the news
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But that doesn't begin to capture the climb in prices of the hottest local markets. In Manhattan, for example, where I live, the median price for sales that closed in May was 23% higher than in May 2004, according to Halstead Property, a New York real-estate broker. The average price, which may better capture the action at the top of the market, climbed 34% from May 2004 to $1.3 million. Mind you, we're talking condo and co-op apartments here -- no back yard, no pool, no two-car garage.
But let's look at those prices adjusted for today's mortgage rates. The interest rate on a 30-year fixed mortgage is set by the yield on the 10-year Treasury bond. Right now, with the 10-year bond yielding an amazingly low 3.9%, you can easily find a 30-year mortgage for 5.1% in New York City (or Los Angeles or Miami, for that matter). (If you don't believe me, just check out MSN Money’s Essential homebuying guide.) The national average, right now, is 5.6% on a 30-year fixed mortgage.
A year ago, in June 2004, the 10-year Treasury yielded 5.2%. The average 30-year fixed mortgage, according to the Federal Reserve, carried an interest rate of 6.3%.
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Look at what the shift in the average interest rate for a 30-year fixed mortgage does to a home buyer's monthly payment. At today's average of 5.6%, borrowing $500,000 results in a monthly payment of $2,870. A year ago, a home buyer would have paid about the same each month, $2,847 to be exact, on a loan of $460,000. Lower average interest rates have given a home buyer a boost of about 8.7% in buying power over the last year. That's remarkably similar to the 8.2% annualized increase in the median price of a home that the Boston Federal Reserve found.
Think of it this way: cheaper money made it possible to pay 8.7% more for a house in 2005 without taking an extra dollar out of the home-buyer's pocket in monthly mortgage payments.
Economics 101
What we're seeing in the housing market is monetary inflation. Pure and simple. Economic theory says that when more money chases a limited quantity of goods, the price of those goods increases. So nationally, cheaper money drives up the price of houses -- which does lead home builders to increase supply at higher prices. In areas where adding supply is harder -- the land for building a large number of apartments in Manhattan is scarce, as is land to build in Silicon Valley, on the Miami waterfront or in the core of San Francisco, to name a few other super-hot real estate markets -- new supply is extremely constrained at any price and prices for existing housing soars as a consequence.
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.
In my next column, I'll take a look at why so many predictions -- mine included -- have been so wrong about interest rates in 2005 -- and what that implies for the rest of 2005 and into 2006.
Changes to Jubak's Picks
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Buy Groupe Danone
With the decline of the euro against the U.S. dollar, the shares of European food companies, where sales will get a boost from a weaker euro, look more attractive than their U.S. counterparts. So I'm adding Danone Group (DA, news, msgs) to Jubak's Picks as a replacement for U.S.-based Sara Lee (SLE, news, msgs). U.S. consumers know the company for its Dannon yogurt, and the company's fresh dairy division makes up 47% of sales. But the real growth engine -- and a reason that this company may be a buyout target not too far down the road -- is its water business (27% of sales). Groupe Danone is a dominant producer in many European markets -- the company has a 60% market share in France, for example -- but what attracts me is the growth of the company's sales of bottled water in Latin America and Asia. In 2004, the company's bottled-water sales soared 30% in Mexico, for example, and climbed 14% in Asia, where the company's main markets are China and Indonesia. In the first quarter a strong euro knocked about 1.2 percentage points off the company's 5.1% sales growth rate, according to management. A weak euro should turn subtraction into addition for the next quarter or two. I'm adding the shares to Jubak's Picks with a target price of $22 by December 2005. I'd set a stop loss at $15.20.
Sell Sara Lee
The weak dollar had put exchange rates on the side of U.S. food companies selling to overseas customers: the U.S. companies' products got cheaper as the dollar fell against the local currency, and the reported sales and earnings of the U.S. companies climbed when they were translated from stronger local currencies back into U.S. dollars. That wind has shifted, at least for the next quarter of two, and I think European food companies now own this same edge vis-à-vis their U.S. counterparts. So I'm selling U.S.-based Sara Lee (SLE, news, msgs) so I can add a European food company to Jubak's Picks. Including dividends, I have a 4.4% loss on Sara Lee since I added the shares to Jubak's Picks on March 18, 2005.
New developments on past columns
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Time is right for these 7 biotechs
The market certainly reacted to the June 7 news that Cell Genesys (CEGE, news, msgs) would lay off a quarter of its work force and sell off one of its manufacturing facilities and convert another from manufacturing to distribution as bad news. The shares dropped 10.5% that day. But I'd argue that this is actually a sign of progress. The company feels confident enough in the prospects for its lead GVAX cancer programs to concentrate all its resources on bringing them to market. Development of a GVAX vaccine, which is in two Phase 3 studies in hormone-refractory prostate cancer, is reaching that more-expensive but critical stage, where the company must fund bigger trials and then prepare the results for submission to the U.S. Food & Drug Administration. The other GVAX programs to get priority in the restructuring are the company's work in leukemia, pancreatic cancer and bladder cancer. The programs dropped were in the crowded fields of lung cancer and myeloma. The restructuring will allow the company to conserve cash while it still has $40 million in cash on its books as of the end of the March 2005 quarter. As of June 10, I'm keeping my price target of $9 by May 2006. (Full disclosure: I own shares of Cell Genesys.)
Editor's Note: A new Jubak’s Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Cell Genesys. He doesn't own short positions in any stock mentioned in this column.
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