The housing market is booming. In many Western economies, house prices have risen 30 to 50 percent since the mid-1990s.
This is one of the positive factors driving the United States economy. Mortgage interest rates have sunk to a 45-year low (averaging 5.21 percent for a 30-year fixed-rate mortgage in June, according to Freddie Mac). Seldom in recent history have mortgages been so affordable—thanks to the Federal Reserve dropping the federal funds interest rate to 1 percent, also a 45-year low. And Americans are taking advantage: New housing starts continue to outpace last year’s levels, with May 2003 increasing 3.9 percent over May 2002 (U.S. Census Bureau). The government also reported a 12.5 percent increase in single-family home sales this May.
Combined, these factors have created a surge in new mortgages, refinancing and equity loans. The economy is showing subtle signs of improvement. The Dow Jones Industrial Average has risen 20 percent since March.
But there is a cloud in the middle of this silver lining. Now there is growing concern that we are witnessing a building bubble in the housing market that may be about ready to burst—with potentially devastating consequences.
Two-Fold Problem
The Economist calls the potential bursting of a housing bubble possibly “the single most important question currently hanging over the world economy” (May 29).
Inflation in the U.S. is hovering around a 50-year low at about 2 percent for May. Inflated house prices, coupled with low inflation, create an environment in which home equity cannot regain its long-term equilibrium through inflation alone. For the market to level out, inflation will have to rise and “house prices will have to fall by at least 20 percent in money terms in most of the countries with bubbles” (ibid.).
Another problem lies in the surge of prices coupled with an even greater increase in household debt. An alarming number of Americans have tapped equity in their mortgages as a source of additional cash. “In America, Britain and Australia mortgage-equity withdrawal is running at record levels of 5-7 percent of personal disposable income” (ibid.).
With rocketing increase in both house prices and mortgage debt, home owners are living on borrowed time. If house prices decrease, homeowners could be left with mortgages in excess of the value of their homes.
Repercussions
For many families, the home is their most stable investment. Already, many have lost from the stock market crash. A drop in the value of their home would be doubly painful. This is of particular concern for those about to retire who are counting on significant profit from the sale of their home to fund their retirement needs.
But homeowners would not be the only ones at risk if the housing market bubble burst. Lending institutions face a potential increase in mortgage default. Banks typically sell their mortgages on the secondary market to either the Federal National Mortgage Association (known as Fannie Mae) or to the Federal Home Mortgage Loan Corporation (Freddie Mac). These two federal entities finance the purchase of mortgages by issuing bonds. They borrow money at a discounted rate to buy the mortgages from issuing banks, and then either add them to their portfolio or package them into securities for sale on Wall Street. The result is a substantial return on their investment. So much so, that Fannie Mae and Freddie Mac are among the 50 most profitable companies in America.
Ironically, they are also some of the most indebted companies, sharing more than $1 trillion of debt combined.
In the late 1960s and early ’70s, these two government-sponsored enterprises (gses) were created by a special congressional charter. The government’s intention was to create an environment in which the banks have more capital to loan, thus more mortgages to offer, all in an attempt to stimulate the sale of additional homes. The gses sell guarantees to banks, which ensure borrowers will make timely principle and interest payments. This guarantee makes the bonds issued by Fannie Mae and Freddie Mac especially attractive to investors.
The gses profit from other benefits that, private competitors argue, create an unfair advantage. Considerable debate about the unique treatment of Freddie Mac and Fannie Mae rages between congressional leaders and industry specialists.
Should the housing market falter, default on mortgages could potentially devastate both Freddie Mac and Fannie Mae, which control about 44 percent of the collective mortgage debt. A dive in the housing market could be the straw that breaks the back of the American financial system. The structure of both Freddie Mac’s and Fannie Mae’s charter doesn’t include a guarantee of government bail-out should mortgage defaults exceed the amount of cash necessary to pay the holders of their bonds. Many assume the government will bail out the companies, but, by charter, there is no obligation for them to do so.
Should the housing bubble burst, the economic repercussions could be more devastating to the economy than the crash of the stock market, because a greater proportion of privately held equity lies in homes than did in the stock market. Ultimately, this could lead the economy into deflation.
Deflation
In June, Alan Greenspan lowered the borrowing interest rate—for the 13th time since the start of 2001—as an insurance action to prevent the economy from slipping into deflation. “Because deflation appears harder to reverse than it is to prevent, Fed officials seem willing to take out insurance against it, even if they see it as unlikely” (International Herald Tribune, June 24). Deflation becomes a greater concern when an economy stagnates. A steady fall in prices might devastate the American economy by causing a decrease in wages, thus making debt repayment unmanageable. With the interest rate approaching zero, there is little room left for the Federal Reserve to maneuver should a crisis present itself—a crisis such as a housing bust.
“It is true that if the Fed had not slashed interest rates after the stock market collapsed, the downturn would have been much steeper. But by inflating a house-price bubble and encouraging households to borrow more, the Fed has merely delayed the day of reckoning. With households now even more deeply in debt, a fall in house prices would have even more serious consequences” (Economist, op. cit.).
Federal Mortgage Agencies
A crash in the housing market would cause great consternation among lending institutions that have inflated the explosive housing bubble.
Government “sponsored” mortgage agencies like Freddie Mac and Fannie Mae hold an inordinate number of mortgages—so much so that a decline in their financial health would have definite and serious implications for the entire American financial system.
Richard Baker, a Republican congressman from Louisiana, expressed concern about the risk these agencies might pose. “He argued that they might eventually land the taxpayer with a bill that dwarfs the savings-and-loan mess of a decade ago. The agencies have been increasing their lending at a 20 percent annual rate in the past couple of years, as, to rather less attention, has the Federal Home Loan bank system [Freddie Mac and Fannie Mae]. The federal mortgage agencies already have combined debts of $1.4 trillion. On current trends, by 2003 they will be bearing some of the risk on half of America’s residential mortgages, up from one third in 1995” (Economist, April 15, 2000).
The Solution
How can this catastrophe be warded off? Some have suggested more federal involvement; others promote less involvement. Some have called for an abolition of tax benefits that encourage investing in the housing market. This was done in Britain, but it is too early to measure the effects. It has been suggested that the countries which offer the greatest incentive, such as the United States and Spain, are at greatest risk of a market crash.
Are lending institutions and gses solely responsible for the precarious market condition? “Credit creation by the federal mortgage agencies has been accused of inflating a credit bubble” (ibid.). The full scale of the problem is a result of many factors; arguably, greed among lending institutions is a primary cause. But they are only meeting the demand of consumers. Not only are corporations guilty of gambling with their financial future; increasingly, individuals are doing the same.
Western societies tend to want to live beyond their means. Aggressive marketing, incentive programs and pressure to keep up with the Joneses all combine to create an irresistible temptation. The solution rests in individual budgeting, savings and wise investment. As previous Trumpet articles have pointed out, statistics suggest that we are sprinting away from simple, economically wise principles.
Should the housing market follow in the footsteps of the stock market, as has already occurred in Japan, economic disaster looms. Japan has struggled for over a decade to regain a robust national economy after the disappearance of so much wealth from its devastated asset markets.
Many economists are keenly aware of the housing bubble. What about you? Are you financially prepared to withstand a crash in the value of housing? Is your house worth less than your mortgage? If so, you may be part of a growing problem that could ultimately crush the economies of the Western world.
Gone are the days of double-digit returns on real estate, just as they disappeared in the stock market. Now is the time to protect yourself by reducing your debt load and increasing your savings so you can weather the approaching storm.