ChartingTheEconomy.Com

The above chart shows the distribution of new home sales in the U.S. by price during the first quarter of 2009.

Data Source:

U.S. Census Bureau

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The above chart gives a historical view of the percentage of new homes sold with sale prices of $500,000 and above, and $750,000 and above.  As you can see from the chart sales of high-end homes have fallen off a cliff.

Data Source:

U.S. Census Bureau

Note:  The $750K homes are also a subset of the $500K category.

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This chart shows the steady decline in homeowners’ equity since 1980.  One of the more distrubing aspects of this chart is how homeowners’ equity during the housing bubble did not increase.  Given the massive run up in home prices during the bubble years you would have expected to see an increase in homeowners’ equity.  This was not the case.  Why?  First, because many existing homeowners were withdrawing equity with the use of home equity loans.  Second, many first-time homebuyers were using no-money down loans and other creative financing to purchase their first home.  The combination of these two trends lead to no significant increase in homeowners’ equity even as home prices soared in the bubble years.  This was a setup for greater declines in homeowners’ equity once the housing bubble burst.  As you can clearly see from this chart, homeowners’ equity has fallen off a cliff in recent years as the housing bubble burst.

Data Sources:

Various historical U.S. Federal Reserve Flow of Funds reports.

The above chart shows the percentage of new homes that are purchased with cash vs. the 30-year, fixed-rate conventional mortgage, historically.  As interest rates decline so do cash purchases.  This is one small (but clear) example of how low interest rates helped fuel the housing bubble by promoting the use of more leverage.  I believe that speculative mortgages (Option ARMS, negative amortization loans) contributed more to the housing bubble than just low rates.  However, cheap money inevitabily causes people to take on more risk.  This chart gives some perspective on the effect of the Federal Reserve’s policy of cheap money on home financing.

Data Sources:

U.S. Census Bureau

U.S. Federal Reserve

Note:  The 30-year fixed mortgage rates use monthly data and are averaged on a quarterly basis.

The Census Bureau released its new home data for March 2009 this morning, and the above charts show the picture.  The first chart shows just how far new home sales have fallen.  For March 2009, new home sales were 356,000 units on a seasonally adjusted annual rate - down .6% from February.

The second chart shows the months’ of supply for new homes at the current sales rate.  For March 2009, the supply was 10.7 months which is slightly improved from the February supply of 11.2 months.  The chart also shows how elevated this rate is on a historical level.

The third chart shows how long new homes are sitting on the market from completion until they are sold.  The median number of months for sale since completion was 10.2 months in March 2009.  As the chart shows new homes are taking longer to sell then at any time on record.

The forth chart shows the median sale price for a new home.  The median sale price for a new home was $201,400 in March 2009.  This price was down 3.5% from a month earlier and down over 12% from March 2008.

Data Source:

U.S. Census Bureau

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New housing units completed for March 2009, were 824,000 at an annual rate and seasonally adjusted.  This represents a slight bounce off of the January 2009 lows of 773,000 units.  Later today I will have a post on new home sales, and we can see the comparison with this newly completed inventory.

Data Source:

U.S. Census Bureau

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This chart of farmland prices over the past decade looks very similar to charts of home prices at their peak.  It leads me to believe that the price of farmland is the next shoe to drop.  Stay tuned for a complete article on this topic in coming days.

Source:  Historical Agriculture Credit Conditions Surveys - Tobias Madden, Federal Reserve Bank of Minneapolis

Has the Housing Bubble Created a Wealth Illusion?

February 2005

By: ChartingTheEconomy.Com

A previous ChartingTheEconomy.Com report “The Housing Market – Are We Blowing a Bubble?” concludes that a housing
bubble is forming.  It also concludes that the bubble may continue to grow, burst, or just deflate and that the future of the
housing bubble primarily depends on interest rate movements.  This paper is a follow up to that report and will investigate
whether the housing bubble has created a wealth illusion in the United States.

In order to make the case for the creation of a wealth illusion, wealth in the U.S. since 1999 is analyzed.  First, all numbers
are presented on a per household basis to personalize the issue.  Second, a baseline is set by showing mean household net
worth and how it has trended.  Third, equity in household real estate is separated from all other equity to show how each has
changed since 1999.  Through this analysis it is clear that equity in household real estate has been the only contributor to
wealth creation in the U.S. since 1999.  It is also clear that without equity in household real estate on average we are much
less wealthy than in 1999 when adjusted for inflation.  Because of this, it is concluded that we are ill prepared if there is a
sudden drop in equity in household real estate.  So, if you believe that there is a housing bubble let’s hope it doesn’t burst.
The best measure of wealth is a net worth calculation (a personal balance sheet).  It is as simple as adding up your assets
and subtracting your liabilities.  What’s left is your net worth or wealth. 1

Let’s take a look at overall household net worth in the United States over the past several years.  Essentially, household net
worth has remained almost flat from 1999 through the third quarter of 2004.  So, the first conclusion is fairly straight forward.
Americans on average are only slightly wealthier now than in 1999.  Chart #1 shows the overall trend in household net worth
during this period.

Household Equity in Household Real Estate

However, to fully understand the effect that real estate has had on household net worth in the U.S. since 1999 let’s dissect
the data from the above chart.  First, let’s take a look at mean household equity in household real estate and how it has
changed over this period.  For this, let’s turn to Chart #2.

Chart#2 clearly shows that real estate has bucked the overall trend in wealth creation in the U.S. during the past several
years.  In fact, the average household equity in household real estate has increase nearly 45% since 1999.  It should be
pointed out that the asset gains from household real estate would be even greater except for the enormous amount of cash
out refinancing, second mortgages and home equity lines of credit that have been taken out between 1999 and 2004.
According to Freddie Mac’s 4th Quarter Cash-Out Refi Report the total home equity cashed out for all prime conventional
loans was $543 billion over this period.  When you add in second mortgages and home equity lines of credit the number
grows to $843 billion. 2  What have homeowners been doing with this money?  Chart #3 shows the use of liquefied funds
from 2001 and 2002 refinancing.

By using Chart #3 we can better understand how cash out refinancing has affected household equity in household real
estate.  Basically, the overall affect (among other things) has been to reduce equity in household real estate and to increase
equity in other assets.  Using the $843 billion number that represents cash out refinancing, second mortgages and home
equity lines of credit between 1999 and 2004 and applying the percentages from Chart #3 across the entire period, we can
make some pretty good assumptions.

First, if we assume all liquefied funds used for home improvements and real estate/business investments were put back into
household real estate, then 55% was taken out.  This represents almost $4100 per household. 3  This means that the actual
gains in household equity in household real estate shown in Chart #2 would have been larger absent the cash out craze of
the past several years.  Second, most of the remaining funds that were liquefied were used to reduce other liabilities, make
financial investments, or purchase durable goods.  Much of these went to increase household equity in other assets –
basically the numbers shown in Charts #4 and #5, below.  It is difficult to precisely estimate the dollar value of this equity
because some of the consumer expenditures were not on items that created wealth, and because it is difficult to know how
the financial investments performed.  Based just on the numbers for repayment of other debts and the dollars put into
financial investments, the amount is about $2750 per household. 4  Suffice it to say the cash out of household real estate
equity since 1999 represents a large shift in equity assets held by households.  The significance there is that the increase in
equity in household real estate is accountable for even more of the wealth creation in the U.S. since 1999 than the numbers
show.

Household Net Worth Less Equity in Household Real Estate

Let’s turn to Chart #4.  It shows mean household net worth without equity in household real estate.  Without equity gains from
household real estate, mean household net worth in the U.S. was actually down from 1999 through the third quarter of 2004.
While we have made real gains in wealth in the past couple of years because of the turn around in the U.S. stock market,
these gains have not been enough to offset the losses from 1999 – 2002.

Inflation Adjusted Net Worth

Chart #5 shows Mean household net worth less equity in household real estate from 1999 through the third quarter of 2004
adjusted for inflation.  This chart drives home the point that without the recent gains in real estate equity U.S. households are
not wealthier than in 1999, especially when adjusted for inflation.

So what does this mean?  On a per household basis we are only slightly wealthier now than we where in 1999.  When you
subtract out equity in household real estate we are actually less wealthy than in 1999 (at least as of the end of the third
quarter of 2004).  In short, household real estate has been accountable for the majority of wealth creation in the U.S. since
1999.

Conclusion

So, is the wealth created by real estate an illusion or not?  That comes down to what side of the housing bubble debate you
are on.  What is clear is that without the gains in household real estate equity during the past several years, there would
have been no wealth creation.  This just adds to the danger of the housing bubble.  Essentially, we have not been creating
other wealth to go along with the increase in real estate equity.  Therefore, if the housing bubble bursts, then we have not
created other wealth to fall back on.  Remember, when you account for inflation the picture is even worse.  Adjusted for
inflation the mean household net worth in the U.S. from 1999 through the 3rd quarter of 2004 is down substantially. It should
also be noted that median household net worth in the U.S. is far less than the mean.  In 2000 median household net worth
was $55,000. 5  Accordingly, most households don’t have as big of a nest egg as the mean household net worth numbers
suggest.

The purpose of this paper is to personalize the housing bubble by showing its effect on wealth creation in the U.S. over the
past several years.  It is also intended to show the effects on net worth if the equity in household real estate was to evaporate
in a burst of the housing bubble.

So again, has the housing bubble created a wealth illusion?  It does seem that many Americans feel wealthier because of the
large increases in home equity in recent years.  However, it is difficult to gauge how people feel about their wealth. The most
obvious way to demonstrate that we feel wealthier because of increases in home equity is by measuring how much equity
many Americans have pulled out of their homes in recent years.  As we have seen in this paper, the numbers are enormous.
Most people will not use their homes as a piggybank unless they are feeling pretty good about your wealth (or if they are very
desperate – it doesn’t appear that many people fall into this category).  Based on this, it is safe to say that most of us are
feeling wealthier these days because of the soaring prices of our homes.

Maybe the easiest way to decide if the housing bubble has created a wealth illusion is this way.  If the housing bubble is an
illusion, then the wealth creation is real.  However, if the housing bubble is real, then the wealth creation of the past several
years is an illusion.  You decide for yourself.

Sources:

Chart #1:  Federal Reserve Flow of Funds report table B.100 Balance Sheet of Households and Nonprofit Organizations.
Data for 2004 is through the third quarter.  Data on number of households is from the U.S. Census Bureau and 2004 is
estimated based off prior data.

Chart #2:  Same sources as Chart #1.  Total number of households in the United States is used to calculate the mean
household equity in household real estate (not just owner occupied units).

Chart #3:  Data is from Federal Reserve Board’s report Mortgage Refinancing in 2001 and Early 2002 by Glenn Canner,
Karen Dynan, and Wayne Passmore with research assistance by Jennifer Attrep and Gillian Burgess.

Chart #4:  Same as Chart #1.

Chart #5:  Same as Chart #1.  To adjust for inflation consumer price index data from the Bureau of Labor Statistics is used.

_____________________________________________________________________________________________

Endnotes:

1 Data on household net worth is from The Federal Reserve Flow of Funds report table B.100 Balance Sheet of Households
and Nonprofit Organizations.  The Fed’s Flow of Funds report includes data on nonprofits so the household numbers may be
off slightly (but not materially).  The Flow of Funds report is widely used as a reference for household net worth.

2 Freddie Mac estimated the total 2004 data.

3 The number of households for 2004 is estimated based off U.S. Census Bureau data for prior years.
4 This number uses the 2001 and 2002 percentages for use of liquefied funds from refinancing and applies these
percentages across the entire period from 1999 to 2004.

5 Note that in this report we use mean household net worth to show wealth trends since 1999 because data to show trends
based on the mean is more readily available.  Mean household net worth is much higher than median household net worth
because of the high concentration of wealth in a very few super wealthy households.  According to a March 2003 report by
the U.S. Census Bureau Net Worth and Asset Ownership of Households:  1998 and 2000 by Shawna Orzechowski and Peter
Sepielli the median household net worth in 2000 was $55,000.
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Helping you navigate the economy

The Housing Market – Are We Blowing a Bubble?

January 2005

By: ChartingTheEconomy.Com

Is there a housing bubble?  This question has been the topic of much debate in recent months with strong advocates on both sides of
the argument.  In this report it is concluded that a bubble is forming.  However, whether the bubble will continue to grow, burst, or just
deflate slowly, is more difficult to predict.  What is clearer is that the scenario is closely linked to future movements in interest rates.

In the equity markets an increase in demand that is not supported by long term fundamentals can lead to the formation of a bubble.  The
housing market is not altogether different though some would like you to think it is.  The affordability of housing is a primary factor in the
increase in demand.  As the affordability of housing improves, demand increases and visa versa.  The primary factor over the past
decade in making housing more affordable has been declining interest rates.  However, as with the equity market, affordability as
compared to alternative choices needs to be examined to get the whole story.  Another key to defining a bubble in any market is an
examination of speculation and its presence in and effect on the market.  Finally, a look at whether the improved affordability and
increased demand in housing is based on long term fundamentals or short term trends is critical to determining if a bubble exists.  The
following report will examine each of these areas.

First, let’s examine housing price appreciation vs. consumer price appreciation.  Chart #1 below shows that over the past decade housing
price appreciation has greatly outperformed the appreciation of consumer prices.  Furthermore, in the past several years the gap between
housing prices and consumer prices has accelerated.  It also shows that the relative cost of homes (as measured by monthly mortgage
payments) has increased at a rate that almost mirrors appreciation in consumer prices.  Costs have been contained even with the spike in
home prices because of falling interest/mortgage rates during the period.  The effect of interest rates on housing will be examined in detail
in the following pages.

Housing Affordability

While Chart #1 shows that housing price appreciation has far outpaced the price appreciation of other goods and services, it does not
fully show another important statistic in revealing the state of the housing market – housing affordability.  Even though housing prices have
increased at a pace that is triple CPI over the past decade, the true cost of housing has become more affordable during that time.  The
single reason for this is the dramatic drop in interest/mortgage rates over the same time.  Chart #2 shows how wages and salaries have
increased at a faster pace than have monthly mortgage payments for both new and existing homes over the past decade.  On a relative
basis homes are now less expensive than they where in 1994.

Through a further look at housing affordability we can see how sensitive the real cost of housing is to interest rates. Essentially, the
stratospheric housing price appreciation of the past decade was largely enabled by low relative housing costs due to falling mortgage
rates.  It is important to remember that the opposite is also true.  In a period of rising mortgage rates the true cost of housing can increase
even if prices are falling.

For illustrative purposes Chart #3 shows how quickly the affordability of housing can change in a rising interest/mortgage rate
environment.  Chart #3 shows that in 2005 if home prices and wages/salaries both increase by 2.8%, and mortgage rates increase just
100 basis points, then increases in housing costs (as measured in monthly mortgage payments) start outpacing wage/salary increases on
a cumulative basis from 1994.  This is assuming a relative slight increase in mortgage rates.  If we see a rate spike in the coming years,
the effect is far more pronounced.

Housing Costs vs. Rental Costs

As we have seen, despite the sharp rise in housing prices over the past decade housing is still affordable relative to wages and salaries.
However, the answer to another question is also important in understanding the housing bubble.  How has housing affordability compared
to alternatives during the past decade? Chart #4 provides the story.  Housing, again due to declining interest/mortgage rates, has
become more affordable relative to rent since 1994.

Because buying is more affordable than renting we are now seeing the highest vacancy rate on record (highest since 1956 the first date
the census report shows).  To illustrate the recent run up in the vacancy rate the data is shown from 1990 through the third quarter of
2004 in Chart #5.

The importance of the high rental vacancy rates is that owners of rental properties will likely have little power to increase prices until the
glut is filled.  If interest/mortgage rates start increasing, housing affordability relative to rent will likely change quickly with rents becoming
more affordable.  Given that rental vacancies are at all time highs, the rental market would be able to absorb much demand before owners
would have much pricing power.  This could work to dramatically reduce the affordability of housing vs. rent if we get into a period of
increasing rates.

Why Interest Rates Matter?

The main argument against a housing bubble is that demand is still outpacing supply.  Simple economics dictate price increases in this
scenario.  However, by making this argument, you simply beg the question.  Why is demand outpacing supply? Low interest rates and
new forms of creative financing are the biggest factors.  Interest rates at forty year lows and new forms of financing such as interest only
loans and no money down loans have a positive effect on housing demand.  First, housing becomes more affordable so more people can
enter the housing market.  Second, those planning to purchase a home can now upgrade to a larger more expensive home.  Third, people
that are on the fence are motivated to take advantage of the low rates and jump into the market.  So, a falling interest rate environment is
a major stimulus to housing demand.

However, a rising interest rate environment is a major drag on housing demand.  First, housing becomes less affordable so fewer people
enter the housing market.  Second, those that do purchase a home tend to downgrade to less expensive homes.  Third, people that are
on the fence are motivated to keep renting until there is a better entry point.  Fourth, defaults are likely to increase as people that are
having trouble making mortgage payments see their interest expenses increase (on adjustable rate mortgages and/or other consumer
debt).

The following table shows how monthly payments vary with different mortgage rates, and how dramatic an effect rates can have on the
real cost of housing.  Essentially, the monthly payment on a $300,000 loan at a 7.5% interest rate is the same as the monthly payment on
a $370,000 loan at a 5.5% rate.

30 Year Fix Mortgage Monthly Payments
Loan Amount    5.50%         7%            7.50%
$300,000      $ 1,703     $ 1,995      $ 2,097
$350,000      $ 1,987      $ 2,328     $ 2,447
$370,000      $ 2,100     $ 2,461      $ 2,587

Basically, interest rates and housing price appreciation can be thought of as being inversely related.  Chart #6 shows that prices and
interest rates have moved in opposite directions over the recent past.  As interest rates have come down, annual housing price
appreciation has increased.  It also shows that high interest rates alone do not cause housing price depreciation.  Even in prior periods of
higher interest rates housing prices still appreciated, though at a much slower pace.

Housing bubbles usually end with the signs that supply is backing up.  If anything can make housing supply back up, it is increasing
interest rates.  Mortgage rates are most often based on the 10 year Treasury bill which has continued to stay at historically low rates the
past couple of years.  So the key question is where are long-term rates going and how quickly?  Most economists agree that long-term
rates are going to increase over the next year but not at a dramatic pace.  There seems to be consensus that long-term rates will be
somewhere around 5% by the end of 2005.  This will likely slow the pace of demand for housing.  It could result in an orderly release of the
air in the housing bubble by bringing the pace of housing price appreciation back to more normal levels.  It also could allow homeowners
with variable rate mortgages time to refinance to fixed rates and lock in their payment plans.

On the other hand, if the current U.S. account and budget deficits continue to increase, then the inflation monster could rear its ugly
head.  A continued increase in the twin deficits could make foreign banks reduce their purchases of U.S. Treasuries. Since foreigners
have been the primary buyers of late, the reduction in demand of U.S. Treasuries could send rates up quickly. Another factor that could
push rates up in 2005 is the continued decline of the U.S. dollar against foreign currencies.  As the dollar falls, imports become more
expensive leading to higher inflation and higher interest rates.  While higher rates alone will not likely cause a major price and demand
reduction in housing, a quick spike in rates likely will.

Speculation

As shown in the preceding section interest rate movements have a major effect on housing prices.  However, it was also shown that higher
interest rates alone do not cause price depreciation.  Other factors must be present, one of which is the presence of speculation.
Speculation has become increasingly obvious in the housing market in recent years.  The signs of it include:

1) The development and use of interest only loans in recent years.  Just the pure nature of these loans is speculative. Interest only
loans by nature provide a vehicle for homebuyers to overextend themselves by affording homes they otherwise could not buy. As long as
the housing market stays strong this is not an issue, but in a weak market it could be financial suicide. If housing prices decline,
homeowners with these loans could find themselves upside down on the loan owning more than the property is worth. If that isn’t
speculative, what is?

2) The development and use of no money down loans in recent years.  Like interest only loans these loans are speculative by
nature. If homebuyers don’t have the money for a down payment, what happens if they get into financial trouble? Without savings they
have no way to weather the storm.

3) The development and use of miss-a-payment and piggyback loans.  Miss-a-payment loans allow homebuyers to miss a certain
number of payments over a given time period and then roll the missed payments into their mortgage.  If missing payments is a significant
concern, you can argue that it is not the time to buy a home in the first place.

Piggyback loans allow homebuyers to take out multiple loans on the same home.  They are most often used to avoid private mortgage
insurance and to enable buyers to put no money down on their homes.

Are miss-a-payment and piggyback loans speculative?  Yes.

4) The high use of adjustable rate mortgages (ARMs).  Chart # 7 shows that even with rates on fixed loans at record lows and the
prospects of higher rates on the horizon, homebuyers are taking ARMs in increasingly large numbers.  In at least some cases buyers are
using ARMs as a means to afford homes they otherwise could not.  What happens when rates increase?  Even if they refinance into a
fixed rate mortgage they may not be able to afford their higher payments.  Again this is speculation.

5) The wave of cash out refinancing over the past several years.  While refinancing has helped reduce the monthly payments for
many homeowners over the past several years, it has also been used by many as a cash machine.  Cash out refinancing is not only at
extremely high levels, but the levels over the past four years dwarf the levels in prior years.  Chart #8 shows total home equity cashed out
on an annual basis.

6) Homeowners not using the low interest rates to reduce their overall debt obligations.  While some homeowners have used
refinancing to reduce their payments, overall debt service obligations for consumers have increased over the past decade.  Chart #9
below shows that consumers are now paying about 2.25% more of their disposable income to cover debt obligations than they were in
1994.  Debt obligations consist of the estimated required payments on outstanding mortgage and consumer debt. From Chart #9 you can
conclude that consumers have not used lower interest rates to reduce their debt, but have actually increased it relative to their income,
which is another sign of speculation.  The primary concern, however, is that if interest rates start increasing, debt service ratios could
increase further.  Going into a period of rising interest rates with high debt service ratios is not the optimal position to be in for
homeowners.

7) Houses for sale at record high levels.  The number of houses for sale is at record high levels.  This shows that not only
homebuyers are speculating, but that homebuilders are doing their part.  The supply of homes at current sales rates is also at the higher
end of recent levels (and this is using record high sales rates).  This shows that homebuilders are ill prepared for a slowdown in
purchases.  Chart #10 shows the numbers.

Where We Go from Here:

The keys to the direction of the housing market over the next several years are interest rates and their movements. Let’s take a quick
look at four different scenarios:

1) Interest rates continue to decline.  This scenario is the least likely to occur, however, it is not impossible.  Over the short term, the
housing market continues to rally with housing price appreciation continuing to outpace overall CPI.  The relative cost of housing (as
measured by monthly mortgage payments) continues to grow at a slower pace than income which supports the high home prices.  Home
buyers, owners and builders will continue to speculate with creative mortgages, more cash out refinancing, and high rates of construction.
Essentially, the housing bubble will continue to grow.  This scenario is the most disturbing in the long term.  The bigger the bubble, the
bigger the explosion when it bursts.

2) Interest rates stay in the current trading range.  This is more likely than a continued decline in interest rates, but is not the probable
scenario.  In this scenario, housing price appreciation will start to slow.  This is primarily because without more interest rate reductions any
price appreciation will be directly reflected in the relative cost of housing.  During a continued period of flat interest rates the housing
market should perform moderately well.  The final outcome depends on how rates behave when they begin to move. They will not stay flat
forever.

3) Interest rates increase gradually.  This may be the most likely path for interest rates over the next several years, and the best for
the housing market long term.  If this happens, the housing bubble will begin to deflate at a controlled pace.  At this point a controlled
deflation of the housing bubble is the healthiest outcome for the economy.  With a gradual increase in interest rates homeowners will have
time to refinance into fixed rate mortgages to protect their payments.  Homebuilders will have time to trim supply. There will be some pain
as housing prices stay flat and even decline over a period of time (maybe several years).  This happens because as rates rise, upward
pressure on the cost of housing increases.

4) Interest rates spike upward. This is also not the most likely outcome, but is a growing possibility.  The largest contributing factors to
this scenario happening are the growing federal budget and current account deficits.  If we don’t get these deficits under control, the risk
of a quick rise in rates increases.  While an interest rate spike alone may not burst the housing bubble, when the rate spike is combined
with the speculative factors present in today’s housing market the housing bubble becomes very unstable.

In this scenario the housing bubble explodes – there is no other way to put it.  The cost of housing increases sharply even as home prices
are falling due to the rapid rise in interest expenses.  Homeowners with ARMs, and interest only loans will likely be caught flat-footed and
not have time to refinance into fixed rate mortgages until rates are much higher.  This will cause loan defaults to increase putting more
supply into the market.  Buying relative to renting will become more expensive causing fewer new buyers to enter the housing market.
Finally, homebuilders will be caught with high inventories since they are not managing supply tightly.  The result is over supply and a drop
in demand. This has a downward spiral effect on home pricing.

Example of an Interest Rate Spike

How might a spike in interest/mortgage rates affect the housing market?  Let’s take a look at a hypothetical example. From the discussion
above we have seen just how sensitive the housing market is to interest rate movements.  In this example, the 10 year treasury notes
increase 150 basis points in 2005 to 5.6%, and another 150 basis points in 2006 to 7.1% from the low of around 4.1% in December 2004.
This may seem like a large increase but remember we are coming off of abnormally low rates.  A 7.1% 10 year treasury is actually just
slightly below the average rate over the past forty-three years of 7.2%.

In the above example, as interest rates increase, the 30 year fixed-rate mortgage follows and rises from current levels of around 5.5% to
around 7% in 2005 and 8.5% in 2006.  If this happens, housing prices can fall sharply, and the cost of housing as measured by monthly
mortgage payments can still increase sharply.  Chart #11 below assumes that mortgage rates increase as just described.  In this scenario
housing prices fall 8% per year in 2005 and 2006 for a cumulative fall of over 18%.  However, monthly payments increase nearly 15% over
the same period.  If you assume wages and salaries rise 2.8% each year, housing prices are no longer more affordable than in 1994
relative to income.  While this is just one of many potential scenarios that could play out, it demonstrates how sensitive the housing market
is to interest rates.

Recommendations

While the housing bubble may not burst, it is important that home builders, owners, and buyers all take some precautions to protect
themselves.  Depending on interest rate movements the bubble may continue building, it may burst, or it may just deflate in a manageable
fashion.  Since most data points toward increasing interest rates in the coming months and years the following recommendations aim to
lessen the negative effects of any rate increases.

1) Homebuilders should begin managing their housing supplies more tightly.  Builders should stop assuming that sales will continue at
record rates when doing their construction and inventory forecasts.
2) Homeowners should move to fixed rate mortgages.  The exception to this is if you are absolutely planning to sell your home in the
near future.
3) Homebuyers should also finance with fixed rate mortgages.  The exception again is if they are absolutely planning to sell the home
within the first several years of ownership.  Creative mortgages should also be avoided because buyers may find themselves upside down
on their mortgages soon after purchasing their home.

Conclusion

The preceding report clearly shows that there has been a sharp run up in housing prices in the past several years.  It also shows how
interest rates have a clear effect on housing prices.  However, interest rates alone do not dictate whether or not there is a housing
bubble. Bubbles are created by multiple factors coming together.  This starts with shifts in housing affordability and the affordability and
supply of alternatives such as rentals.  The importance of interest rates is that their moves can influence supply and demand and
affordability in dramatic ways.  Over the past decade interest rates have had a cumulative positive effect on the housing market.  An effect
that has been exaggerated in recent years as interest rates settled at record low levels.  The exaggerated effect has been demonstrated
in the sharp increase in housing prices in recent years - increases that can only be maintained in a falling interest rate environment.  In
short, the recent price appreciation of housing has not been caused by positive long-term fundamentals.  The price appreciation has been
caused by declining interest rates that cannot be sustained.

Another factor that must be present to create a bubble is speculation.  As we have seen in this report, the one thing there is not a
shortage of in the housing market today is speculation.  Homebuyers are speculating with creative financing terms, homeowners are
speculating with higher debt service ratios and cash out refinancing, and homebuilders are speculating with high inventories.  Given that
all of the necessary factors for the creation of a bubble are present in the housing market today, there is little doubt that a bubble has
formed.  However, whether the bubble continues to grow, slowly deflates, or bursts is largely dependent on interest rates and their future
movements.

Predicting interest rate movements is difficult and there are many moving parts to the economy that influence them.  So it is safe to say no
one knows for sure where interest rates are going and how fast they will move.  What is more certain is that interest rates are at historical
low levels, that the federal reserve has been raising short term rates, and that many economic and trade statistics are pointing toward
higher long term rates.

What is even more certain is the influence interest rates have on the housing market.  The almost continuous decline in interest rates over
the past decade has made housing more affordable even as housing prices have soared.  This has created one of the strongest housing
markets in history and provided record price appreciation.  But, let us not forget that in a rising interest rate climate the opposite can
happen.  Housing prices can decline while the cost of housing increases.  So remember the bubble that low interest rates blew, high
interest rates can burst.

Sources

Chart #1
- Housing price appreciation uses Office of Federal Housing Enterprise Oversight (OFHEO) Housing Price Index data through 3rd Q
2004.
- CPI less shelter is from the U.S. Bureau of Labor Statistics (BLS) through November 2004.
- Monthly Mortgage payments use data on median existing home prices. The data is National Association of Realtors (NARs) data
from the National Association of Home Builders website through Oct. 2004.

Chart #2
- Data on wages and salaries is from U.S. Bureau of Labor Statistics through 3rd Quarter 2004.
- To determine monthly mortgage payments, mortgage rate data from Freddie Mac’s Weekly Mortgage Market Survey is used through
November 2004.  Data on existing homes is NAR data from the National Association of Home Builders website through Oct. 2004.  Housing
prices are median prices.
- Data on New Homes is from the U.S. Census Bureau and HUD through 3rd quarter 2004.  Housing prices are median prices.
- For information on how monthly mortgage payments were calculated see Methodology section.

Chart #3 – Uses the same methods as Chart #2 to determine wages and salaries and housing payments.

Chart #4 – Uses the same methods as Chart #2 to determine housing payments.  Data for rents is from the BLS and uses owners’
equivalent rent of primary residence and rent of primary residence data through November 2004.

Chart #5 – Uses Census Bureau household data on rental vacancies.

Chart #6 – Uses data on the 10 year treasury rates from the Federal Reserve.  Data on housing price appreciation is from OFHEO and is
3rd quarter data.

Chart #7 – Uses Freddie Mac monthly data on adjustable rate mortgages (ARMs).  The monthly data is averaged to reflect annual
numbers.

Chart #8 – Uses Freddie Mac’s Cash-out Refi Report for 3rd Quarter 2004.  Data is for annual cash-out volume for all prime conventional
loans. 2004 is Freddie Mac’s forecast.

Chart #9 – Uses data from the Federal Reserve’s Household Debt Service and Financial Obligations Ratios report.

Chart #10 – Uses Census Bureau and HUD data on Houses for Sale by Region and Months’ Supply at Current Sales Rate.

Chart #11 – Uses historical data from the same sources as Chart #2.

Methodology

To calculate monthly payments, NAR pricing data for existing homes and Census Bureau and HUD price data for new homes was used
(median sales price).  Mortgage rates form Freddie Mac’s Weekly Mortgage Market Survey were applied to these prices.  An adjustment
was made to reflect that homebuyers have been continuously paying less origination/discount points on their mortgages.  The adjustment
was a 25 basis points reduction on annual mortgage rates for each origination/discount point reduction.  For example in 1989 the average
buyer paid 2.1 origination/discount points and in 2003 they paid 0.6 points.  The adjustment was a reduction in the 2003 mortgage rate
from 5.83 to 5.455. A 10% down payment was also assumed.