ChartingTheEconomy.Com

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.