[PEN-L:30149] housing bubble (II)

["Devine, James" <jdevine@xxxxxxx>]

Title: housing bubble (II)

The Basics
What to do if home prices plunge

A sustained period of declining home prices would turn a lot of traditional thinking on its head. Paying down your mortgage can be risky, and cash becomes your most valuable asset.

By Liz Pulliam Weston

Now that it's clear we experienced a stock market bubble in the late 1990s, economists are wrangling over whether we're experiencing a similar phenomenon in housing prices.

The answer could matter a great deal to you, whether or not you're in the market for a home.

The bursting of this bubble -- if it is a bubble, and if it can really burst -- could be devastating for the economy and for your personal finances. The rise in home equity probably has played a significant role in keeping the economy afloat, and many people have become dependent on tapping their homes to fuel their spending.

True deflation in the housing market could bring on another recession, or make an existing one worse. Those who have borrowed heavily against their homes, or snatched up a house to avoid being priced out of the market, could get hurt the most.

First, we'll need to recap the is-there-is or is-there-ain't a bubble debate.

The anti-bubble economists

Federal Reserve Chairman Alan Greenspan is among the respected economists who argue there is no bubble. These learned thinkers note that, unlike stocks, home prices are determined regionally rather than nationally, and that there is so much diversity in regional markets that it's unlikely a nationwide bubble could form. In other words, housing prices could plunge in your area, but it's unlikely they could plunge from sea to shining sea.

The anti-bubble economists also point out that houses take a lot longer to buy and sell than stocks, which they say inhibits the kind of buying frenzy that drove stock prices beyond all reasonable limits. Finally, they say, real, long-term trends such as rising population and low interest rates have helped fuel demand.

The pro-bubble crowd

The "you bet we're in a bubble" crowd disagrees on virtually every point. They note that demand is likely to drop now that the baby boom generation has nearly finished forming new households. Immigration and the boomers' kids may take up some of the slack, they say, but not enough to offset the basic downward trend.

[also, if the economy slumps again for another reason, that will discourage the purchase of houses by or for immigrants.]

These economists see home-buying frenzies in many markets, as home prices continue to rise at unsustainable, double-digit paces. They think an uptick in interest rates alone could be enough to burst the bubble and send prices tumbling across the board.

[a simple continuation of slow growth could also have this effect, by implying rising unemployment and stagnant consumer incomes.]

They concede that not all markets will feel the pain equally, since not all markets have been bid up at equal rates. But substantial drops in large markets could be sufficient to drag down prices nationwide.

"There's probably no bubble in Gary, Ind., or Springfield, Ill.," said economist Dean Baker, co-director of the Center for Economic and Policy Research, a moderate [!!!]think tank. "But you're talking about large stretches of the country, up and down both coasts, where there is."

[Moderate? say it ain't so, Dean!]

Home prices vs. inflation

Home prices historically have just outpaced inflation. Since 1968, home values rose at an annual 6.3% rate, according to the National Association of Realtors, compared to 5.1% for inflation in the same period.

In the last seven years, however, home prices have risen nearly 30% more than the rate of inflation, adding $2.6 trillion to homeowners' equity, Baker said. He argues, in his Aug. 5 commentary, "The Run-Up in Home Prices," that there is no clear reason, other than speculation, for prices to have risen so fast.

Home prices are also beginning to diverge from rents, which are considered one of the ways to measure a home's fundamental value. (See my recent column, "Don't get trapped in a housing bubble." [which I sent to pen-l recently.]) While home values continued to shoot up during the first half of the year, rent increases slowed sharply.

The bubble-burst scenario

What if the bubble should burst? Baker quantifies it this way:

    * Home prices nationally could fall 11% to 22% -- wiping out most or all of recent gains. In some markets, prices could fall by 30%.

    * Between $1.2 trillion and $2.6 trillion of home equity would be lost.

    * Consumer spending, which has remained vigorous despite stock market losses, would finally slow or decline -- triggering another recession, with more layoffs.

The bubble crowd believes a collapse in home prices could be even more devastating economically than the bursting of the stock market bubble. Each dollar of home value gain is estimated to trigger 6 cents of additional spending, compared to 3 cents to 4 cents for each dollar of stock market gain.

This, they say, is the reason that consumer spending has held up so well despite three years of tumbling stock markets. If home prices should start to fall, however, Baker predicts a fall in consumer spending and demand equal to as much as 2.9% of the nation's gross domestic product. He notes that Japan is still trying to recover from the near-simultaneous crashes of its stock and real estate markets more than a decade ago.

Upside down

A decline in home prices could leave millions of homeowners "upside down" on their mortgages -- owing more on their loans than their houses are worth. Many people have been whittling away their home equity through cash-out refinancings or home equity loans, giving them less of a cushion than at almost any time in history.

While the average homeowner in the 1960s, 1970s and 1980s had equity equaling about 67% of their home's value, according to Federal Reserve statistics, today that ratio is just 55.2%.

Being "upside down" isn't necessarily a crisis -- unless you lose your job, as often happens in recession, or otherwise need to sell, perhaps because you stretched too far to buy the home in the first place. Then you can lose everything you put into the house, and then some.

So what's a homeowner, or prospective homebuyer, to do? You shouldn't necessarily put off a home purchase if you can otherwise afford it and believe you'll be able to remain in the house for several years.

If you're already a homeowner, selling your home now would allow you to lock in your gains. But you'll still need a place to live, and there's no telling whether you could afford to buy back into your market in the future.

After all, economists' opinions are not guarantees, and home prices could continue to rise or plateau rather than crash.

How to protect yourself

But do consider the following moves to protect yourself just in case:

See http://moneycentral.msn.com/articles/banking/basics/10318.asp

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Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine