Bubble? Schmubble!!

That's the basic message of a new housing price inflation study from the Federal Reserve Bank of New York. Conducted by senior economist Jonathan McCarthy and Fed vice president Richard W. Peach, the report takes a hard look at the possibility -- widely hyped in books and the media -- that current high home values could be "susceptible to a steep decline that could have a severe impact on the broader economy" nationwide.

The authors acknowledge that the increase in U.S. home prices experienced during the past decade has been unprecedented. Adjusted for inflation, home prices have increased at "roughly double" the rate of appreciation experienced even during the late 1970s and late 1980s home price booms. Even more significant, they say, the median home price in the U.S. is now more than three times median household income -- a record level well in excess of price-to-income ratios during the booms of the 1970s and 1980s.

Why then, is there little or no statistical likelihood of a bursting of the national housing hot air balloon? For starters, say McCarthy and Peach, the cost of mortgage money remains at near-record lows. Low rates, in turn, allow home buyers to pay higher prices for properties without stretching their household incomes.

McCarthy and Peach computed the ratio between annual principal and interest payments at prevailing mortgage rates on new single-family homes and median household incomes. Assuming a 30-year loan with 20 percent downpayment, the ratio is currently at or close to a 25-year low point -- 15 percent. Put in simpler terms, even with significantly higher real housing prices, home buyers' monthly outlays to pay for their mortgages are the lowest they've been in a quarter century, thanks to 40-year lows in mortgage rates.

"This is in sharp contrast to the conditions of the (hyperinflationary) 1970s and 1980s, when high home prices and high nominal interest rates combined to erode cash flow affordability," said McCarthy and Peach.

A significant increase in mortgage rates would throw a monkey wrench into this equation, of course, but probably not trigger a blowout decline in prices, absent other negative economic events such as a severe jump in unemployment or a decline in the rate of household income growth.

Where home prices are potentially vulnerable in the years ahead, according to the study, are in regional markets that have experienced the highest appreciation rates during the past decade. California, New England and much of the mid-Atlantic seaboard historically have had "the most volatile home prices" -- and highest cost levels -- in the country. All have experienced significant swings in home pricing, with sharp run-ups followed by corrections.

The reason for this volatility, according to McCarthy and Peach, is an "inelasticity" in housing supply caused by "population density and building restrictions." In contrast, states with comparable income growth but relatively low housing appreciation rates -- Utah, New Mexico, Idaho, North Dakota, for example -- have much more abundant and steady supplies of housing relative to demand.

Translated into real estate terms: When local and regional governments in densely populated markets restrict housing development or available housing supplies within commuting distances of employment centers, they help inflate housing prices. That inflation, in turn, can contribute to volatile swings in property values, with high-gain periods followed by cool-down periods or actual contractions. For example, during the early 1990s, Southern California houses that had been appreciating at double digits during the "go-go" years of the late 1980s, declined in value by an average 25 to 30 percent.

The bottom line here, according to the Fed economists: Nationwide, there is no housing bubble. Incomes and price gains are in synch, thanks to low interest rates. But in markets with inelastic housing supplies and high appreciation rates, any economic jolt -- rising costs of money, rising unemployment -- could trigger price declines.

Published: June 28, 2004

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.