Bubble or no bubble? Real estate economists and Wall Street soothsayers have been arguing that question, pro and con, for more than two years. But now a prominent mortgage bond economist has weighed in with a comprehensive statistical analysis that suggests that -- hold on now -- both sides may be right.

Dr. Michael D. Youngblood of Friedman, Billings, Ramsey & Co. says emphatically that there is no nationwide housing price bubble. Using current and historical per capita income and house price data in 369 major markets, statistical tests confirm that on a countrywide basis, there is a long-term "equilibrium" that "precludes a (national) bubble" in house prices, according to Youngblood.

However, using the same statistical tests, he found that there are localized bubble situations where housing price appreciation is seriously unhinged from growth in household incomes. There are, by his calculations, 27 such markets around the country, with an aggregate population of 57 million, representing about 19 percent of the U.S. population. They include San Diego, San Jose, Santa Barbara, Los Angeles and several other major California markets, but also include Boston, New York City, and Honolulu.

The mere existence of localized bubbles does not mean that they all must at some point bust or deflate. None of the 27 markets is likely to see significant housing price deflation in the immediate future, according to Youngblood -- not until their local economies show four straight quarters of recession.

To illustrate the dynamics of housing bubbles, Youngblood examined the experience of the Los Angeles market from 1988 through the mid-1990s. Los Angeles house prices hyperinflated at double digit rates -- sometimes exceeding 20 percent a year -- in the mid and late 1980s, and fit the economic profile of a "bubble" by the final quarter of 1988. (Youngblood defines a bubble as existing when the "expected growth rate of an asset" -- in this case house prices -- "dominates fundamental factors in determining the price of an asset. In a bubble, the self-fulfilling expectations of market participants cause the price of an asset to change.")

What triggered LA's five-year housing deflation of 1990-1995 was the local economy's steady, grinding decline, culminating in 1993's 0.6 percent net decrease in per capita incomes and an unemployment rate of 10 percent. House prices in the Los Angeles market didn't really begin to recover until 1997-1998, after net declines that exceeded 20 percent in many parts of the metro area.

Los Angeles today is again seeing high double-digit appreciation -- more than 30 percent from the third quarter 2003 to the same period in 2004, according to the federal agency that tracks prices. But the local economy shows no signs of the unraveling that occurred a decade earlier. The household unemployment rate fell to 6.3 percent in late 2004, according to Youngblood, per capita income is up by 3.5 percent, and payroll employment expanded by 1.7 percent.

"We do not expect (LA's) bubble (in housing prices) to burst until economic activity contracts briskly for a minimum of four quarters," says Youngblood. Clearly that is nowhere in sight at the moment. However, if and when household incomes decline and unemployment rises, deflation along the lines of the mid-1990s experience would be likely.

The bottom line here for buyers and investors in Youngblood's list of 27 bubble markets? For clues on the timing and severity of possible future price reversals, keep a close eye on the most fundamental local economic statistics -- jobs and incomes. When they start heading south, and do so for several quarters, the bubble is highly likely heading for trouble.

(Youngblood's 27 markets include: Santa Barbara, Santa Cruz, San Luis Obispo, San Jose, Salinas, Oxnard, Petaluma, San Diego, Los Angeles, Santa Rosa, Napa, Fairfield, Vallejo, Paso Robles, Chico, Riverside, San Francisco, Modesto, Merced, and Stockton, all in California. Bubbles outside of California include: Boston; New York City; Danbury, CT; Honolulu; Boulder, CO; Provo, UT; and Bellingham, WA.)

Published: January 24, 2005

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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.