In it's FYI reports, the Federal Deposit Insurance Corporation (FDIC) has been following housing booms and busts, and asking the rhetorical question "Does bust always follow boom?" the FDIC follows up with another FYI.

Despite five-year growth, in which housing prices have risen almost 50 percent, surpassing any increase in the last 25 years, most U.S. cities have demonstrated fairly stable home price trends over time, noted the February report, with only 20 percent of 361 cities experiencing either a boom or a bust.

The current issue of FYI updates the home price analysis from the previous report, using recently released 2004 data for the house price index (HPI) published by the Office of Federal Housing Enterprise Oversight (OFHEO). Based on this index, U.S. average home prices rose by almost 11 percent in 2004, up from seven percent in 2002 and 2003. Moreover, the number of boom markets according to FDIC definitions increased by 72 percent last year, and now includes some 55 metropolitan areas.

"The broadening of the U.S. housing boom during 2004 may imply a growing role for national factors -- including the availability, price, and terms of mortgage credit -- in explaining home price trends," suggests the report. "To the extent that credit conditions are in fact driving home price trends, the implication would be that a reversal in mortgage market conditions could contribute to an end of the housing boom. While history clearly shows that housing booms don't last forever, the manner in which they end matters for mortgage lenders and borrowers alike."

The FDIC's February report defined a "boom" market as one in which inflation-adjusted prices rose by at least 30 percent in a three-year period. Based on this definition, some 63 cities had experienced a boom at some point in the last 30 years, and 33 cities were experiencing a boom as of the end of 2003. The report also defined metro-area housing "busts" as markets in which home prices had declined by at least 15 percent (in nominal terms) over a five-year span. While 21 housing busts have occurred since 1978 under this definition, only nine of them have occurred on the heels of a housing boom, which means that busts don't necessarily follow booms.

Booms lead to busts in only 17 percent of metro-area markets prior to 1998, says the report, and were typically preceded by significant distress in the local economy. The most common way for a housing boom to resolve itself was through a period of price stagnation that allowed local economic fundamentals to catch up with high home prices.

But due to the relatively new variable of low-entry loans and heavily leveraged borrowers, which has driven market speculation (nonowner-occupied housing accounted for one-third of housing sales in 2004) as well as homestead buying, will a change in mortgage interest rates cause a bust?

The FDIC is uncertain, because of other factors:

• Based on the OFHEO house price index, U.S. average home prices rose by almost 11 percent in 2004. This was the most pronounced gain in nominal home prices since 1979 and was a substantially higher rate of appreciation than the seven percent gains in both 2002 and 2003. Adjusted for inflation, the price of the average home in the OFHEO sample increased by eight percent -- the fastest pace recorded in 30 years.

• The acceleration in home prices last year appears to have been greater than the improvement in underlying economic fundamentals would have suggested. Fundamental economic factors, such as rental rates and personal income, typically help to determine home price trends. Last year, home prices rose 11 percent, but rents only increased by 2.7 percent nationwide. In 2003, the seven percent gain in home prices also outstripped a 2.4 percent gain in rents.

• As for personal income, it grew 5.8 percent in 2004 and 4.2 percent in 2003. While stronger than the pace of rent growth, this was still far less than the pace of home price gains during the past two years. This gap between growth in home prices and incomes has been widening since the decade began. Moreover, the price-income gap has become especially pronounced in high-cost metro areas.

• The housing affordability index for first-time homebuyers of the National Association of Realtors, which takes into account home prices, incomes and interest rates, slipped 3.8 points in 2004 to 77.7. This marks the second-lowest annual level for the affordability index since the recession year of 1991. The lowest reading during this interval was 75.9 in 2000, when 30-year mortgage rates were over eight percent. If this decline in affordability continues, it might eventually weigh on home sales and price appreciation as first-time buyers are priced out of the market.

• The number of individual markets that met the boom criteria increased by 72 percent in 2004, to 55 metro areas. Some 15 percent of the 362 metropolitan areas for which OFHEO publishes the HPI met the boom criteria at year-end 2004. This represents the highest proportion of "boom" markets nationwide in the 30 years of historical price data published by OFHEO. The 55 boom markets last year compare to 22 just two years earlier, and to only nine boom markets identified as recently as 2000.

Why did some areas boom? A combination of historical price volatility and strong local market fundamentals. Almost half, or 47 percent, of the 2003 boom markets had seen other booms prior to 2000. However, of the 24 boom markets added to the list in 2004, only six have ever previously experienced a boom in their history. Eighteen markets are booming for the first time according to the OFHEO data and based on our criteria.

National as well as local factors may also be a reason. Historical booms and busts in local markets typically relate mainly to local market factors. However, the notable expansion in the number of boom markets in 2004 suggests that national factors could be helping to drive home prices higher.

If national factors are coming more into play, then clearly the most important factors to look to would be the availability, price, and terms of mortgage credit, advises the report:

• The cost of mortgage credit has remained at generational lows during the past two years. The annual average contract rate for 30-year mortgages published by Freddie Mac fell below six percent in both 2003 and 2004 -- the first time this index has ever been below six percent in its 33-year history. Meanwhile, rates charged on adjustable-rate credit have been based on short-term Treasury rates that fell to their lowest levels since at least the late 1950s. The low cost of mortgage credit at this stage of the housing cycle could be one factor pushing prices higher by enabling buyers to qualify for larger mortgages given the same monthly payment.

• There have been a number of changes in mortgage markets that could have an influence on home prices, including the emergence of high loan-to-value lending and subprime lending. Subprime mortgage originations showed a marked increase during 2004, surging to nearly 20 percent of all mortgage originations from just under nine percent in 2003. This reversed a three-year decline in the relative size of the subprime market. The majority of subprime loans have been characterized by short-term adjustable-rate structures, many with prepayment penalties.

• Use of adjustable-rate mortgages, or ARMs, remains high. According to the Mortgage Bankers Association, ARMs accounted for almost 46 percent of the value of new mortgages in 2004 and 32 percent of all applications. Both figures were up sharply from their 2003 levels of 29 percent and 19 percent, respectively. It is noteworthy that this development occurred despite the fact that the average annual fixed rate for a 30-year mortgage remained virtually unchanged from 2003.

• Data from the Federal Housing Finance Board indicates that the ARM share is high and rising in several boom markets. Taken together, these trends suggest that highly-leveraged borrowers are increasingly taking on interest-rate risk as they stretch to afford high-cost housing. Although home owners taking out ARMs may be more exposed to "payment shock" when their monthly payments adjust upward with rising interest rates, for many, this event is some years off. A large share of ARMs originated in recent years featured initial fixed-rate periods that could last up to ten years.

• Another evolving trend that has not been tested in a housing market downturn is the increasing market penetration of innovative mortgage products, such as interest-only (I/O) and option ARMs. These mortgages are specifically designed to minimize initial mortgage payments by eliminating principal repayment; but these also can increase leverage and expose owners to large jumps in monthly payments as interest rates rise.

• Heightened investor purchases of homes could also be signaling a higher degree of speculative activity in housing markets during 2004. Data from Loan Performance indicates that nine percent of U.S. mortgages in 2004 were taken out by investors, up from just under six percent in 2000. Furthermore, this share is significantly higher in local markets that are experiencing the strongest home price appreciation. In some of these markets, it is estimated that the investor share of new mortgage originations is as high as 19 percent. Academic studies show that residential property investors are less loss-averse than owner-occupants and thus, more likely to sell precipitously in a declining market, thereby aggravating any existing downtrend in home prices.

Conclusions? Analysis of the OFHEO historical home price data shows that metro-area housing booms don't last forever. But what matters to lenders and borrowers alike, is the manner in which housing booms end. In over 80 percent of the metro-area price booms we examined between 1978 and 1998, the boom ended in a period of stagnation that allowed household incomes to catch up with local home prices. While neither lenders, nor current homeowners particularly like stagnation in home prices, such an outcome represents a necessary adjustment in market conditions that helps bring home prices within the reach of new homebuyers.

Published: May 5, 2005

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