Viewpoint: Fed grapples with rocketing home prices

Recent reports in the news recount how older Northern cities with large populations are losing residents because of high housing costs. These residents are moving to the Southwest where it’s warm, and real estate costs are lower. The irony is that their influx is driving up home prices in that region as well.

It is symptomatic of a problem that is causing a good deal of worry for Alan Greenspan and the Fed. Part of the problem is that the 22 major local markets with the fastest-rising prices are responsible for 35 percent of the nation’s housing values, according to a report by Comstock Partners Inc.

The report noted that the chief economist for the Federal Deposit Insurance Corp., Richard Brown, said: “It’s a widespread boom and has macro implications. A slowdown would not only hurt these markets, but the U.S. as a whole.”

In the eyes of the FDIC, a local market is having a boom if it has appreciated 30 percent or more in the past three years (adjusted for inflation). Last year, 55 of 362 markets met that criterium and accounted for 40 percent of national residential values. Some observers hold a converse opinion, believing the boom is just local and will have little effect nationally.

A recent report from Fannie Mae said the likelihood of regional housing bubble bursts is up sharply in some parts of the country. The report found that conditions in these areas reflect “past conditions that preceded regional housing busts.”

Among those conditions are big increases in riskier loans, interest-only loans, or those loans not supported by proof of the borrower’s income and assets. More than 30 percent of the sub-prime loans were topped with a home equity loan that was approved at the same time. In total, mortgage loans climbed to an average of 91 percent of home values.

Comstock Partners, an investment company, observed on its Web site: “In our view a housing bubble with national implications definitely exists, and the risks to the economy are enormous. The Fed and other depositories are acutely aware of the situation, leaving them with the dilemma of what to do about it. If they tighten enough to really halt the rapid rise in home prices, the economy could very well go into a nosedive, a particularly scary situation, considering that all the debt still remains on the books. On the other hand, if they do little or nothing, the boom could get even further out of hand, making the eventual economic and financial unraveling even worse.”

To date, the Fed is following what it terms a “measured pace” in raising the Fed funds rate. Along with other agencies, it has started a policy of moral persuasion. Should that not work, we may see more actual tightening. Whichever way the Fed decides to move, the outcome may be very unpleasant for the economy and for the stock market.

Comstock said the Fed’s present dilemma is a direct result of its policy, which was launched early in 2001. It was aimed at trying to avoid the potential damage of a bursting housing bubble by prompting a rapid increase in housing prices. Soaring home prices were converted to ready cash through cash-outs on mortgage refinancing, hundreds of billions of dollars of them.

That, plus falling savings rates and rising household debt, allowed consumers to keep on spending in spite of declines in wages and salaries. Also, since the economic upturn began in November 2001, a full 43 percent of private sector employment increase has been in housing and housing-related industries. While all that worked short term, the long-term damage from this policy may be far greater than anybody anticipated, Comstock reported.

The high concern of the Fed was revealed in a press release with several other agencies back in May. The statement issued new guidelines it said were meant to promote “sound risk” management practices for home equity lines of credit and loans. The agencies found that in some cases, these practices for home equity lending haven’t kept pace with the loans’ rapid growth and looser underwriting standards.

The Fed’s concern also has been revealed in speeches and testimony. When Greenspan testified before the Congressional Joint Economic Committee, news stories focused on his comments that economic growth was solid. Mostly overlooked, however, were his remarks on the housing problem.

Greenspan noted before the committee, “signs of froth in some local markets where home prices have risen to unsustainable levels.” He also cited the growth of second-home purchases and the greater amount of speculative activity in stimulating the recent price increases. In addition, Greenspan mentioned the sharp increase in interest-only loans and what he called “exotic forms of adjustable-rate mortgages.”

Comstock reported the areas of “froth” noted by Greenspan are the locales with the biggest populations and the highest gross domestic product. Six days after the chairman’s testimony, the Federal Reserve Governor warned that the soaring rise in house prices may be unsustainable and urged banks and lending institutions to protect themselves against potentially harmful events.

The investment firm commented: “The problem is that even a mere cooling of the housing market, let alone a decline, kills the major impetus to the entire recovery since November 2001, and highly increases the probability of a recession and falling stock market with all of the associated risks to the fragile consumer debt structure.”

From the July 6-12, 2005, issue

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