No U.S. Housing Bubble Yet

While the recent rise in prices in the U.S. housing market is not currently indicating a bubble, the increases may be showing the emergence of one. However, bubble conditions are unambiguously emerging in several local markets, especially in the West. A housing market bubble is characterized as a sharp run-up in prices, followed by a subsequent rapid retracement. The initial rise is usually fueled by speculative activity that results in a sharp divergence from underlying economic fundamentals.The second phase of falling prices, however, brings the real worry to lenders and borrowers alike, since lending may have occurred on the basis of inflated, and thus unsustainable, asset values. Though recent price increases are not yet flagging bubble conditions, the increases are starting to approach worrisome levels. Housing prices nationally were rising largely due to favourable fundamentals rather than to speculative pressures that would be indicative of a housing market bubble. However, the situation seems to have changed recently. Affordability has deteriorated significantly in the second and third quarters of 2005 as housing price increases have spiked higher. As a result, affordability is quickly closing the gap relative to this measure's long-run historical average. Bubble conditions may not be present yet but are approaching such and thus require close monitoring going forward. To allay this concern, housing price increases will need to start to moderate soon from recent sharp increases. Our expectation is that this should occur, since rising mortgage rates should slow the growth in housing prices to a rate below gains in income. Sizeable declines in housing prices occurred in the early 1980s and the early 1990s, but both of these periods followed recessions. The attendant weakening in family income exacerbated the decline in housing prices by sharply reducing household demand. Pressures are particularly evident in the West where housing prices in local markets such as Riverside-San Bernardino (outside of Los Angeles) and Las Vegas are rising rapidly with an attendant marked deterioration in affordability. Rising prices in those areas seem more the result of speculative pressures and thus indicative of local housing market bubbles. There is the definite risk in these markets that prices will eventually need to correct sharply lower.