BUBBLE, BUBBLE, TOIL AND TROUBLE!

Abstract

Introduction and summary Home prices have been in the news a lot lately. In particular, some observers fear that the swift increase in prices during the early part of the new century may have constituted a housing price bubble. (1) This concern has been prompted primarily by the rapidity of the rise, both compared with previous years and relative to growth in rents. (2) The home price increases, however, occurred during a period of rising incomes and falling mortgage rates. The changes in both income and mortgage rates made housing more affordable and therefore have led to higher home prices, all else being equal. In this article, we document changes in prices for the country as a whole and for many major markets. We examine whether changes in the economy, including income and mortgage rates, are enough to explain home price changes, both nationally and locally. To determine whether there has been a bubble--and whether the bubble is bursting--we need to know what home prices should be. We use data from 1980 through (midyear) 2006 to create a simple reduced-form model of single-family home prices. Our focus is on the relationship between home prices and mortgages rates. We use a metric that measures the fraction of income necessary to cover the mortgage payments on a home. We find that this metric helps explain home prices and that, as expected, falling mortgage rates are associated with higher prices. Our sample period includes times when home prices were growing rapidly and times when they were not. One focus of this article is to determine whether the past few years are truly different from prior years, that is, whether there is a housing bubble, either in the nation as a whole or in selected markets. As noted, in recent years, home prices have increased more than rents. We show that they have also increased relative to changes in mortgage rates and income. When we estimate our regression model, we find that, on average, home prices are above their predicted levels in the post-1999 part of our sample. However, this result does not hold true uniformly across the country. Markets on the coasts, especially those in California, Florida, and the Northeast, have prices significantly above predicted levels. Some other markets have prices below predicted levels. Thus, to the extent that prices have been overheating, the phenomenon is limited to some markets, many of which have traditionally exhibited volatile prices. Still, if factors such as the recent increases in mortgage rates cause prices to move toward their predicted levels, there could be significant corrections on the horizon in some markets. When we focus on the Seventh Federal Reserve District, (3) we find little evidence of a housing price bubble. Home prices in the larger markets in the Seventh District show some volatility, but are generally in line with other markets in the interior of the country. In the smaller markets, home prices have not deviated much from their predicted values. Background Figure 1 charts the median sale price of an existing U.S. single-family home over the last 36 years (all dollar values are in constant 2006 dollars). (4) Over the period, prices were generally increasing, except for several years in the early 1980s. The median home price was $118,500 in 1972. It increased to $148,700 in late 1980 before high mortgage rates and inflation pushed prices down. Prices fell through 1984, reaching a minimum of $131,400 near the end of that year. There then was a period of moderate price increases from 1984 through 1994, with prices increasing at a 1.2 percent annual rate. After that, prices increased at an accelerating pace through 2000, rising at 2.1 percent per year; at the end of 2000, the median home price was $169,400. This increase was similar to that of the 1970s. But starting around the turn of the century, the rise in home prices really began to accelerate. Prices went up at an annual rate of 7. …