J A N U A R Y 2 0 0 6
Is the U.S. Housing Bubble Over-inflated?
The US residential housing market has experienced
rapid price appreciation over the past several
years, driven by an improving economy, low
KEY FINDINGS interest rates and increased levels of home
s While evidence suggests that the US housing ownership. The median price for existing homes
market is slowing, the risk of a housing bust nationwide increased 8% in 2003, 9.1% in 2004,
seems low. We believe a gradual slowdown and will likely exceed 10% in 2005, a material
in the rate of appreciation in housing prices increase from the 55-year average annual increase
is a more likely scenario. of 4.8% (see Exhibit 1). These outsized gains
s Housing affordability is at historical lows, the risk have enticed speculative investors to participate
profile of borrowers has increased, and savings in the US housing market and encouraged lenders
rates have continued to decline, suggesting to market riskier financing products to prospective
consumers are spending a meaningful portion buyers, with both parties increasingly using
of their housing-related wealth. optimistic expectations for further price
appreciation to justify their investment decisions.
s Offsetting these concerns, favorable
demographics support steady housing demand, US homeowners borrowed $600 billion against
stable vacancy rates in the rental market suggest the growing equity in their homes in 2004, which
that supply and demand for housing are has tripled in the past five years to represent
relatively well-balanced, and upward resets on approximately 7% of disposable personal income.2
outstanding Adjustable Rate Mortgages (ARMs) Mortgage debt in mid-2005 totaled approximately
will be fairly well-distributed in coming years. $8 trillion, or 43.5%, of total US housing value
s The UK experience suggests that a reversion to of $18.4 trillion. Investors now represent
normalized levels of annual home price appreciation approximately 18% of home buyers through June
could have a negative impact on consumer 2005. With home prices significantly outpacing
spending, which has been one of the key drivers personal income, affordability has reached all-time
of the US economy for the past several years. lows, forcing buyers to take on more leverage with
a greater degree of interest rate risk to purchase
a home. How will this cycle end?
Annual National 14
House Price Growth
Source: E.H. Boeckh 8 Average Growth Rate
and Associates, Bureau
of Labor Statistics,
US Census Bureau 6
and Freddie Mac,
November 2005 4
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
National Association of Realtors
Greenspan, Alan and Kennedy, James, Federal Reserve Board. Estimates of Home Mortgage
riginations, Repayments, and Debt on One-to-Four Family Residences, September 2005.
Is the U.S. Housing Bubble Over-inflated?
LOW RISK OF A HOUSING BUST a 30-year fixed rate 5.5% mortgage to an
adjustable rate mortgage with a 1% teaser rate.
While there is evidence that the US housing market Yet the $500 out-of-pocket differential per month
may be slowing, the risk of a housing bust, carries significantly greater risk, namely that the
characterized by a 10% or greater decline in 1% teaser rate could rise dramatically over the
nominal house prices nationwide, appears low. course of the loan. While the borrower in a 30-year
Catalysts for such a decline could include an fixed rate mortgage would feel no impact from
oversupply of housing coupled with either a rising rates, his monthly payment in an ARM would
significant increase in unemployment, a sharp increase by roughly $200 for every 1% increase in
and unexpected spike in interest rates, or an rates. If rates increase more than 2.5% over the life
economic recession. None of these catalysts seem of the ARM, the borrower would have been better
to be on the horizon in the US economy: housing off remaining in the 30 year fixed rate mortgage. 3
supply has lagged job growth in most regions,
unemployment rates are low, long-term interest
rates are relatively unchanged while short-term RISING INTEREST RATES HURT
rates have been rising at a measured pace, and HOMEOWNERS WITH ADJUSTABLE RATE
US economic growth remains healthy. In fact,
these factors could serve to alleviate a bust. MORTGAGES
Clearly, a rising interest rate environment will hurt
What appears more likely is a gradual slowdown homeowners with adjustable rate mortgages.
in the rate of appreciation in housing prices going To the extent that short-term interest rates
forward. Overheated markets in coastal areas that continue to rise and long-term bond yields remain
have enjoyed strong double-digit appreciation may low, the spread in yield between 2-year and
experience a sharper decline. Such a slowdown 10-year Treasuries may continue to shrink. An
could have a negative impact on consumer inverted yield curve, whereby short-term rates are
spending, which has been one of the catalysts higher than long-term rates, is often associated
driving the US economy for the past several years. with an economic slowdown or even a recession,
which would be negative for home equity values.
BUYERS TAKING ON MORE RISK While the Fed has historically eased monetary
policy within a few months of a yield curve
Affordability of US housing is at an all-time low. inversion, the Fed’s apparent focus on achieving
As home price appreciation has outpaced income a neutral level of short-term interest rates and
growth, prospective buyers have been forced maintaining price stability could come at a cost in
to take on greater interest rate risk to purchase terms of slower economic growth in the near term,
a home. While the more innovative financing posing an additional risk to the US housing market.
alternatives may look attractive to prospective
buyers, many of them may not understand
the underlying risks they are taking with
One example is the use of an adjustable vs.
a fixed rate mortgage. There are several types
of adjustable rate mortgages (ARMs), however,
all share one feature: after an initial period of fixed
payments with low rates, the loans adjust – usually
to the prevailing yield of one-year Treasury bills plus
a margin of one to three percentage points. Using
reasonable assumptions, the monthly mortgage
payment on a $230,000 home could decline by as
much as $500 per month simply by switching from
2 Janus Research.
SAVINGS RATES CONTINUE TO DECLINE years, which may have contributed as much as
1% to US economic growth. If this wealth effect
As home equity values have made consumers feel were to diminish, consumer spending, and indeed
wealthier and supported higher levels of consumer economic growth, could be adversely affected.
spending, savings rates have continued to decline.
Savings rates fell to a record low of -1.5% in late
2005 from 2004’s already-low 1.7% average rate RISK PROFILE OF BORROWERS
(see Exhibit 2). A slowing housing market would HAS INCREASED
dampen the positive wealth effect associated with
rising home equity values, driving consumers to Within the mortgage-backed securities market,
save a greater share of their incomes and returning the risk profile of borrowers has increased over
the savings rate to positive territory. While this the last several years. A brief snapshot of the prime
may be a healthy turn of events over the long mortgage subsection of the market, which includes
term, the hit to consumer spending in the near only non-agency jumbo loans, illustrates this trend.
term could be significant. Prime borrowers have increasingly used ARMs to
Exhibit 2 $320,000 10.0
Personal Saving Rate
New One-Family (percent: red line: rhs)
Houses: Averege $280,000 7.5
with Personal 5.0
Source: Census Bureau, New One-Family Houses:
BEA, Merrill Lynch, Average Sales Price
December 2005 (dollars: black line: lhs)
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
HOUSING WEALTH HAS BOOSTED reduce their near-term mortgage payments,
CONSUMER SPENDING while exposing themselves to greater interest
rate volatility over the life of the loan. While
Consumers have extracted money from their homes representing only 36% of total mortgage
to increase spending levels over the past several originations, ARMs accounted for 71% of all
years, which has been an important driver of US prime originations by late 2005 (see Exhibit 3).
economic growth. One recent study suggests Innovative mortgages, such as interest-only
that the long-term wealth effects of housing ARMs and option ARMs, have also become
and equities are similar, but that 80% of housing a large portion of the prime, near-prime and
wealth finds its way into consumer spending sub-prime markets in the last several years.
within 12 months, while stock market gains
typically translate into consumer spending over
a five-year period. Using reasonable assumptions,
housing wealth has likely accounted for over 20%
of the growth in US consumer spending in recent
Is the U.S. Housing Bubble Over-inflated?
Loan-to-value (LTV) ratios have increased, Assuming replacement demand of 20 million units
effectively reducing total home equity, and over that time period, the US will need to build
debt-to-income (DTI) levels have risen by roughly 59 million new units between 2000 and 2030.6
9%. The percentage of prime mortgages sold to
investors has tripled during this period, and the Furthermore, in several desirable regional areas,
percentage of full documentation loans, which job growth has meaningfully exceeded housing
require borrowers to provide more information growth, which has put upward pressure on
to process the loan, has nearly halved, both housing prices. In the year ending March 2005,
indicative of greater risk in the sector. 28,000 new jobs were created in Orange County
on the Southern California coastline, while only
Exhibit 3 Origination Year ARM% FICO Current LTV Loan Size Investor% Full Doc DTI
Prime Mortgages 1998 9.0% 725 72.3% 330 0.6% 72.2% 25.5%
2000 33.1% 723 74.5% 368 1.1% 64.0% 29.5%
Source: Source: UBS,
July 2005 2005 71.4% 731 73.5% 453 3.3% 38.6% 34.5%
8,200 new building permits were issued. In
NOT WORRIED ABOUT A Washington D.C., 66,400 new jobs were created
HOUSING BUST with only 30,300 new building permits issued.7
We identify five factors which may serve to offset This supply/demand imbalance has resulted in
these concerns. significantly greater price appreciation in both
areas than in other parts of the country. As long
Favorable Demographics Driving US as local employment remains healthy, strong
Housing Demand housing demand should create a pricing floor
First, favorable demographics are driving US in these markets.
housing demand nationwide. The US population Real Estate is a Local Business, not a
is projected to grow by approximately 2.7 million National One
people annually for the next 10 years, while Japan
and much of Western Europe will most likely Second, localized ”mini-bubbles” can burst
experience a notable decline in population. 4 without necessarily throwing the national housing
Between 1990 and 1999, approximately 12 million market into a tailspin. Real estate is a local business,
new US households were created as a result of not a national one, and housing prices are largely
record numbers of immigrants entering the U.S. driven by the relative strength of the local job
over the past 2 decades and a growing number market. Historically, the volatility in home prices
of “non-traditional” – single-parent, single person, experienced in desirable locations, such as Southern
unmarried couples, female-headed – households. California, has been materially greater than the
Another 14 to 15 million new households are nationwide average. Beginning in 1991, San Diego
expected to be added between 2005 and 2015. experienced 3 consecutive years of job losses and
Together, household growth and replacement existing home prices declined approximately 10%,
demand are expected to support the construction with national housing prices largely unaffected.
of another 20 million new homes over the next While home prices in the Northeast have
decade,5 which would require annual housing appreciated close to 70% over the past five years,
starts to remain at approximately 2 million. housing prices in Texas and other parts of the South
Looking further into the future, estimates suggest have risen roughly 25% over the same period.8
that population growth will require nearly 39 Annual increases in house prices in 2005 range
million new units between 2000 and 2030. from less than 5% to over 25% (see Exhibit 4).
U.S. Census Bureau, Population Division, Interim Opportunity To Rebuild America, The Brookings Institution
State Population projections, 2005. Metropolitan Policy Program.
Joint Center for Housing Studies of Harvard (7)
John Burns Real Estate Consulting, Local Building Market
University, The State of the Nation’s Housing 2005. Intelligence.
Nelson, Arthur C. Toward A New Metropolis: The (8)
Housing Credit Market, Goldman, Sachs & Co., November 2005
WA NH ME
16.1% VT 12.5% 14.1%
Exhibit 4 MT 16.2%
OR 11.5% ND MA 12.1%
Single Family House 14.8% ID 9.5% MN NY
9.7% 15.4% RI 17.4%
11.9% SD WI
Price Growth, 9.6% MI CT 14.2%
WY 9.3% 4.9% PA
Q204 – Q205 NV 10.9% 13.8% NJ 18.7%
27.0% NE 5.6% IN 5.4% DE 17.4%
UT 4.9% IL WV VA MD 23.7%
CA 9.1% CO 10.1% 4.9% 8.9% 21.8%
25.7% 5.5% KS MO KY
Source: Freddie Mac 4.9% 7.8% 6.0% NC 6.1%
Conventional Mortgage AK AZ TN 7.1%
Home Price Index 11.9% 28.0% NM OK SC 7.1%
Annual Growth, 11.9% 7.4% GA
MS AL 6.4%
June 2005 4.4% 7.8%
Adjustable Rate Mortgage Rates Will Reset Build to Order Model Mitigates Risk of
Gradually Over Time Housing Glut
Third, notwithstanding the growing concern Fourth, the evolution of the build-to-order
about the rise in ARMs as a percentage of total model within the homebuilding industry should
mortgage originations, these innovative mortgages contribute to a more rational supply/demand
represent only 36% of total outstanding mortgage environment as the housing market slows. In many
obligations, with the remaining 64% in fixed-rate markets, over 50% of the homebuilder’s costs are
product. Additionally, over the next decade, no not incurred until a buyer orders the home.
more than 6% of the mortgage market will Because the majority of his costs are not exposed,
experience an ARM rate reset in any given year. the builder has little incentive to construct unsold
The distribution of ARM resets should mitigate a homes and create excess inventory. In addition,
high concentration of defaults in any given period. the builder increasingly has the ability to option
land, rather than purchase it outright.
Exhibit 5 9-10
as a % of the
Years in the future
Source: Bear Stearns 3-4
Jumbo's, Alt.-A’s, and 1-2
Subprime securitized <1
0% 2% 4% 6% 8%
Percentage of universe that resets
Is the U.S. Housing Bubble Over-inflated?
By putting most of the money down only when rates typically decline as potential home buyers
ready to start construction, builders can assess the decide to rent instead. However, if vacancy rates
market and estimate their expected returns before continue to fall, demand for rentals usually
committing more capital and creating more supply. increases, driving up rental costs, and renters
If demand softens and estimated returns are too may decide that buying a home is a more attractive
low, the builder may elect to sit on the land, to investment. Double digit vacancy rates coupled
build fewer homes and accept a lower price for with strong home price appreciation might be
them, or to renegotiate terms with the land owner. a cause for concern as buyers may be reaching
This flexibility should reduce the likelihood that beyond what they can afford. Vacancy rates in the
builders will create an oversupply of unsold mid single digits historically suggest that owning
housing inventory. Inventory sale time for new and renting a home are both relatively attractive
homes has been remarkably stable over the past alternatives. After peaking in early 2005, apartment
five years at just under five months, suggesting vacancy rates have stabilized at 6%, suggesting
that supply and demand have been better aligned that while there may be some switching from
than in previous economic cycles. buying to renting on the margin, supply remains
relatively tight in the housing market.
Exhibit 6 15
Months Supply of 13
Homes for Sale 12 Existing Homes
Bureau and National
Association of Realtors, 8
November 2005 7
4 New Homes
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Investors Increasingly Renting, HOUSING PRICES MORE LIKELY TO
Not Flipping Properties
Finally, outside of overheated markets like Miami
Rather than experiencing a nationwide bust,
and Las Vegas, many investors in the housing
the housing market should level off, with annual
market are renting their properties rather than
nationwide home price appreciation slowing from
trying to sell them for a quick profit. With housing
10% to the low single digits. Overheated markets
investors earning a low single-digit annual return
in coastal areas where home prices have increased
by renting their properties, new homes purchased
20% per year may see a much sharper slowdown.
by investors that have entered the rental pool are
Notwithstanding the strength in consumer
less likely to come for sale in the open market,
spending and the decline in household savings
reducing the risk of a supply glut.
rates over the past several years, consumers have
One way to analyze the risk of a supply glut is not spent 100% of the appreciated value in their
through demand for apartment rentals, which homes. In the event of a sharp fall in home equity
are effectively the substitute product for home values, the past several years of appreciation will
ownership. As home prices appreciate, vacancy create a cushion for homeowners.9
6 Greenspan, Alan and Kennedy, James, Federal Reserve Board. Estimates of Home Mortgage Originations, Repayments,
and Debt on One-to-Four Family Residences. September 2005.
While consumer liabilities are growing, assets have times the median annual income.11 To the extent
grown substantially as well. Widespread defaults that home prices level off and consumers feel less
are unlikely so long as home equity is still positive. wealthy, overall consumer spending could be hurt,
which would in turn weigh on economic growth.
The negative wealth effect of lower home price
appreciation, however, may weigh on consumer
spending. While consumers have been feeling UK EXPERIENCE SUGGESTS SLOWER
wealthier and spending more, income growth CONSUMER SPENDING
has not kept pace with home price appreciation.
Between 2001 and 2004, home price appreciation The UK experience over the past several years is
exceeded income growth by an average of 6.5% illustrative in this regard. UK average home prices
on existing homes and 7.1% on new homes. have increased roughly fourfold in the past 20
Estimates suggest that this gap between home years. The majority of the UK mortgage market
prices and incomes increased to nearly 8% on is comprised of two-year ARMs. The mid-1990’s
existing homes and 12.6% on new homes in ushered in a period of strong double-digit annual
2003–2004. In the most expensive US cities,
10 home price appreciation, which has since leveled
the median home price now represents 8 to 9 off with little to no appreciation in the past 2
years. Home equity values have not declined in
absolute terms. However, the negative wealth
Exhibit 7 35
effect associated with financing an asset that
30 is no longer rising in value at higher interest rates
U.K. House Price
is a factor that has sharply curtailed UK consumer
spending and increased the UK savings rate during
(3 Mo. Avg. Y/Y % 20 this period.
15 At the peak of the UK housing market in
2003, annual home price appreciation reached
Source: International approximately 25% and retail sales had grown
Strategy and Investment, 5 nearly 8% over the prior year. Today, UK home
November 2005 prices are stable with annual appreciation of less
than 5%, while retail sales growth has slowed
-5 to less than1%.
To put this in perspective, US housing prices in
88 90 92 94 96 98 00 02 04 2003 and 2004 increased 8-9% per year, less than
half the UK’s peak annual increase of 20%. In
addition, the US housing market has experienced
Exhibit 8 12
roughly half the appreciation that the UK market
U.K. Nominal has in the past 20 years. Furthermore, while ARMs
10 increased from 9% to 36% of the outstanding
mortgage universe between 2001 and 2005,
(Y/Y % Oct. 0.2%) 8 fixed-rate mortgages remain a much larger share
of the total loans outstanding in the US than in
6 the UK. Less dramatic price appreciation and more
Source: International modest exposure to rising interest rates together
Strategy and Investment,
4 suggest that the impact of slowing home price
appreciation on consumer spending appears likely
to be more modest in the US than in the UK.
88 90 92 94 96 98 00 02 04
7 Janus Research.
Standard and Poors, US House Prices: Even Pretty Bubbles Pop.
Is the U.S. Housing Bubble Over-inflated?
US IS MORE LIKE THE UK, FINANCIAL SERVICES LESS EXPOSED
LESS LIKE JAPAN THAN IN PAST CYCLES
While the recent UK housing cycle provides insight From a financial services perspective, where is all
with respect to the potential range of outcomes this risk in the mortgage industry going? Certainly
in the US, the Japanese real estate collapse is a the banking system is accepting its fair share with
lessuseful analogy. While the UK and US real estate mortgage portfolios exceeding $50 billion at Bank
booms have been concentrated in the residential of America, Wells Fargo, Washington Mutual,
housing market, Japan's real estate bubble was Countrywide and Golden West. Mortgages held
concentrated in the commercial sector. A healthy by US commercial banks increased 160% from
economic environment and strong job growth 2001 through 2004. 12
helped drive housing prices higher in the US, while
the Japanese real estate boom was largely a result However, a real change in the mortgage industry
of excessively loose lending standards on the part is the growth in the securitization market – where
of the major banks, which provided companies an originated mortgage is packaged into a pool
looking to invest in office space, golf courses of similar mortgages and sold as individual
and other non-core activities with plenty of cheap securities with varying degrees of risk. Once
capital. Unlike the gradual monetary tightening dominated by Government-Sponsored Enterprises
by both the Bank of England and the US Federal (GSEs) Fannie Mae and Freddie Mac, this $5.6
Reserve, the Bank of Japan increased interest rates trillion secondary market has enabled financial
rapidly and dramatically to curb speculative activity institutions to remove some of the credit risk
and pop the commercial real estate bubble in that from their balance sheets, while distributing
country. Notwithstanding that many of these real that risk among a diverse set of investors seeking
estate projects were financially under water, the higher-yielding fixed income securities. New
banks who had lent the money refused to call in issuance of private-label Mortgage-Backed
the loans they had extended to their corporate Securities (MBS) increased 40% in the first half
borrowers, and the losses continued to mount. of 2005 over the same period in 2004. As Fannie
The growing pool of non-performing loans on Mae and Freddie Mac have continued to lose
bank balance sheets, coupled with significant market share, non-GSE mortgage securitizations
overinvestment by Japanese manufacturers, have more than doubled as a percentage of the
subsequently led to a sharp contraction in overall MBS securitization mix in the past 3 years,
Japanese bank lending, and the Japanese accounting for 53% of all securitization activity.
economy, in the years that followed. 2004 saw a record $864 billion in non-agency
issuance, a 47% increase over 2003. As a result
In contrast to the Japanese experience, UK of this trend, while the mortgage portfolios at
and US banks have remained relatively disciplined many banks have grown substantially in the past
lenders in the context of rapidly rising home several years, their underwriting risk has been
prices. US and UK banks have more robust cash mitigated somewhat. Exhibit 9 shows the
provisioning practices, whereas Japanese banks percentage of outstanding bond market debt
have always relied on collateral provisioning, invested in MBS as of March 2005.
which is less liquid and more prone to murky bank
lending and moral hazard. In addition, rather than
keeping all the real estate exposure on their own
balance sheets as the Japanese banks did, US
financial institutions have aggressively used
securitization as a tool to remove some of the
mortgage exposure from their books. We discuss
this topic in more detail in the next section.
Office of the Comptroller of the Currency Quarterly Journal, JPMorgan Investor Presentation, October 2005.
Vol. 24, No. 3, September 2005. Inside MBS & ABS.
Bond Market Association.
MBS as a % of Total Corporate ($4.9) 9%
20% 1. Interest-bearing marketable public debt.
($ trillions) 2. Includes FHLMC, FNMA, FHLBs,
Treasury ($4.1)1 Sallie Mae, Tennessee Valley Authority
17% and Farm Credit System.
Money Market ($3.0)5 3. MBS include GNMA, FNMA and FHLMC
Source: Bond Market 12% mortgage-backed securities, CMOs, and
Association, March 2005
Agency Debt ($2.7)2
4. Includes public and private placements.
4 5. Includes commercial paper, bankers’
acceptances, and large time deposits.
MORTGAGE-BACKED SECURITIES LIKELY This trend appears to have already begun,
as investors in lower credit-quality MBS products
TO SEE SPREAD WIDENING have begun to demand more compensation for
Within the fixed income markets, the yield heightened credit risk. For example, spreads on
spread between mortgage-backed securities BBB-rated subprime MBS widened by 153bps
and US Treasuries will likely widen if housing price from October through mid-December 2005,
appreciation slows to a more "normal" rate. Agency bringing yields to 2-year highs (see Exhibit 10).
MBS, which have the guarantee of timely payment In contrast, spreads on agency-wrapped MBS
of interest and principal by Fannie Mae, Freddie widened by only 40bps over the same period.
Mac or Ginnie Mae, should experience less spread A similar “tiering” or credit risk would most likely
widening than the other sectors of the mortgage occur within the entire MBS market should the
market. The initial impact would probably be felt housing market continue to show signs of slowing.
in the subprime and innovative mortgage sectors
of the MBS market, which would likely experience
higher defaults and more severe losses in an
Exhibit 10 last=303
BBB Fixed Rate 270
Source: Bloomberg, 150
December 2005 120
12/12/03 2/12/04 4/12/04 6/12/04 8/12/04 10/12/04 12/12/04 2/12/05 4/12/05 6/12/05 8/12/05 10/12/05
Is the U.S. Housing Bubble Over-inflated?
While there is clear evidence that the US housing
market is slowing, the risk of a housing bust
appears low. A gradual slowdown in the rate
of appreciation in housing prices going forward
appears to be a more likely scenario. While
overheated markets in coastal areas, which have
enjoyed strong double-digit appreciation, may well
experience a sharper decline, this would be unlikely
to throw the national housing market into
a tailspin. The UK experience suggests that
a reversion to normalized levels of annual home
price appreciation could have a negative impact
on consumer spending, which has been one of the
factors behind the US economy for the past several
years. Financial services companies with large
mortgage portfolios are likely to be somewhat
insulated by the removal of some of this credit
risk through securitization activity. Fixed income
markets are likely to experience spread widening
in the lower-quality sub-prime and innovative
sectors within the MBS market.
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