No Trouble from Bubble

So far this year, home prices nationwide continue to rise at a pace faster than economists had estimated. And the good news is that few of them see evidence of a widespread home price bubble - for the moment.

Data compiled by a government regulatory agency and by Freddie Mac both indicate that in the second quarter, home prices nationally increased at a rate not seen since the 1970s, outpacing expectations that price appreciation would slow down this year.

Freddie Mac's quarterly home price index rose 10% on an annualized basis in the second quarter. Freddie Mac deputy chief economist Amy Crews Cutts attributed the strong price increases to nearly record low interest rates in March, which helped fuel strong housing demand.

All regions of the country posted an increase in the second quarter, with the strongest price gains being notched up on the West Coast.

In a company news release, she noted that fast gains in house prices lead to the question of whether or not these gains are sustainable. Thus far, she said annual price growth is consistent with the market fundamentals of declining interest rates, a shortage of land suitable for building, and the strength of consumer spending.

"That said, anyone thinking about investing in a house should probably consider whether it would still be a good investment if the value only increased at one-third or one-half of the rates we've seen recently. I don't think home values will come down, but their rate of growth will likely slow back closer to average levels over the next year or so," Ms. Crews Cutts said.

The Office of Federal Housing Enterprise Oversight also found that home prices increased at the fastest rate since 1979, increasing 9.36% between the second quarter of 2003 and the second quarter of 2004.

Patrick Lawler, chief economist at OFHEO, said in a report that the data "show no signs of the long-anticipated, and ultimately inevitable, slowing of house price inflation."However, he said house prices are "increasingly vulnerable" to higher interest rates in the future.

Several economists interviewed by Mortgage Servicing News said they do not see any evidence of a house price bubble forming. A bubble, were it to burst and lead to a sharp, widespread decline in prices, could lead to markedly higher mortgage defaults.

Karl Case, a Wellesley College economics professor, said that his research indicates that in 43 states, income gains fully explain recent increases in home prices. However, on both the East and West Coasts, concern remains about the possibility of a bubble.

Another way to measure the risk of a price decline is to survey homebuyer expectations about home price trends, he said.

"People are a little bit exuberant in the Northeast and in California," he said.

If indeed price growth stalls, that could dampen home sales, as buyers and sellers start to have more difficulty negotiating a mutually agreeable price.

He anticipates that home sales volume may slow down as a result, without any significant decline in values. The two coasts are especially vulnerable to this possibility, he said.

And Celia Chen, director of housing economics at Economy.com, also does not believe there is a housing price bubble.

"However, there are definitely markets where housing prices have been increasing rapidly," she said.

Particularly on the two coasts, some markets have seen price increases "well past what could be sustained based on income growth in those areas," she said, citing San Francisco, San Jose and Los Angeles as areas that might be vulnerable. Whether markets where prices have increased dramatically experience a crash or a soft landing depends on the economic outlook for those areas, she said. In most metropolitan areas, as long as economic growth continues to accelerate, then a price correction should be fairly innocuous, with prices leveling off or just dropping by a few percentage points.

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