Evaluating the Housing Bubble

We've all heard the news. The housing market has slowed considerably. But just how bad is it, and will it get any worse? If you're a homeowner – or looking to become one – here are some facts to consider about one of the nation's largest industries:

• It must be remembered that all property values are relative. No good model exists for valuing homes other than neighborhood appraisals that focus only on current market values of similar properties.
• Housing prices relative to household incomes are up dramatically.
• Household incomes now include the earnings power of about 60 percent of married women who work (up from only 30 percent in 1960) and yet housing prices have still risen faster than these two-wage-earner households on a combined income basis.
• If housing prices are examined relative to a single worker's income rather than the entire household's income, then prices look even more drastically out-of-sight.
• Housing prices in many metropolitan areas are also increasing faster than potential rental income (known as a housing price-to-earnings (P/E) ratio). A divergence such as this cannot be sustained in the long term. Low interest rates can be used to explain much of the appreciation in prices, but one must consider the very real and reasonable possibility – if not probability – that rates will not always be so low.
• Once rates begin to increase (and they already have to some degree), housing prices will start to contract, as new buyers will qualify for much less funding.
• The housing market has enormous amounts of debt leverage throughout the system, from individual homeowners to the secondary market entities.
• While debt leverage can dramatically increase returns to homeowners, banks, and government-sponsored agencies in the mortgage business, it can also dramatically increase risk and magnify losses of things turn bad.
• The recent refinancing boom has only added additional leverage and risk to the system.
• Homeowners have taken on record amounts of mortgage and consumer debt.
• Mortgage foreclosures are occurring at an increasing rate and personal bankruptcies have also reached unprecedented levels.
• Highly leveraged homeowners are dealing with other people's money and therefore, with less of a personal stake in the property, are more willing to "walk away" if things go bad.
• Banks are not truly motivated to control risk in their mortgage lending activities because they get paid very large fees for these transactions. Additionally, they don't hold many of the mortgages that they originate on their books, but rather pass them through to the secondary market agencies and long-term investors.
• Appraisals in the housing industry are suspect because they look only at very recent and local market transactions and appear not to be totally independent judgments of a property's inherent value.
• Self-policing of risk in the mortgage business seems to have all but disappeared.

These facts are not meant to frighten you away from the market. If you're looking to buy a home, there are still good deals to be had. And as prices start to head downward under the pressure of more supply than demand, packages could get even better. (Remember, lenders must lend in order to stay in business.) Just be aware of what the housing market is doing, especially the market where you wish to purchase. And don't let anyone talk you into borrowing more than you can comfortably afford, even if you qualify for more. Don't get over-leveraged. The decisions you make today will have long-lasting ramifications; make sure that they're good ones.