Steady as it Grows

Key indicator suggests Fed sensitivity to the housing recovery



Home prices are higher, but many worry the Fed’s Quantitative Easing program might be creating another price bubble.

www.scpr.org

Attendees at the Pacific Coast Builders Conference in San Diego in June were happy that home prices are higher, but many worried that the Fed’s Quantitative Easing program (QE) might be creating another price bubble or that rising mortgage rates of the last few months will stop the housing recovery.

We at Market Watch have studied bubble theory for years. In fact, we wrote a book in 2000 describing a fully formed bubble in another market. So, we examined whether concerns about a Fed-instigated bubble are valid.

Conclusion: Yes, there is a potential problem and we’re close, but it isn’t technically a bubble. Bubbles grow out of mass euphoria, when homeowners and investors lose the rational link between price and value and wildly drive prices far beyond what can be maintained. This is not the current situation.

However, the Fed can do things that result in something like a bubble, even without homebuyer euphoria. Its QE program has the potential to drive prices higher than wages and free-market interest rates can support once they take away their program to keep rates low.

The best way to evaluate how close we are to this is through the affordability index, which measures the percentage of workers who can buy a median-priced home at current rates. Affordability in California over the last 25 years shows the historical average is 33 percent. Home prices that create affordability numbers around that 33 percent are considered somewhat stable. If it falls to 22 percent, however, one should be cautious.

According to the California Association of Realtors, affordability in the first quarter, when the median price was $350,000, was 44 percent. This is their latest published data. However, in just one quarter the median price has grown to $400,000. Calculations by CAR indicate an interest rate of 4.84 percent would put this price at an affordability of 33 percent. They also calculate it would take an interest rate of 7.58 percent to produce a 22 percent affordability which we feel is a caution area. Right now QE mortgage rates are about 4 percent.

No one knows where mortgage rates would go once QE ends. An economist at PCBC speculated it might be in the 5 percent range. If they went to 5 percent it would put the affordability of a $400,000 home somewhere between normal and caution. These calculations seem to show that current prices are OK but near the cusp and any significant gains from here could present a problem when the Fed stops QE.

Vic Cooper and Mike McDonald are partners in Market Watch LLC, a nationally recognized real estate advisory company that produces The Desert Housing Report. Visit www.marketwatchllc.com

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