Fed Taper Talk Bursts Bubble

The Fed may have accomplished a remarkable feat last month: a quick and relatively painless bursting of an incipient bubble in many local housing markets. The July data on new home purchases, which showed a sharp 13.4 percent drop from June, indicates that the rise in mortgage rates seriously altered the dynamics in the housing market.

The basic story is straightforward. The collapse of the bubble in 2007-2010 sent prices plummeting nearly everywhere. Not every market was over-valued to the same degree, but nearly every market was over-valued at the peak of the bubble in 2006.

When prices began to drop that year and then go into free fall the following year, many markets overshot on the downside. Prices in places like Phoenix, Arizona and Los Vegas, Nevada were down by well over 50 percent from their bubble peaks. Adjusting for inflation, house prices in these markets were far below their pre-bubble levels.

In this context there was room for prices in these markets to rebound, at least back to trend levels. That is exactly what began to happen in the most battered segments of the most depressed markets starting in the spring of 2011. Prices originally rose slowly, but soon the prices increases seemed to feed on themselves in classic bubble fashion.

For example, prices for homes in the bottom third of the Phoenix market rose by more than 75 percent between March of 2011 and June of this year, the last month for which there is data. Prices rose at just under a 15 percent annual rate through the rest of 2011. They rose at almost a 30 percent annual rate through the first five months of 2013.

In Los Vegas the turnaround started a bit later but has been even more rapid. Prices for homes in the bottom third of the Las Vegas market rose by 51.7 percent between April, 2012 and June, 2013. It is possible to find many other markets with similar stories. Many of the central valley cities in California, another center of the bubble, also had areas where prices were rising at 30-40 percent annual rates.

In these markets much of the activity was being driven by investors. In many cases, private equity and hedge funds were buying up large blocks of real estate with the idea that they would rent them out for a period of time, but ultimately sell them for a profit. Many smaller scale contractors were also buying houses, with the idea that they would make some minor repairs and then flip them for a profit in 3-6 months, just like they did in the bubble years.

In most cases house prices were not yet out of line with the fundamentals of the market. However if prices are rising at a 30-40 percent annual rate, it would not take them long to again be into serious bubble territory.

Unlike the bubble of 2002-2006, it was not likely this bubble would be moving the economy any time soon. The huge backlog of vacant housing is continuing to put a check on new construction. Bubble inflated prices will eventually feed into consumption through the housing wealth effect, but we were probably not seeing much bubble driven consumption yet.

The biggest threat from these bubbles is that many homeowners would again buy into bubble-inflated markets, possibly paying 20-30 percent too much for a home. Since the price of a home dwarfs other wealth for most homebuyers, this is a huge amount of money for them to throw into the toilet.

For example, if a homebuyer has an income of $60,000 and buys a home for $200,000, and the home subsequently loses 30 percent of its value, she has lost a full year’s income. That’s a pretty awful story even she can still afford her mortgage and doesn’t lose her house.

Fortunately, the Fed’s taper talk at the end of June appears to have taken the air out of this bubble before it had a chance to get out of hand. The fear of an early end of quantitative easing sent mortgage rates soaring to over 4.5 percent. This quickly led to anecdotal accounts of investors fleeing the market and houses beginning to sit for longer periods of time.

This is all for the good. Anyone who lived through the collapse of the housing bubble should not want to see another one develop. House sales and prices are back at trend levels.

The rise in interest rates has had some negative aspects. There has been a flight of capital from many developing countries. This is creating temporary problems, but since it was going to happen at some point in any case, these countries are better off making the adjustment sooner rather than later.

And higher rates will have some negative growth effect in the U.S., but that will be limited. We have already gotten the biggest benefit from low interest rates in the form of a massive wave of mortgage refinancing.

The long and short is that the Fed did a really nice job in preemptively bursting a housing bubble before it grew large enough to do much damage. This may not have been its intention, but they deserve praise nonetheless.