Government Price Supports Create Mini-Bubble

The August Case-Shiller 20-City index showed a 1.0 percent rise in house prices for the month.  The index has now risen at a 12.7 percent annual rate over the last three months.  Prices rose in 16 of the 20 cities in the index, with only Charlotte, Cleveland, Las Vegas, and Seattle registering price declines for the month.

In some cities, the price rises are reminiscent of the bubble years.  In San Francisco, prices rose 2.6 percent in August and have risen at a 41.2 percent annual rate over the last three months.  The price rise in Minneapolis was only slightly smaller, with a 2.3 percent rise in August and a 38.0 percent annual rate over the last quarter.  Washington, D.C. came in a distant third, with a 1.2 percent price rise in August and a 19.2 percent annual rate of increase over the last three months.

The August Case-Shiller index and other recent reports suggest that the housing price supports put in place have at least temporarily stopped the drop in house prices.  This should not be surprising given the dramatic nature of the measures taken.  The $8,000 first-time home buyer tax credit amounts to nearly 5 percent of the median purchase price of an existing home.  The Fed’s purchase of mortgage-backed securities has pushed mortgage rates down by 0.5 to 1.0 percentage points lower than they would otherwise be.  And the FHA is backing an enormous amount of loans, many of which are of questionable quality.

Of course, these price supports are all likely to be temporary, implying that house prices will resume their decline once the supports end.  The Fed is planning to phase out its purchases of mortgage-backed securities in the first quarter of next year.  The first-time buyer credit may be extended, but it is unlikely to run past the middle of 2010.  Furthermore, with many potential first-time buyer having already bought a house in the initial period, it is likely to have less impact on market prices as a smaller share of purchasers qualify for the credit.  And the FHA may see its lending reined in as its losses push its reserves below mandated levels.

For all these reasons, it is virtually certain that prices will resume their fall and are likely to be 5-15 percent lower next year than this year.  This fact makes it possible to assess whether any of the actors in the housing market have learned anything from the previous bubble.  For example, are banks requiring larger down payments in the frothy markets that are almost certain to see sharp price declines once the price supports end?  Are Fannie and Freddie imposing tougher standards on the loans that they buy in these markets?

How about realtors; are they warning prospective buyers that they are likely to see lower prices next year?  Those who stand to benefit from the first-time home buyer credit may still decide to jump in, but this would be a good argument for waiting for most prospective buyers.  And what about the non-profits that promote “asset building” through homeownership?  Are they warning their clientele that the house they buy today is likely to sell for considerably less in a year or two?  If there are no changes in behavior among these actors now, when the wreckage of the housing bubble is everywhere, then it is a safe bet that the market is as bubble-prone as ever and the major actors (including the regulators) have learned nothing.

The recent data from the Mortgage Bankers Association mortgage applications index suggests that we may not have to wait too long before the housing market begins to weaken again.  The purchase applications index dropped 5.2 percent last week, its third consecutive decline.  This index now stands 15.4 percent below its year-ago level.

This is a predictable result of the ending of the tax credit.  It is now too late for someone to be able to contract for a home and be able to close in time to take advantage of the tax credit.  The extension of the credit may help, but with so many purchases already pulled forward, its impact will be limited.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C.  This article was published by CEPR on 28 October 2009 under a Creative Commons license.

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