Trouble at Home

May 19, 2002 |
The housing boom helped us out of the recession, but it may be a new speculative bubble.
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After all the rhapsody about the digital age, it was skyrocketing home prices and sales that finally shook the U.S. economy out of its doldrums this year. While stock markets languished, mortgage refinancing pumped more than $1 trillion into consumers' pockets. Nationally, average home prices rose above the $200,000 mark for the first time ever. But rather than signal prosperity, the housing boom may be largely driven by the financial maneuvers of wealthier Americans. Housing, in fact, has become part of the bubble economy, with potential consequences more serious than the stock market fiasco.

Historically, the housing market has closely mirrored the nation's underlying economic health: strong during good times, weak during bad. After World War II, state and federal incentives, including lavish tax deductions and outright subsidies, encouraged homeownership and construction. Housing starts steadily rose. The mortgage-lending industry expanded. The proportion of U.S. households owning homes grew from less than 45% in the 1940s to about 65% by 1965.

The relationship between housing and the larger economy shifted markedly in the mid-1970s. Oddly, U.S. residential real estate investment started to peak when stock and other equity markets, and often the economy, cooled. Data collected by Susanne Trimbath, a research economist at the Milken Institute, show that this obverse relationship between housing prices and Wall Street intensified throughout the 1990s. Something other than buying a home was shaping the housing industry.

Wealthier, investment-savvy Americans were learning that the housing finance system was a tax-subsidized means to offset losses in stocks and other financial assets. As long as stocks and paper securities appreciated in value, they parked most of their capital in such equities. During the recent stock market boom, in fact, the share of residential real estate in the average American's personal asset portfolio fell to historical lows.

When equity markets went out of whack at the peak of the leveraged-buyout craze of the 1980s and the Internet mania of the 1990s, the paper economy dramatically shrank. But housing finance was a near-perfect antidote for the disappearing windfalls.

After Wall Street collapsed, the Federal Reserve Board lowered interest rates to promote long-term business investment and jump-start U.S. factories. The sharply lower interest rates also enabled cash-strapped investors to refinance their mortgages, cut their monthly payments and tap their real estate equity--all with substantial tax advantages. As a result, America's wealthier classes, in particular, could maintain their lifestyles despite suffering equity market setbacks and even have a few dollars left over to wager on the next stock craze.

In the recession just ended, mortgage refinancing unquestionably stimulated consumer spending, because U.S. job and income growth were relatively stagnant. By the end of 2001, mortgage originations topped $2 trillion, and refinancings accounted for nearly 60% of that total.

Yet, using the housing market as medicine for Wall Street-induced ills can produce dangerous side effects. One is the need to maintain high home prices. Housing sales set the maximum loan amount at any particular time. As long as houses remain relatively expensive and homeowners have large equity "cushions" in their property, lenders are happy to write enormous loans--even during economic downturns. But if home prices fell in line with other equity markets, they would think twice before making such loans. Accordingly, homeowners have every reason to keep their homes expensive. And, by coincidence or design, as home-equity finance has gained popularity, so too have no-growth movements, restrictive local zoning laws and other policies that constrain new-home construction.

Demand soon outstrips supply. Since the mid-1970s, the U.S. population has grown by more than 30%. During this time, the annual rate of new housing starts fell from nearly 2.5 million units in 1975 to just 1.6 million in 2000, a 40% decline. The result: Average home prices have soared.

Fewer houses available for sale mean fewer families can afford to buy a home, particularly in regions such as the western United States, where strong population growth triggered strong anti-growth reactions. In much of urban California, less than 40% of all households can qualify for a home loan. The National Housing Conference recently reported that one in seven households nationwide are forced to spend more than 50% of their income for housing or live in substandard facilities.

By the late 1990s, real estate wealth took on the same upper-income skew typical of stocks and other financial assets. Census data in 1995 indicated that the wealthiest 40% of U.S. households owned more than 50% of the country's net equity in residential real estate. The poorest 40% owned less than one-quarter. This gap has almost certainly widened because average home prices have jumped an additional 30%. Younger, working- and many middle-class buyers are increasingly locked out of the U.S. home-buying market.

Equally troubling, the easy availability of cheap home-finance capital can distort U.S. investment priorities. That wealthier investors can tap home equity or refinance their mortgages to neutralize stock market setbacks probably helped feed the irrational Wall Street run-ups of the last 20 years. When the costs of being wrong are reduced, people will invest more carelessly.

An economy sustained by pricey homes may also grow in a boom-and-bust pattern. This month, for example, government data showed that San Jose, Seattle and San Francisco suffered the highest year-to-year percentage job losses in the nation. Yet, because the housing supply in these areas is extremely tight, home prices have barely budged and remain almost double the national average.

A region addicted to costly housing tends to gamble on bubble-like economic development. More normal, balanced industrial growth doesn't generate the income and stock windfalls needed to defray inflated living expenses. The region's long-term economic vitality correspondingly suffers.

Government created, and now subsidizes, many of the key tools of home finance to promote the worthy goals of homeownership and an upwardly mobile society. But when the housing market is manipulated to support economic extravagance, these goals are compromised. Can we reclaim the government's original intent?

At the very least, the commitment to supply houses to the widest range of citizens should be reaffirmed. Politically powerful pressures to constrain new-home production can be overcome by streamlining permitting processes and adding economic incentives for new construction.

Subsidizing tax-deductible mortgages for purposes unrelated to housing should also be rethought. The nation's mortgage market and tax system were built to facilitate homeownership, not provide wealthy investors with another source of capital. One solution would be to limit mortgage-interest deductibility to, say, adding a bathroom on a house rather than taking an Alaskan cruise, buying a BMW or gambling on dot-com ventures.

Absent a concerted effort to return to the basic goals of homeownership, the U.S. housing market could succumb to the same speculative excesses that upended Wall Street.

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