TCS Daily


Bubble Bubble, Is There Trouble?

By Arnold Kling - June 29, 2004 12:00 AM

"the price-earnings ratio for homes in the Bay Area and greater Los Angeles is also skyrocketing, according to a forthcoming report from UCLA economist Ed Leamer. He says homes are so overvalued that prices are likely to fall when the Federal Reserve raises interest rates."
-- San Francisco Chronicle

Many people, economists and laymen alike, are suspicious of the recent behavior of house prices, particularly in coastal urban areas. However, I would argue (and other economists would agree) that the bubble is in the bond market, not in the housing market. That is, if interest rates remain close to where they are today, then there is no reason for house prices to collapse. However, some of us think that interest rates ought to rise more than the market expects.

In order to analyze the housing market, I believe that you have to understand interest rates. Therefore, although the purpose of this essay is to provide homeowners and potential homeowners some perspective on house prices, it is necessary first to review some basic economics of interest rates.

Nominal and Real Rates

Economists draw a distinction between nominal interest rates and real interest rates. The nominal interest rate is the rate that is quoted on a typical mortgage, bond, or savings instrument. The real rate is the rate that you can expect to earn after adjustment for inflation. Using a formula that is due to early 20th-century economist Irving Fisher, we have:

real rate = nominal rate - expected inflation

For example, if you can earn a nominal rate of 6 percent on a ten-year bond, but inflation is 5 percent, then the real interest rate is only 1 percent. On the other hand, if inflation is only 2 percent, then the real interest rate is 4 percent.

In almost all cases, the real interest rate is uncertain. Interest rates on financial instruments are quoted in nominal terms, and you just have to take your chances with inflation.

An important exception is inflation-indexed Treasury securities, which provide a real interest rate. The availability of these securities provides investors with a hedge against inflation, and it also provides economists with a market-based measure of real interest rates and expected inflation.

Real Interest Rates and Intrinsic Value

Financial assets, such as homes or stocks, have what is called an intrinsic value, which means the price that you would pay if there were no need for a margin of safety. The intrinsic value is equal to the income from the asset, discounted at the real interest rate. In the case of a house, the income is the rent that someone would pay to live in that house. In the case of a stock, the income is the profits of the company.

The lower the real interest rate, the higher the intrinsic value. In October of 2002, I wrote What's Your Margin of Safety?, in which I adapted figures from Bill Gross to estimate the intrinsic value of stocks. At that time, the real interest rate was much higher than it is now. Because the real interest rate is lower today, the intrinsic value of both stocks and houses has gone up.

How much has the real interest rate declined in the past two years? According to this chart from Ohio State Professor J. Huston McCulloch, the real ten-year interest rate in late June of 2002 (the blue line in the chart) was just over 3 percent. In late May of this year, according to this chart, the real ten-year rate was slightly over 2 percent.

The drop in the real interest rate of one percentage point from 3 percent should have raised the intrinsic value on stocks and houses by 33 percent! So, if house prices in your area have gone up 33 percent in the past two years, that may seem dramatic, but it is not out of line with the drop in the real interest rate. Incidentally, the Dow Jones stock average, which was at about 7600 when I wrote the article, is about 33 percent higher today, also.

If the real interest rate is just 2 percent, and if houses were priced at their intrinsic value, the price-earnings ratio (or the ratio of prices to annual rents on corresponding homes) would be 50. However, because houses are risky assets, they ought to be priced below intrinsic value by a margin of safety. Allowing for a generous margin of safety, the appropriate price-earnings ratio might be 25. According to Leamer's analysis, the price-earnings ratio for houses in the San Francisco Bay Area was 13.8 recently. Although this is higher than the P/E ratio several years ago, it seems to me to provide a considerable margin of safety at today's real interest rate.

As Brad DeLong put it, "P/E ratios -- of all kinds -- should be high when interest rates are low now and are expected to be low in the future. Interest rates are very low now. Long-term interest rates tell us that short term rates are not expected to rise that much. How should we expect house prices to react to low interest rates?...Personally, I think we are in an interest rate bubble -- and that high housing prices are (outside of New York, SF, and LA) probably a rational reaction to very low interest rates."

Will Real Interest Rates Remain Low?

I have argued that the drop in real interest rates helps to justify a rise in housing prices. But this raises the question of whether real interest rates can remain low.

Many economists are skeptical that real interest rates will remain low. It appears to us that investors are ignoring the potential for large increases in borrowing by the U.S. government as deficits accumulate. For example, Rudolph Penner describes some alarming scenarios, including one in which our debt-to-GDP ratio reaches 100 percent in twenty years and keeps climbing thereafter.

Interest rates are low today in part because foreign investors have been willing to increase their holdings of U.S. assets. They cannot go on raising the share of U.S. assets in their portfolios forever.

If the real interest rate doubles in the next five years, then the intrinsic value of houses would drop by 50 percent. This does not necessarily mean that home prices would fall by 50 percent. Home prices will be equal to their intrinsic value less the margin of safety. The margin of safety could drop, so that home prices do not have to fall by the full 50 percent.

Inflation and Nominal Interest Rates

Another plausible scenario involves an increase in expected inflation, with a corresponding increase in nominal rates. In that case, home buyers with fixed-rate mortgages will enjoy a benefit. They will see their incomes rise relative to their monthly payments. Suppose that you earn $4000 a month, and your monthly payment is $1600, which is a hefty 40 percent of your income. If your salary goes up 7 percent per year (say, 5 percent per year for inflation and 2 percent per year above inflation), then in four years you will be earning over $5200 a year, and the monthly payment will be down to 30 percent of your income.

In the late 1970's, homeowners experienced this sort of drop in their debt burdens, and they made out really well. The savings and loan industry, which lent the money for those fixed-rate mortgages, got clobbered.

Financial Advice

So, what is the bottom line? I think that there is some reason to be concerned that both real rates and expected inflation could increase more than the market expects over the next five years. The advice implied by that perspective is as follows:

1. Do not borrow using an adjustable-rate mortgage. If either nominal or real interest rates increase, your debt burden will skyrocket. If you cannot qualify for a fixed-rate mortgage for the house that you wish to buy, then you just have to pass on that house.

2. If you are worried about house prices being too high, and you would like to hedge or speculate against this, keep in mind that the bubble is more likely to be in interest rates than in house prices. Therefore, if you were to short Treasury bond futures, you probably will earn a profit in almost any scenario in which house prices decline, because a drop in bond prices (increase in interest rates) will almost certainly be necessary to trigger any major setback for home prices. Keep in mind, though, that if you have a fixed-rate mortgage on your house, then you are already hedged, especially against an increase in inflation.

3. The hypothesis that there is an interest rate bubble implies that you should avoid putting long-term, fixed-rate assets in your portfolio. The assets to avoid would include five-year bank CD's, corporate bonds, and Treasury bonds (although inflation-indexed bonds may be ok). Stocks are still priced with a good margin of safety below their intrinsic value, so that putting some of your financial assets in a money market fund and some in a stock index fund seems reasonable, in spite of the potential for interest rates to rise.

4. Be cautious about buying a home that you will live in for less than five years. If you are likely to relocate, get married, or otherwise have to sell your home within a few years, there is a risk of having to take a loss.

5. On the other hand, if you foresee remaining in a house for at least five years, then taking advantage of today's still-low fixed-rate mortgages seems like a good idea. I would not let the talk of a housing bubble scare me away.


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