With the economy going strong and the Fed raising rates, nobody really wants to talk about the housing bubble. However, whether you want to look at it or not, the U.S. real estate market has been heated up to extreme levels.
Housing Price Surging Past Critical Level
On Tuesday, January 26, the Federal Housing Finance Agency (FHFA) announced that house prices in the U.S. rose half a percent in November 2015, after increasing by the same percentage in October. (Source: “FHFA House Price Index Up 0.5 Percent in November,” Federal Housing Finance Agency, January 26, 2016.)
The FHFA measures house prices in the U.S. using its monthly Housing Price Index (HPI), which is based on home sales price information from mortgages sold to or guaranteed by Fannie Mae and Freddie Mac.
While the headline number doesn’t seem that substantial, note that from November 2014 to November 2015, the HPI has climbed up 5.9%. Moreover, since October 2015, the index has surpassed its previous peak level from March 2007.
The FHFA is not the only one saying that house prices have gained momentum. According to the S&P/Case-Shiller 20-City Composite Home Price Index, the U.S. housing market has enjoyed a 5.8% yearly gain by the end of November 2015. Moreover, the reading marked the fastest annual increase since July 2014. (Source: “Home Prices Accelerate at Fastest Pace in 16 Months: S&P/Case-Shiller,” MarketWatch, January 26, 2016.)
More Rate Hikes Could Prick the Housing Bubble
Note that mortgage payments are strongly tied to interest rates. Depending on the size and length of the mortgage, a one-percent upside move in mortgage rates could result in hundreds of dollars more on your monthly payment. And let’s be honest, America has become too comfortable with low interest rates. The good times might be over sooner than you think.
The U.S. Federal Reserve decided to raise its benchmark interest rate last month, marking the first rate hike since the financial crisis. Although the increase was only by a quarter of a percentage point, the Fed is expecting as many as four rate hikes in 2016.
The thing with bubbles is that if you’re in one, you might not even notice it. Moreover, you can feel quite good living in a real estate bubble as long as it doesn’t burst. For example, if you bought a house right before or during the early stage of the bubble, it’s very likely that your house is worth more. Also, if you feel that you’re better off now (the positive wealth effect), you might decide to spend more. In aggregate, more consumption is not a bad thing for the economy.
So, you are better off for now, but what if the bubble bursts? Well, then the wealth effect would work against the homeowners: when home prices drop, the owners feel poorer and tend to spend less. Moreover, since existing mortgages don’t change when home prices are falling, homeowners could have negative equity on their properties. If they decide not to make mortgage payments anymore, since they are in negative equity, foreclosures would put more negative pressure on the housing market and might even cause financial institutions to collapse. Sound familiar?
The worst part about a housing market bubble is that once it bursts, the effects tend to last for quite a long time. For instance, during the house price crash that followed the last real estate bubble, many mortgages remained underwater years after the burst. By the end of December 2010, 11.1 million residential properties, or 23.1% of all U.S. homes, were still in negative equity. (Source: “CoreLogic: Underwater Mortgages back Above 11 Million in 4Q,” Housingwire.com, March 8, 2011.)
Sure, the housing bubble may not be that huge and it might not burst anytime soon, but with the FHFA’s Housing Price Index (HPI) entering uncharted territory and the Fed intending to raise interest rates a few more times this year, the U.S. housing market might not be as sound as it looks.