Two Wise Old Men and One Bright Young Lady

The Center for Policy and Economic Research is a liberal economic research organization in Washington founded by economists Dean Baker and Mark Weisbrot. These two gentlemen, whom I call the Two Wise Old Men, correctly predicted the stock market bubble that burst in 2000. Today, they are convinced the real market will be the next bubble to burst.

The Two Wise Old Men started a contest to see who could make the strongest argument against their view of a real estate bubble waiting to burst. Participants were invited to submit written essays on why the housing market will not burst. Enter Hilary Croke, the Bright Young Lady. Ms. Croke, an assistant economist at the Federal Reserve Bank in Washington, won the contest with a 740- word essay arguing there is no real estate bubble.

Ms. Croke’s basic premise is that the rise in housing prices is based solely on solid economics, not “irrational exuberance” in the real estate market. The Bright Young Lady argued:

— Government incentives to boost home ownership, such as the creation of Freddie Mae and Freddie Mac, have enabled more consumers to buy homes.

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— Back in 1993, the average new mortgage carried an interest rate of 9.3% compared to 5.4% today. A consumer who could afford a $250,000 mortgage in 1993 can now afford a $368,800 mortgage with the same monthly payment.

— Even if interest rates climb, housing prices will not collapse because change in home ownership takes time.

Economists Baker and Weisbrot, on the other hand, had these comments for their contestants:

— The ratio of mortgage debt to home equity is at a record high. This is very risky given the fact that equity values may be inflated by 20% to 30% because of the housing bubble.

— New homes are being built faster than can be supported by population and income growth.

— Demographics are changing. With the baby boomers approaching retirement, many home owners should have paid off their mortgages to prepare for retirement. Instead, they have borrowed more through home equity loans.

The Two Wise Old Men are predicting a coming loss of $2 trillion to $3 trillion in housing wealth. They say the real estate downturn will be much worse than the fallout from the stock market crash.

In my humble opinion, the direction of the real estate market and housing prices is based more on interest rate cycles than demographics and government sponsorship.

Rates peaked in 1981 (remember 20% mortgage rates) at a time when the stock market and real estate market were in the doldrums and gold was at a record high. Today, interest rates are at a record low. And the reverse is happening-real estate and the stock market is booming and gold is in the doldrums.

So, the big question is, where are interest rates headed? To get this answer, I need to look no further than the bond market. Long term bond yields have been moving up since March. Bond prices are not collapsing, but they are breaking down below their various moving averages. The bond market is telling us higher interest rates are in the cards, maybe sooner than most economists predict.

If the cycle of lower interest rates has ended, and the cycle in rates is upward, higher interest costs will certainly dampen the housing market. But I do agree with the Bright Young Lady in that the housing market will not collapse immediately, because it will take time for the higher interest rates to filter through the mortgage market. An orderly decline in real estate prices is what I see, once interest rates start to rise.