Bubble trouble?
The red-hot housing market reminds some of the latter days of the 1990s stock market. How will it end?
At a 5 percent annual interest rate, that represents a mortgage payment of about half of your household income. "I suppose you could pay that much if you stopped going out to dinner and cut back on travel," says Shiller. "But what if you have an adjustable-rate mortgage, and we get an oil shock that pushes interest rates way up? Then you've got a major family crisis."
That's exactly the predicament a growing number of home buyers could face. As of last month, more than a third of those buying homes financed them with adjustable-rate mortgages--up from just 12 percent three years ago--mostly because they feature lower payments than fixed-rate mortgages do (at least initially), allowing buyers to qualify for homes they might not otherwise be able to afford. In hot markets like San Diego and New York City, as many as half of all buyers are now using such strategies to get into their dream houses.
That is why some experts believe an interest rate spike could be the pin that pops the housing bubble. In the best-case scenario (one already underway since the Federal Reserve began raising interest rates in June), a steady but modest rise in mortgage rates begins to cool demand as buyers find they can't afford to pay top dollar. Sellers unwilling to accept lower offers hold out, increasing the inventory of unsold homes over time and eventually forcing sellers to begin lowering prices. In such a case, "it's not going to be a free fall," housing economist Celia Chen of Economy.com says of forecasts that call for slowing price increases over the next year or two, followed by a small decrease in prices for a few quarters. "We see up to about an 8 percent decline in the overpriced areas."
Far scarier, however, would be an oil price shock, a rapid decline in the U.S. dollar, or ever mounting budget deficits (or all three), which could force the Fed to aggressively raise interest rates to stave off inflation. That could quickly bring the real-estate market to a standstill. As higher rates begin to affect homeowners' ability to pay their adjustable-rate mortgages, some will be forced into foreclosure while others who have put little money down will simply walk away. (Even those with fixed-rate mortgages could find themselves in trouble if circumstances force them to sell into a declining market.) Banks will be left holding the bag, as will Fannie Mae and Freddie Mac, the nation's largest purchasers of mortgage debt. If they stumble, "we will be looking at trillions of dollars of losses and a major recession or a possible banking crisis," says economic consultant John R. Talbott, who predicts such a meltdown in his book The Coming Crash in the Housing Market.
Most experts think that scenario is unlikely. Yet even some longtime real-estate boosters are proceeding with caution. Take real-estate analyst Sanford Goodkin, who three years ago decided to sell his large house in Del Mar, just north of San Diego, and downsize to a condo, in part out of concern that the market had become overheated as hordes of speculators bid up prices. "My rule of thumb is when 15 percent of sales are to speculators, you're in trouble," says Goodkin. "And I would say San Diego is up to 20 percent by now."
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