The Housing Bubble

In the article linked in the title, there is a fascinating chart that shows the decoupling of house prices with the 'owner equivalent rent', the amount the owners would charge if they rented the house. This value measures the consumption value of the house, the amount that the owners are paying themselves for rent, as opposed to the value of the house as an investment asset. In equilibrium the rates of growth in owner equivalent rent and the price of the house should be similar. In a speculative real estate market, the growth rate of the price exceeds the growth rate of the owner equivalent rent. This leads to what we see now, a housing boom that is resembling a bubble more and more. With the additions in types of funding, in particular the interest only loan, where the homeowner pays only the interest on the loan for the first 10 or so years, rests on the assumption that the value of the house, and therefore the price the owner can expect when it is sold exceeds the price paid. However, if the price has been artificially increased due to speculation, this type of loan can put the homeowner at a considerable risk. If the price of the house is less when it is sold then when it is purchased, the owner will be left with a lot of debt. In addition, with the refinancing boom as large as it is currently, where people are refinancing their mortgage to pay off other debt or pay for new purchases, there is an additional risk. If the housing boom stops and especially if the boom has created a bubble, the value of homes will fall significantly, reducing the net worth of people dramatically, while also increasing the debt they owe. If this phenomenon is widespread, and it appears that many people are suceptible, the resulting economic damage could spill over into the economy as a whole. If a large amount of people suddenly find themselves with less net worth and higher debt, they will cut their consumption. This cut in consumer spending would have a large impact today because the economy in the last few years has been fueled by consumer spending, often paid for by increasing debt, either in credit cards or home equity loans. If this consumer spending decreased, it could easily push the U.S. economy back into a recession that would have serious long-term consequences on median income and the distribution of income.