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The Fed and the Housing Bubble

Housing Bubble

James Hagerty and Ruth Simon find some people who are certainly acting like they would in a housing bubble. Up until six months ago, I could account for housing prices in terms of scarcity (they aren't building many houses near the California coast any more) and low interest rates. That's getting less possible with each passing day: - As Prices Rise, Homeowners Go Deep in Debt to Buy Real Estate: A year ago, Ryan Epstein and his wife had whittled down the mortgage on their four-bedroom colonial house in North Beach, Md., to $130,000. Then Mr. Epstein had a chat with a mortgage broker. The broker helped the Epsteins refinance their home, valued at about $300,000, to take advantage of lower interest rates. He also encouraged the couple to take out extra cash, a popular technique called a cash-out refinancing. The Epsteins used that cash, $25,000, as the down payment to buy a rental property. That purchase swiftly led to others. Today, Mr. Epstein says he has about $1.4 million of equity in nine dwellings -- and $2 million in mortgage debt. Those rapid profits reflect surging house prices, rising at a double-digit rate in the Epsteins' area near Washington. "It's a wonderful market out there," Mr. Epstein says.

Five years into a housing boom that has boosted U.S. home values an average of 50% and added an estimated $5.5 trillion to the total market value of residential real estate, many Americans no longer think of their home as just a place to live. Instead, it's a cash machine that can be used to rapidly build wealth. To that end, a growing number of people are tapping into their home equity to invest in more real estate. That's a lot like using a margin account -- a line of credit backed by securities in an investor's portfolio -- to buy stocks. During the 1990s, many investors used such accounts to buy shares in fast-rising tech stocks. When the dot-com bubble burst, the value of the shares bought on credit cratered and investors' borrowing worsened their losses. Economists say today's debt-fueled investment binge in real estate is fanning the flames of an already overheated housing market, and making demand from people who actually need houses to live in seem stronger than it truly is.

In some markets, this buying is adding to a glut of rental housing and causing rents to fall, which will make it more difficult for investors to break even. Already, there are signs that a few investors are starting to get burned. On Friday, Federal Reserve Chairman Alan Greenspan suggested that house-price inflation in some parts of the country is starting to look excessive. "At a minimum, there's a little froth in the market," Mr. Greenspan said in response to a question at a lunch hosted by the Economic Club of New York. "We don't perceive that there is a national bubble, but it's hard not to see that there are a lot of local bubbles," he added. He played down the idea that the market could suffer a dramatic crash like the bursting of the dot-com bubble, in part because homes don't sell as quickly as stocks do. Also, most people still have plenty of equity in their homes, he noted, so the prospect of mass bankruptcies in the event of a housing-market decline seems far-fetched.

Others express more anxiety. Dean Baker, co-director of the Center for Economic and Policy Research, a think tank in Washington, says many Americans are being "incredibly reckless" in assuming that real-estate prices will keep rising or, at worst, flatten out. "It's a classic phenomenon you expect to see in a speculative bubble," Mr. Baker says. He is so bearish on housing prices that he sold his own home last year and now rents. In another sign of growing concern, the Federal Reserve and other bank regulators last week issued guidelines calling for lenders to tighten their criteria for making loans backed by home equity by looking more closely at borrowers' ability to repay under various possible future market conditions. The regulators are starting work on similar guidelines covering mortgage loans used to purchase homes. Among regulators' top concerns: the surge in popularity of interest-only loans, which allow people to pay only interest in the initial years and face the burden of paying back the principal later....

Why are people like the Balderstons so confident of strong returns from real estate even amid growing warnings about the dangers of a housing bubble? "People form their expectations on a backward-looking basis," says Jan Hatzius, an economist at Goldman Sachs in New York. Based on the experience of recent years, they tend to see real estate as a very promising investment, he says, adding: "That's probably not correct.... You should think pretty hard about whether you want to increase your exposure to real estate at a time when it is trading at historically high valuations." Like the Epsteins, who used their home equity to buy rental housing in Maryland, many real-estate investors see the stock market as far riskier. "If you buy stocks," Mr. Epstein says, "the next day they can tumble in the toilet." Home prices can't fall nearly as quickly as stocks, he reasons, because people tend to hang on to their real estate when prices are weak and await an upturn. And unlike those who buy stocks with borrowed funds, home buyers don't face margin calls, or demands from their creditors for additional funds, when prices fall....

What makes this get-rich-quick formula more dangerous is that many investors are willing to buy properties on which the rent is too low to pay for financing and other monthly costs. Their bet is that rising property prices eventually will make these deals profitable...