Low rates, speculation drive up home prices

Federal Reserve Board Chair Alan Greenspan has recently issued some strong words about what he considers highly speculative investments in housing. I agree with him, but also think the Fed caused the current situation by pushing and holding the overnight lending rate under 3 percent.

The construction industry in Northern Colorado has been doing very well, and I believe a healthy and growing construction industry drives the rest of any economy. Of course, a healthy construction industry depends on demand for new structures and existing infrastructure repairs. This, in turn, depends on new employment opportunities and increasing wages and wealth that drive consumer spending.

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Construction spending is being fueled by interest rates still historically low. Consumers are taking advantage of these rates by reducing their savings and buying as much housing as they can afford. That’s because the annual increase in housing value exceeds the cost of the money used to purchase it, and also exceeds the rate of return on other savings instruments.

This has fueled substantial speculation in some markets. My son is trying to buy his first single-family detached house in Portland, Ore., one of the country’s hottest housing markets. He is being forced to compete with investors buying on pure speculation of further price increases and resale that generates a greater return on their investment.

Many of these purchases are made with 0 to 5 percent down payment and interest-only loans. Recent reports indicate that over 40 percent of recent loans in Denver are of this type. Fort Collins is rumored to have an even higher percentage.

Needless to say, this is a highly risky situation for lending institutions. If the demand for housing slows suddenly, speculative buying will end and investors will want to shift their money into instruments yielding higher returns. This will introduce additional housing supply on the market even as demand dries up. As the resale value of their investment falls (or stagnates), investors with little of their own money at risk will abandon the investment. Does this remind anyone of the savings and loan crisis of 1989?

In July, Colorado ranked fifth in the nation in the number of home foreclosures. Buyers are increasingly getting in over their heads as their wages increase more slowly than housing prices and cost increases in building materials outpace general inflation by a wide margin.

The Federal Deposit Insurance Corp. considers a local housing market to be a boom market if values have appreciated 30 percent or more over the past three years, a compound rate of about 9 percent per year. A recent FDIC study indicates that 55 metropolitan areas in the U.S. meet this criterion, accounting for 40 percent of the total value of residential real estate, up from 30 percent in 2000. Data for Northern Colorado were not presented.

Housing prices, even in the most overheated markets, are not likely to suddenly crash. The housing market would be flat for several years, with 10 to 20 percent declines in some regions. Even local housing crashes take years to unfold.

Housing price increases will eventually level off, restraining consumer spending and increasing savings rates in other investment instruments. To keep the U.S. and local economies growing, business investment and exports will have to increase and pick up the slack.

John W. Green is a regional economist who compiles the Northern Colorado Business Report‘s Index of Leading Economic Indicators. Green, a Fort Collins resident, was previously chairman of the University of Northern Colorado economics department.