Tuesday, January 24, 2006

A Northern Perspective on the Bubble

A view of the US Housing Bubble, from Montreal:
While the recent rise in prices in the U.S.
housing market is not currently indicating a bubble, the increases may be
showing the emergence of one, according to a new report released by the BMO
Financial Group Economics Department. However, bubble conditions are
unambiguously emerging in several local markets, especially in the West.

A housing market bubble is characterized as a sharp run-up in prices,
followed by a subsequent rapid retracement. "The initial rise is usually
fueled by speculative activity that results in a sharp divergence from
underlying economic fundamentals," according to Paul Ferley, Assistant Chief
Economist, BMO Financial Group. "The second phase of falling prices, however,
brings the real worry to lenders and borrowers alike, since lending may have
occurred on the basis of inflated, and thus unsustainable, asset values."

The report concludes first that though recent price increases are not yet
flagging bubble conditions, the increases are starting to approach worrisome
levels. "Housing prices nationally were rising largely due to favourable
fundamentals rather than to speculative pressures that would be indicative of
a housing market bubble," said Ferley. "However, the situation seems to have
changed recently. Affordability has deteriorated significantly in the second
and third quarters of 2005 as housing price increases have spiked higher. As a
result, affordability is quickly closing the gap relative to this measure's
long-run historical average."

Ferley notes that if the projected near-term peak in mortgage rates were
used in making the affordability calculations, these measures would generally
deteriorate to levels not seen since the early 1990s, the last period that
resulted in marked declines in housing prices. As a result, affordability is
approaching levels that suggest price gains may be starting to reflect more
speculative pressures rather than favourable economic conditions.

"Bubble conditions may not be present yet but are approaching such and
thus require close monitoring going forward," stated Ferley. "To allay this
concern, housing price increases will need to start to moderate soon from
recent sharp increases. Our expectation is that this should occur, since
rising mortgage rates should slow the growth in housing prices to a rate below
gains in income."

— The Boy in the Big Housing Bubble