Talking Indexes
By David Blitzer

Remarks by David M. Blitzer, Managing Director & Chairman of the Index Committee, Standard&Poor's.

With the U.S. stock market still meandering sideways, the favorite activity among financial writers, forecasters and many others is debating whether or not there is a housing bubble. Seeing bubbles from the inside is nigh-on impossible. Those who have been in the financial markets for a decade or more might reflect on the stock market of 1995-2000, a recent and excellent example of a bubble. What we tend to forget-what we probably want to forget-is that over those five or so years just about all of us bought into the idea that there was no bubble and that stocks really deserved the lofty multiples and high prices they had achieved by the beginning of 2000. Even Alan Greenspan, who gave us the term "irrational exuberance" in late-1996, apparently became a believer before the end. One possible reason for suspecting there is a housing bubble today is Robert Shiller. His book, Irrational Exuberance, gave a timely warning of the stock market bubble; it is now available in a second, revised edition that warns of a housing bubble.

Rather than try to settle the debate, let's look at a few facts about housing in hopes of injecting a bit of sense and economics into the discussion. Housing prices in many countries have risen substantially faster than GDP, consumer prices and equity prices in recent years. In the June 16, 2005, issue, The Economist identified eight markets where home prices rose ten percent or more in the year ending in the first quarter of 2005. The list is led by South Africa (23.6 percent) , Hong Kong (19 percent) and Spain (15.5 percent); the U.S. is sixth, up 12.5 percent. A possible hint of things to come is included as well-South Africa, Spain and others are experiencing lower rates of increase this year than last.

Among those who see a bubble in housing, the next step is to warn about a coming collapse and blame the bubble on the Fed. We will return to the collapse warnings a few paragraphs from now. As to the Fed, while many believe it is the world's central bank, I doubt the entire global housing bubble, if there is one, can be credited to the Fed. The rise in home prices is global, with starting and peak times varying from country to country. The Fed's easing after the stock market collapse of 2001 and the September 11th attacks is certainly one factor in housing prices, but it is not the only factor. Moreover, location and local conditions are quite important in determining home prices, so the Fed is unlikely to be a major factor in many countries other than the U.S.

Anyone familiar with the stock market should have been expecting a housing bubble, or at least a frothy market, for a long time. Consider the differences between the housing and stock markets. In the housing market, most buyers have home mortgages and leverage 75 percent or more of the purchase price. In the U.S. stock market, margin buying is far less common and is limited by regulation to 50 percent. Furthermore, stock investors are subject to margin calls if the value of their collateral drops substantially; banks and mortgage lenders rarely call loans unless monthly payments are deeply in arrears. By that time, any broker would have liquidated their client's account. In most stock markets, short sellers can exert downward pressure and temper some price surges; short selling in the housing market, however, is not practical. Modern financial theory tells us that readily available information helps keep prices close to true economic values and assures properly functioning markets. Information in housing markets, however, is less readily available and more subject to rumors than it is in the stock market: Housing markets have fewer regulations to assure access to information, less regulation of advertising, fore casts and predictions, and no generally accepted benchmarks or indexes. Altogether, housing is a bubble waiting to inflate.

Home prices cannot rise faster than most other things forever-if they did, housing would represent all the assets in the economy and the stock market would either consist of nothing but REITs or would wither away. Indeed, one warning sign from the 1990s, seen with hindsight, is the tripling of the tech sector's market cap weight in the S&P 500. In Herbert Stein's words (referring to another never-ending phenomenon, the federal budget deficit), "If something cannot go on forever, it will end." So, what is the end likely to look like?

A downturn in home prices will dampen growth and could easily contribute to a recession, but it won't bring on a depression. One comment in the recent bear market was that the losses didn't really matter until you sold your stocks. Maybe that is stretching the truth, but it is less of a stretch for housing than for stocks. The truth is that most current home owners don't have an accurate idea of how much their house is worth. They do know how much remains to be paid on the mortgage, and that is probably a lower bound to their estimates of the value of their homes. Since closing on the sale of a house takes several weeks, rather than the three days to settle a stock purchase, the market moves more slowly and any decline is likely to be less vicious. There will be secondary effects-a fall in home prices will mean less construction, fewer jobs, lower incomes for realtors and a host of other negative effects. Falling home prices aren't good, but they aren't a global disaster waiting in the wings. Maybe the biggest question about the impact of a burst housing bubble is how the Fed would respond. Would they step in and try to stem the collapse by again lowering interest rates? And if they did, would that ease the pain or simply reinflate the bubble?