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No U.S. Housing Bubble Yet, But Worrying Signs Emerging - BMO

While the recent rise in prices in the U.S. housing market is not currently indicating a bubble, the increasesmay 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 paper also concludes, however, that concerns about national market conditions can be tempered by the fact that economic conditions in the two most recent periods of a pronounced drop in housing prices were quite different from today's environment.  “Sizeable declines in housing prices occurred in the early 1980s and the early 1990s, but both of these periods followed recessions,” said Ferley.  “The attendant weakening in family income exacerbated the decline in housing prices by sharply reducing household demand. 

“But in the current environment, interest rates are not rising to punitive levels; rather, the current tightening is meant to keep growth at a sustainable pace,” noted Ferley.  He stated that as a result, the current economic environment is less vulnerable to a pronounced weakening in housing prices.

Despite these conditions, the paper further concludes that bubble conditions are definitely emerging in several local markets.  “Pressures are particularly evident in the West where housing prices in local markets such as Riverside-San Bernardino (outside of Los Angeles) and Las Vegas are rising rapidly with an attendant marked deterioration in affordability,” said Ferley.  “Rising prices in those areas seem more the result of speculative pressures and thus indicative of local housing market bubbles. There is the definite risk in these markets that prices will eventually need to correct sharply lower.”

Ferley also noted that housing prices in Chicago and the Midwest are more in line with the national numbers, which suggests that there are no clear cut signs of a bubble although the possibility exists the market could be approaching one.  As with the national market, developments there will need to be monitored closely.

The full report is available at

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