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After Long Boom, Weaknesses Appear in the Housing Market

By PATRICK BARTA Staff Reporter of THE WALL STREET JOURNAL

Cracks are spreading in the foundation of the U.S. housing boom, as
evidence mounts that the long run-up in home prices can't be sustained.

For the past several years, a rare confluence of factors -- including
low interest rates, low unemployment, easy credit standards and tight
housing supply -- have combined to stimulate an unprecedented surge in
home sales, sending prices rocketing up. The result: housing has been
one of the most important bulwarks of the U.S. economy, even as it gets
buffeted by plunging stocks, business scandals and the war on terror.



IN YOUR NEIGHBORHOOD


• See a map showing the regions with the largest differences between
the growth of housing prices and personal incomes.

There's mounting evidence that the long run-up in home prices is reaching
a level that can't be sustained. Research the sales history of homes in
your neighborhood in the Toolkit at RealEstateJournal.com



But now some of the factors behind the housing boom show signs of fading,
and indicators that traditionally foretell weakness in the market are
emerging.

In more than 100 U.S. cities, home prices have climbed at least
twice as fast as household incomes since 1998, according to data
analyzed for The Wall Street Journal by the economic consulting firm
Economy.com. Nationally, prices have risen at more than triple the rate
of incomes in the last two years, a surge that is steadily putting home
ownership out of the reach of more people. The nationwide price and
income figures had tracked together closely through the 1990s boom.

Lengthy List

Though the problem is most common in the Northeast and on the West Coast,
the list of localities with out- of-proportion prices includes large
cities around the country such as Atlanta, Las Vegas, Denver, Houston,
Tucson and Charleston, S.C. In Miami, home prices have shot up 58% since
the beginning of 1998, while incomes have risen only 16%. In New York's
Long Island suburbs, an 81% increase in home prices compares with a 14%
rise in incomes. In Boston, home prices have jumped 89%, compared with
income gains of only 22%.

And in some cities, including San Diego, Miami and Washington, the run-ups
have accelerated in the past year -- confounding expectations that the
market would cool off before it got too far out of line. In the late
1980s and early 1990s, the presence of such "bubblettes" in places such
as Boston, Houston and Los Angeles signaled the end of a boom cycle. This
time around, "the Boston area is still holding, and I don't know why,"
says Helen Babcock, manager of Carlson GMAC Real Estate in Winchester,
Mass., a Boston suburb. "It's going to slow."

First-Time Buyers Hurt

All this is pricing first-time homebuyers out of the market in many areas
of the country. That threatens a domino effect on demand for homes and
suggests price appreciation must slow or reverse course until the market
becomes affordable again. When the end comes, real estate isn't likely
to deflate quickly, as technology stocks did, but even air seeping out
slowly will have an impact on the broader economy.

"I have never seen an asset market -- whether it's stocks or real estate
-- that has boomed to excessive prices ... without a serious downturn,"
says Allen Sinai, chief global economist of Decision Economics Inc.,
a forecasting firm. "I really doubt we will escape" without price
corrections in some cities, he says. "Asset prices don't go straight
up forever."

Sales are still headed for another record year, and low interest rates
alone could keep propping up the market -- for as long as they last. But
lenders are beginning to tighten credit for some high-risk borrowers,
with mortgage delinquencies near their highest level in a decade and a
record 1.23% of mortgages in the foreclosure process. Market observers
say it's only a matter of time before lenders pull back further. "At some
point, it has to happen," says Gary Gordon, a mortgage- banking analyst
at UBS Warburg. "That would be one of the ways you could really get the
big slowdown."

Meanwhile, job losses in many cities have piled up: Boston, for
example, has shed 85,000 jobs since January 2001, while Seattle has
lost 66,000. Speculative money that once went into the stock market
increasingly has been flowing into the housing market and artificially
pushing up prices. Such speculation is usually temporary and tends to
presage a market peak.

Despite the recent run-ups in some cities, sales and prices of high-end
homes in many places have slowed compared with a year ago. In Atlanta,
a local forecasting group recently estimated a 21-month supply of homes
priced at $500,000 and above. And homes are sitting on the market longer
than before, as in affluent Collin County, north of Dallas, where listings
have jumped 25% due to a flood of local job cuts. "Homes are just stacking
up," says Bill Sabino, the managing broker at REMAX Preston Road North.

Inventory on Rise

Even the small inventory of housing, which has been a pivotal strength
of the market, has gradually risen. Though still low enough to help
cushion a correction, it has edged up from its all-time bottom in March
2000 when it would have taken just 3.9 months to sell every home if no
more were built. Now that figure is at five months.

That leaves low interest rates as virtually the only undamaged pillar of
the housing market. Low rates have endured longer, at lower levels, than
almost any analysts expected, with average rates for 30-year fixed-rate
loans now under 6%, the lowest since the 1960s. A turnaround in rates
could have a dramatic effect in the opposite direction on prices. A
half-point uptick would price two million more households out of median-
priced homes, according to research by Sanford C. Bernstein & Co.

It's unlikely that a nationwide housing bubble would pop dramatically
like the stock market, whose continuing bust has wiped out more than $7
trillion in investor wealth. While reliable price data only go back to
the late 1960s, most economists agree there has not been a protracted
period of falling home prices nationwide since the Great Depression,
in part because real estate is such a local phenomenon.

While a nationwide bust is possible, it would probably require a market
that is far more inflated across all parts of the country, coupled with
far greater job losses or dramatically higher interest rates. Home-price
gains remain in line with incomes in many cities, including Cincinnati,
St. Louis, Kansas City and Columbus.

If job creation and income growth accelerate significantly, it's possible
that home prices could slow slightly but keep growing until incomes --
and the broader economy -- catch up again. Some long-term trends for
housing remain favorable, including land-development constraints that
are making it harder for builders to add new homes, as well as continued
new demand from immigrants.

A likely scenario if the housing market stalls, real-estate analysts say,
would be a nation in which some areas continue growing modestly while
other markets slowly deflate, rather than pop. That's because unlike
stockholders, homeowners don't normally panic and run for the exits
when trouble strikes. After all, they have to live somewhere. That can
make home-price corrections more manageable, but also slower to unwind,
than stock-market corrections. As long as the economy doesn't contract
sharply and job losses don't accelerate significantly, "I think the
'going flat for a while' scenario is the right one" in most cities,
says Karl "Chip" Case, an economist at Wellesley College and one of the
country's leading authorities on housing bubbles.

Even a flat housing market could knock the wind out of the economy in
some areas. Among other things, it would reduce homeowners' ability to
tap rising equity in their homes though "cash out" refinancings that
often depend on increased home values. Those refinancings have been a
major source of consumer spending over the past year and a half. And the
longer home prices keep rising faster than incomes, the greater the risk
of even more painful local-market corrections becomes.

That puts the Federal Reserve, whose steps to reduce interest rates have
helped fuel the recent price rises, in a tight bind. If down the road
the Fed tries to curb inflation by raising rates, that could push housing
prices down. If prices start to fall, consumer confidence in the economy
would almost certainly wane, prompting shoppers to rein in spending. In
a worst-case scenario, some homeowners could find themselves stranded
in homes they cannot sell, as happened in the late 1980s and early 1990s
in Texas, California, Massachusetts and New York, among other places.

That would almost certainly lead to more foreclosures, because it would
make it impossible for families with strained balance sheets to sell
their homes to get out of trouble, which in turn could lead to more
credit-tightening, spurring a vicious cycle causing more price declines,
as happened in the last downturn.

"You can see this being a pretty nasty scenario," says Robert Edelstein,
professor of business administration and co-chairman of the Fisher Center
for Real Estate and Urban Economics at the University of California
at Berkeley.

The recent rises are all the more dramatic when compared with past
bubblettes that popped, such as Boston's. During a five-year period
ending in the late 1980s, home prices there rose 73%, while incomes grew
42%. That disparity -- far less dramatic than the current scenario in
Boston -- turned out to be unsustainable when the local job market went
sour amid a technology downturn at the end of the decade. Home prices
fell 11% over about two years and didn't fully recover for about five
years after that.

Similarly, home prices shot up 89% over a six-year period in Los Angeles
in the late 1980s and early 1990s, while incomes grew 37%. The ensuing
correction, spurred by a local recession driven by defense-industry
cutbacks, knocked Los Angeles home prices down 24% over five years, and
they took about four more years to fully recover. Other cities escaped
unscathed at the same time -- in Chicago and Minneapolis, for instance,
prices continued rising through the late 1980s and early 1990s.

Rising costs are especially important to first-time homebuyers, who in
turn are especially important to the market. Without them, homeowners have
little chance to profit on their homes and make the move-up purchases
that represent the other part of the market. "If first-time homebuyers
can't afford houses," says Chris Mayer, a professor of real estate at the
Wharton School at the University of Pennsylvania, "then home prices fall."

That's bad news in San Diego, where Greta Cohn and her husband Dale
Gill are itching to buy their first home. Together, the two earn about
$62,000 a year, well above the median for the area of $48,300, and they
have good credit. Their lender, Ms. Cohn says, has told them they can
qualify for a loan of $160,000. But the median price of a house in San
Diego has surged 75% since 1998 and 21% in the last year alone to reach
$362,000, making just about every home in sight beyond their means. And
the loan they qualified for was a no-down-payment mortgage, exactly the
kind of loan some analysts believe will disappear from the market if
credit conditions deteriorate.

"I've given up on the American Dream, at least for now," says Ms. Cohn,
a 30-year-old nurse midwife with a master's degree and a 500- square-foot
apartment. Now she and her husband are weighing another option: "Just
rent for the rest of our lives and take great vacations."

Trouble in Concord

Mary Downes, 35, is running into the same problem in a normally quieter
market: Concord, N.H., where home prices have been revved up by commuters
who can't afford to live in Boston. Ms. Downes, an education director for
a local nonprofit housing developer, figures she can afford a mortgage
of $110,000. But most of the houses she finds are over $140,000.

"I torture myself and look on a Web site every now and then to see what's
out there," she says.

The loss of such prospective buyers forces the market to be sustained by
"move up" buyers who already own homes and are using the equity they've
gained in recent years to make down payments on their next homes. But
those who didn't buy in the past several years are winding up on the
sidelines, leaving the market without an important source of new blood
to keep sales strong over the next several years.

The national "affordability index," computed each month by the National
Association of Realtors, nevertheless remains at very favorable levels:
It now stands at 134.4, meaning that U.S. households with the median
income can afford to purchase a home that is 34% more expensive than
the median price. But that, some economists say, only demonstrates how
dependent the market is on low interest rates, which are factored in to
the index. When the affordability index is calculated just for first-time
homebuyers, moreover, it comes in much lower: 76.9.

Another indicator that affordability is waning: Adjustable-rate mortgages,
which help consumers offset rising costs by allowing them to get extremely
low monthly payments for a short period of time, have increased to
about 20% of the market from a recent low of 10% in the spring of 2001,
according to the Federal Housing Finance Board. That indicates that some
buyers are being forced to choose houses beyond their means, and can't
afford the extra dollars for a fixed-term loan even though it provides
the best long-term investment when rates are low. The large proportion of
ARMs also means more risks if interest rates rise, making those owners'
monthly payments more expensive.

Meanwhile, mortgage lenders, who have been making things easier for
buyers, are poised to get tougher. Much of the current boom was made
possible by huge changes in the mortgage business over the past decade,
including the growth of Fannie Mae, the giant government-chartered company
that buys loans from lenders to help improve the flow of capital through
the home-loan market. Along the way, lenders began using computerized
loan-approval systems that make it cheaper to process mortgages and
easier to identify at-risk borrowers that deserve credit.

Lenders now require much smaller down payments than before, and they let
buyers devote larger portions of their income to mortgage payments. Such
innovations helped boost the homeownership rate to a record 68.1% last
year from less than 64% in 1994.

In more recent quarters, however, the homeownership rate has begun to
decline. It now stands at 67.6%. More importantly, lenders say many of
the foreclosures and delinquencies are coming on their low-down payment
loans and others that represent easier credit. And the Federal Housing
Administration program, which insures loans primarily for first-time
homebuyers, is seeing nearly 12% of its borrowers late on their loan
payments, up from less than 11% a year ago.

Lenders have already started reining in some of their more ambitious
programs. Some have been tightening the rules under which they will give
loans to borrowers who can't fully document their incomes. Just last week,
Fannie Mae said it would be raising fees for certain cash-out refinance
mortgages after it determined the loans were defaulting more often than
other mortgages.

It's also unclear how much more growth can be tapped from lower-income
families that don't yet have homes. Down payments for first-time buyers
are already low, averaging 6%, compared with 10% in 1989, and some
economists question whether those figures can go much lower.

Anecdotal evidence from real-estate agents around the country suggests
much of the demand for homes now is coming from speculators and investors
who pulled money out of the stock market, rather than families who
intend to hold on to their homes for years. "Flipping Properties,"
a guide to making money in real estate, recently cracked the Top 100
sellers on Amazon.com. While some of that demand is good for the market,
it also pushes prices to unsustainable levels.

That's what some fear is happening in Lawrence, Mass., an industrial town
about 30 to 45 minutes north of Boston that's home to a large population
of Hispanic immigrants.

Miqueas Quinones, a nursing assistant who expects to make about $55,000
this year, has been looking to buy a house in Lawrence. Median home
prices there have doubled since 1999, according to the Warren Group,
a real-estate news publisher that compiles housing statistics in
Massachusetts, but Mr. Quinones notes ruefully that to Boston investors
that's still a bargain. "It's practically a war out there to get a
house," says Mr. Quinones, who recently lost out to an out-of-town
investor after bidding $270,000 for a 102-year-old property.

Lawrence has seen a boom and bust before. The median reached $135,000
in 1989, then crashed to $40,000 in 1994. Mr. Quinones's broker, Isabel
Kianda of the Neighborhood Assistance Corporation of America, thinks
Lawrence won't face anything that bad again, but she worries for customers
such as Mr. Quinones. "It can't keep going up," she says. "Right now,
I wouldn't be buying property as an investment."

Write to Patrick Barta at patrick.barta@wsj.com