HOUSE PRICES SURGED IN 2004 AS FALLING mortgage rates and rising employment and household income energized home buyer demand. Several major Wall Street media outlets (including Fortune and Barron's) argue that speculators piled onto the process, bidding up prices with the intention of “flipping” the properties in short order for quick gains. They also argue that use of adjustable-rate mortgages with interest-only repayment schedules fueled the speculative process.

Greenspan Speaks Federal Reserve Chairman Alan Greenspan addressed the speculation issue during a speech given to a group of bankers in October. Greenspan stressed that large transaction costs are significant impediments to speculative trading in homes and an important restraint on the development of price bubbles. He also pointed out that speculation ordinarily does not involve owner-occupied residences since homeowners must move and live elsewhere after they sell. While noting that, in recent years, some home buyers fearful of losing purchases had bid through sellers' offering prices, Greenspan did not classify this as an important speculative activity.

Greenspan concluded that truly speculative trading involves investors in single-family rental and second-home properties. In this regard, he cited evidence that mortgage borrowing by such investors amounted to about 10 percent of total home mortgage originations in 2003, up from other recent years but still not that big a deal at the national level. Greenspan stressed that “a national severe price distortion seems most unlikely” in the United States, although he conceded that “local economies may experience significant speculative price imbalances.”

Local Market Dynamics House price surges in local markets tend to remain concentrated in those markets. Housing inventories can't be shifted in from other places, new production can increase supply only slowly (particularly when land-use constraints are severe), households seldom jump from one market to another solely because of house price differentials, and not many owners sell and rent in the same area.

These realities create a double-edge sword. Local market prices that are driven upward by speculation may not spread to surrounding areas, but those local markets may face sharp corrections when the speculative process runs out of steam and prices move back toward market fundamentals.

Speculative Evidence Analysis conducted by Fannie Mae and presented at the NAHB's fall Construction Forecast Conference shows a definite positive correlation between the investor share of purchase loans and the rate of home-price growth across major metropolitan areas. About one-sixth of the metro areas analyzed by Fannie Mae had investor shares above 15 percent in the second quarter of the year, well above the national average.

Heavy use of interest-only, adjustable-rate mortgages (IO-ARMs) also can signal speculative buying. Fannie Mae found a substantial increase in this type of mortgage financing, particularly for relatively high-risk borrowers, and detected some positive correlation between the IO-ARM share and home-price growth across metro areas. Fannie also found overlap between high investor shares and high IO-ARM shares.

Bottom Lines Evidence of speculative activity has emerged in a limited number of metro markets in areas featuring relatively rapid increases in house prices, particularly in California, the Northeast, and Florida. While ongoing improvements in local economic conditions (income and job growth) should support prices, some corrections could occur before long as mortgage rates gravitate upward.

David Seiders
Chief Economist, NAHB Washington, D.C.