by Calculated Risk on 7/29/2005 11:06:00 AM

Economics Professor and former Dean of the UCI Graduate School of Management Dennis Aigner writes in the OC Register: Trouble in housing market no game, Region's house of cards ready to topple as prices reach unsustainable levels.

Are you familiar with the game Jenga, where players successively remove small wooden blocks from the bottom of a tower and place them on top, creating a progressively more unstable situation until one player causes the whole structure to tumble? (Our family record is 31 courses, by the way, if you want to compare notes.) The remaining players yell, Jenga!, we all clean up the mess, restack the blocks and begin again.

That's basically what's about to happen very soon in parts of California and several other "hot" housing markets around the country. Merrill Lynch recently issued a "bubble" warning for six California housing markets - San Diego, the Inland Empire, Los Angeles, San Francisco, San Jose and Sacramento, where "affordability" indexes are at historic lows. In other words, household incomes are way out-of-sync with home prices.

... it won't take a big uptick in mortgage interest rates to trigger a slow-down or retrenchment in prices, and the argument that such high prices are justified by insufficient supply coupled with strong demand just doesn't hold water now that we have gone beyond all rationality with respect to affordability across the board.

We're in the midst of a classic speculative bubble, and even the venerable Alan Greenspan referred to a bit of "froth" in certain housing markets in a recent speech. The UCLA Anderson Forecast, which has been warning of a break in the bubble for the past couple of years, echoed that warning again in its latest quarterly update and predicted a recession to follow even if it's a "soft landing."

A hard landing is more likely (where nominal prices actually fall) because houses are more overvalued than in past booms, inflation is lower and many people have been buying houses as investments.

But the most compelling evidence of a bursting bubble to come is the divergence of home prices and rents. In the United States over the past decade the ratio of home prices to rents has increased by almost 40 percent.

The increase is much higher in hot housing markets like Orange County (99 percent), where the ratio of median home price to average monthly rent now stands at 433:1.

To re-calibrate to more reasonable historical levels will require rents to rise sharply, which is constrained by household income growth, or home prices will have to fall, the only other possibility.
...
Over the past four years, 90 percent of the growth in U.S. GDP was accounted for by consumer spending and residential construction. Declines in the nation's biggest housing markets are likely to trigger a major economic slowdown.

It is not a question of whether this will happen but when, how dire will be the consequences on economic growth, and how long it will take to restack the blocks and begin again.

See Dr. Aigner's commentary for some comparisons to foreign markets.