"People who talk about a bubble are blowing smoke,” said real estate economist Michael Carney. It was February 2005 and Carney was confident that house prices in California wouldn’t fall. But by the end of the year the market turned. And between August 2007 and August 2008, California house prices fell by more than 40%.
Carney wasn’t alone in his confidence. Even as the bubble came close to bursting many commentators insisted that California’s growing population and undersupply of houses guaranteed that prices would stay high. In late 2005 the Reason Foundation’s Leonard Gilroy argued that California’s tough land use and environmental controls were throttling the market and driving up prices. "While the state projects an average annual need of approximately 220,000 new housing units," he wrote, "housing production has lagged far behind, with an average of 170,000 new residential construction permits issued each year since 1999."
Even economists who were convinced that the state’s soaring house prices were unsustainable agreed that there was a serious undersupply of housing. In 2004 UCLA’s Paul Ong explained why housing supply was not responding to increases in demand:
… in part because the construction industry has adopted a strategy of building new units only after they have secured buyers. The relative unresponsiveness of supply in the face of increasing demand has pushed real estate prices to record highs and decreased the number of households that can afford to purchase a home.
Industry figures scoffed at claims that there was a housing bubble citing the high level of unmet demand. In June 2005 Alan Nevin, the California Building Industry Association’s chief economist, said that "Currently, the standing unsold inventory in California housing tracts is effectively zero and should remain that way".
Nevin was half right. The state’s stock of unsold houses had been falling since the early 1990s. By early 2005 the California Association Of Realtors reported that the unsold inventory index had dropped to 1.8 months. This meant that, at the then current rate of sales, the stock of houses on the market could be sold in less than 2 months. According to the San Francisco Chronicle’s Kathleen Pender, "An index of 5.5 to 6 months means supply and demand are in rough equilibrium." Clearly it was a sellers’ market.
Another reason commentators were unconcerned about a bursting bubble was the low rate of foreclosures. In an article titled ‘There is no Housing Bubble in the USA‘ economist James F Smith argued that national foreclosure rates were too low to affect future demand. And by the first quarter of 2005 foreclosure rates in California were lower than at any time since 1979.
According to a survey by ING Direct, most buyers entering the market in 2005 thought prices were still on the way up. According Amey Stone at Business Week, "Of 1,000 people surveyed, all of whom had closed on a new mortgage or refinanced an existing mortgage in the prior six months, 73 percent said they were not concerned that a downturn in the housing market would lead to lower home values in the next year. In 2004, 67% said they were not concerned."
But towards the end of 2005 buyers abandoned the market and sales volumes fell. According to CAR’s deputy chief economist, Robert Kleinhenz the "market turned when affordability constrained sales" (ppt). Without buyers, the market cooled, unsold inventory rose sharply and foreclosures followed. Suddenly, the boom was over.
While the end of the boom might have been a surprise to some new home owners, it was not a surprise to economists. What was surprising was the speed of the price decline that followed. In 2004, before the market peaked, UCLA’s Christopher Thornberg wrote:
… when this episode ends we shall see yet again a sustained period of low housing turnover and housing appreciation that grows, but at a pace that is slower than the pace of inflation, allowing the fundamentals to catch up; in short real estate bubbles do not die, they simply fade away.
The idea of a protracted adjustment in prices had been a popular among commentators. In the March 2004 edition of Money magazine, Jon Birger wrote that "An outright decline is unlikely because the vast majority of homeowners would rather let their homes go unsold for months than lower their asking price." And that may have been true. But not everyone in the market had a choice.
Both banks and home builders found themselves with properties they needed to sell quickly. Neither had the capacity to become property managers. According to the Wall Street Journal’s Jeff Opdyke, builders were willing to do whatever was necessary to get their homes to sell. "Among other things, they are offering buyers cash discounts of as much as 20 percent, throwing in a pool and agreeing to finish basements, garages and other spaces at a cost of several thousand dollars – incentives much richer than builders were offering as recently as six months ago, when the downturn didn’t look as bleak."
No doubt the sub-prime mortgage market bears a large share of the responsibility for California’s rapid fall in house prices. After the market turned, sub-prime borrowers could no longer sell their way out of trouble. The high rate of foreclosures may have helped to deflate the bubble quickly rather than slowly. But it does not explain why the bubble formed. As Kelly Cunningham, chief economist at the San Diego Institute for Policy Research, said earlier this month, "We’re coming back to reality, probably where prices should have been if things had gone along at a more normal pace."
Most Australian commentators insist that Australia has no housing bubble to burst. They say that while houses may be overvalued, rapid falls are unlikely. Earlier this month James Dunn of the Australian spoke to Liam O’Hara, senior economist at Australian Property Monitors. O’Hara explained why the US experience wouldn’t be repeated here:
The main reason, he says, is that whereas the US has a heavily oversupplied housing market, Australia’s is still undersupplied. "Australia has been undersupplying housing demand for some time, and that’s helping to maintain prices," he says. "If that undersupply weren’t the case, I suspect that we’d be seeing some more major movements in the market."
It may be that house prices in Australian cities will plateau in nominal terms or decline slowly in real terms. But the experience in California suggests that an undersupply of housing is no protection against rapidly declining prices. It seems odd that this has become such a popular theory in Australia. Even the Reserve Bank’s Ric Battellino is saying that "US house prices stopped rising essentially because the supply of houses overtook demand."
Even as the US bubble reached bursting point, commentators there insisted that there was no problem because there was no evidence of oversupply. As James Smith, chief economist for the Society of Industrial and Office REALTORS, wrote in 2004, "One indicator of a bubble is a rapid increase in the supply of the asset in question. [But] housing inventories have been at very low levels for over five years suggesting there is no excess supply of houses."
The argument seems perverse. According to Nicholas Gruen, it takes "a shortage of houses on the market and high demand to produce a ‘bubble’ or high prices." While US cities like Los Angeles experienced high demand along with limited supply, other cities like Dallas and Houston experienced both high demand and readily available new housing stock. By matching supply with demand, these Texan cities seems to have avoided a bubble. When demand fell away, so did building activity.
If easy credit combined with constraints on supply drive housing bubbles, then surely Australians have good reason to be worried.