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The Kevlar housing bubble
Those who see home prices bursting often say: 'When mortgage rates rise...' But what if they don't?
May 24, 2005: 10:13 AM EDT
By Chris Isidore, CNN/Money senior writer
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NEW YORK (CNN/Money) - Will low mortgage rates remain around long enough to keep housing prices inflated?

It's a question worth asking amid new talk of a possible housing bubble even in the face of continued strength in the real estate market.

Friday, Federal Reserve Chairman Alan Greenspan said the nation's housing market showed signs of "froth", adding he didn't believe there was a nationwide housing bubble nationwide but that some local markets may be experiencing one.

Still the National Association of Realtors on Tuesday reported a record pace of sales of previously owned homes in April, with sales coming in at a 7.18 million annual pace. That's up from a 6.87 million sales pace in March, and it topped forecasts of a 6.90 million rate from economists surveyed by

The median home price was up nearly 7 percent from March.

On Wednesday, the government is set to report on new home sales. That reading is expected to show a drop to 1.3 million in April from a record pace of 1.4 million in March.

The strong real estate market continues to be supported by low mortgage rates.

Mortgage financing firm Freddie Mac put the average 30-year fixed-rate mortgage at 5.71 percent last week. While that was higher than some weeks over the last year, it's still below any annual average rate since Freddie started tracking the numbers in 1973. And it's below the rate last June, when the Fed started raising short-term interest rates.

While the Fed rate hikes have led many in the housing market to say mortgage rates will soon rise, there is a small but growing number of experts who now say that long-term rates, including mortgage rates, won't necessarily rise as far or as fast as many had projected.

The crystal ball on rates

Last week Bill Gross, manager of the world's biggest bond fund, wrote a commentary predicting long-term bond yields would hold at or near their current low levels for several more years.

"If we had to forecast (and we do), we believe a range of 3.75 to 4.5 percent for 10-year nominal Treasuries will prevail during most of our secular time frame," said Gross, meaning three to five years.

Mortgage rates often follow the direction of long-term Treasuries, such as the 10-year, although not always in lock step. Frank Nothaft, chief economist for Freddie Mac, shares a similar view that mortgage rates can stay low along with the Treasury yields.

Nothaft says the 30-year should stay below 7 percent through the end of 2006, and not rise much past that in 2007. If that pans out, it would give the mortgage a five-year run below 7 percent, the longest stretch below that level since the six years ending in 1968. The loan last averaged above 7 percent in March 2002.

Nothaft said that low inflation expectations have kept long-term rates low even as the Fed has raised its target for the federal funds rate, an overnight bank lending rate, eight straight times, to 3 percent from 1 percent.

"The Fed has been very successful in wringing inflation out of the expectations of investors," said Nothaft. "Today's (rate environment) feels very much like the mid-60s."

Doug Duncan, chief economist with the Mortgage Bankers Association, admits he's also surprised by how low rates are, but he too sees them staying low. His group has forecasted 30-year mortgage rates at 6.75 percent at the end of 2006. He said in addition to low inflation expectations, strong demand for Treasury bonds and other U.S. debt from overseas has been a powerful force keeping interest rates low.

"Look around the world and ask where else you would rather have your money," he said. "It's hard to find a lot of places that can compare to the U.S."

Some still see bubble

But some economists who are less sanguine say they still see a housing price bubble. Dean Baker, the co-director of the Center for Economic Policy Research, admits he's been wrong about when mortgage rates would rise, but he still expects them to top 7 percent as soon as year's end. And he said that even if mortgage rates don't start to climb, he expects home prices to start coming down, sooner rather than later.

"We're building at a 2 million-a-year pace, which is more than demand, and we're going to keep building at that pace until home prices correct," said Baker. "It's already showing up in the rental market, oversupply is pushing down rental prices."

Baker, who last year sold his condominium and started renting an apartment in the same neighborhood, said he might be wrong about how close prices are to peaking, but he's convinced that current prices cannot be sustained, given the run-up in recent years.

"Even if rates stay low, the bubble will burst," he said. "I'll be surprised if can keep doing this for another year or two and not see downward pressure on prices. If rates go up, the fall will be faster."

But Duncan at the Mortgage Bankers Association said he believes even if mortgage rates jump, he's not convinced there will be a drop in home prices.

"I think it'll take a couple of (percentage) point move to make a substantial change in the market," he said. "I haven't seen an instance in the past when interest rates themselves brought home price declines in a local market. It's taken a combination of rising unemployment," and people moving out.

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