Home market feeds on itself until collapse

  • Article by: CHRIS FARRELL , Star Tribune
  • Updated: February 17, 2008 - 11:43 AM
Q: The median price of a house in California is $430,000. I don't understand how this is possible. How can people afford houses? This is relevant to me in Minnesota, because there's something about the way the housing market works that I just don't understand. - CHIP

A: Wild, isn't it? From 1995 to 2005, home prices rose nationwide by an astounding 44 percent, after adjusting for inflation.

But first, let's go back to 1995, when the upturn in the housing market was driven by several broad, reinforcing trends. Good growth in jobs and incomes started generating greater investment in housing. Low interest rates and slow price appreciation also made buying a home far less costly than at any time in the previous two decades.

Demographic trends were favorable, too, including the aging of the baby boom population and record numbers of immigrants eager to call a place their own. Mortgage lending to low-income households and minorities was growing.

All these factors, especially low interest rates, remained in place after the 2001 recession. The momentum built on itself. Home prices kept rising, more renters felt left behind and jumped into the market, and so on. But the real culprit behind the housing boom this decade was lending institutions.

Flush with cash and eager to make profits in a low-interest-rate environment, they shoveled money at borrowers - especially anyone they could charge more, namely low-income borrowers or those who had tattered credit scores.

To get an idea of how lax lenders became, let's look at the relationship between home prices and median incomes. A rule of thumb is that home prices are reasonable when they are about four times median income in a given area.

If home prices jump to say, six times median income in a region, that's a sign that the market has gotten ahead of itself.

Well, according to figures compiled by Housing Tracker, last year prices in Los Angeles were 10.5 times median incomes.


Chris Farrell is economics editor for American Public Media's weekly "Marketplace Money" show on public radio. He lives in St. Paul. Send questions to cfarrell@mpr.org and put "Your Money" in the subject line.
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