The S&P; reports Regional Housing Bubbles Vulnerable, then asks the follow up question: Will they fizzle or pop? Let’s have a look.

With housing prices continuing to outpace both income and inflation from coast-to-coast, it is hard not to see a housing bubble, according to a comprehensive report published today in Standard & Poor’s CreditWeek. The report looks at the implications of the bubble for builders, bankers and owners in the US and abroad, as well as in the structured finance and REITs markets, from both the credit and equity perspectives.

“If the past is a guide,” says S&P; Chief Economist David Wyss, “home prices in the U.S. are less likely to crash nationwide than to stop accelerating and then stabilize until incomes catch up with unsustainably high mortgage debt. This happened after home price spikes in the late 1970’s, and again in the late 1980s. The coming rebalancing period could last half a decade, because it will take a 20% correction nationally to restore the normal ratio of home prices to income.”

Echoing a similar theme abroad, Standard & Poor’s senior economist in Europe, Jean-Michel Six, forecasts an orderly slow down in house price inflation in Europe, owing to a combination of demographic, financial, and structural factors, with a soft landing likely in the UK and near-term overheating in Spain.

“While the overall outlook may be reasonably benign,” Mr. Wyss continued, “there’s a regional danger: the possibility of deeper, more disruptive corrections in the most overvalued markets. In urban areas on both coasts, for instance, housing costs have risen 30% or more above the normal home price-to-income ratio – all the more alarming considering that in these regions this ratio was about twice the U.S. average before prices soared. This could make such places particularly vulnerable to economic shocks or rising interest rates.”

The economists at the S&P; seem to be parroting the consensus view:
1) The overall outlook is benign
2) There is no national housing bubble
3) There are indeed regional housing bubbles
4) There will be a housing soft landing in both the UK and the US
5) The only real problem is in the most bubbly areas on the coasts

Wyss did attempt to give himself an out by mentioning a “possibility of deeper, more disruptive corrections in the most overvalued markets” but his overall “benign” view seems to me to be the equivalent of the “permanently high plateau” theory. It is based on his interpretation of “prior history” but more importantly on a belief in rising incomes. “If the past is a guide, home prices in the U.S. are less likely to crash nationwide than to stop accelerating and then stabilize until incomes catch up with unsustainably high mortgage debt.”

Well judging from the experience in Japan, if past history is any guide, US home prices will sink for the next 18 years. Since there are differences between Japan and the US let’s instead focus on the income side of the statement.

Are incomes likely to catch up to “unsustainably high mortgage debt”? I think not.

  • We are losing manufacturing jobs.
  • We are outsourcing technical jobs.
  • We are gaining service jobs at Walmart, Pizza Hut, and retail outlets.
  • Pension plans are going under (United Air, Northwest Airlines to name two), and auto pension plans at Ford and GM are under attack.
  • 50% of the jobs gained in this recover were related to housing expansion. What happens to those incomes if housing so much as slows?
  • Will pay raises at Walmart catch up with mortgage debt? When?
  • What about rising energy costs and peak oil? When will wages catch up to those costs?
  • What about those on ARMs whose mortgage costs will start rising dramatically in 2006 and 2007 from low teaser rates?
  • What about rising property taxes and increased medical expenses, or does the S&P; suggest that such items are not a concern?

Mish wonders what the economists at the S&P; are smoking when they think that rising wages will catch up to the absurd home prices in the bubble areas in any sort of likely “soft landing”. We are three years into a recovery and real wages in general are still declining. Demand for housing as suggested by rising inventories is now slackening at the same time. Demand for gasoline even seems to be recently declining. What about real estate sales commissions if home sales even modestly decline? What about other sales commissions if retail spending slackens? Is Wyss aware that there is an 18-1 or 20-1 wage differential with China that is putting pressure on jobs, wages, and benefits? Under what logical scenario will overall wages finally start rising now, this far into a recovery? The only way I can see wages rising is if the bubble keeps inflating. All that would do would be to postpone the problem and make it bigger in the long run.

Note too, that the S&P; also seems to be discounting the affects of Katrina as well as any upcoming recession. Perhaps the economists at the S&P; think that the spend and spend policies of this Congress and this administration have forever eliminated the business cycle as well. Who knows? Whatever they are smoking sure is powerful stuff.

I do not buy this “permanently high plateau” nonsense or any talk of a miracle “soft landing” either. Nor do I accept that the business cycle has been defeated and there will be no more recessions. The next consumer led recession is going to be a doozie and along with it will come a severe strain on home prices. The upcoming correction is likely to be dramatic in terms of price action or length of time or both. It may come about as a very long painful slow leak (the Japan scenario), or some sort of faster price crash. I think the latter is the most likely scenario, perhaps in a sloping stairstep fashion. The least likely ending is the widely held fairy tale belief that wages keep rising, jobs will be plentiful, the business cycle is defeated, and “everyone lives happily ever after”.

Mike Shedlock / Mish/