Bubble Trouble

Wildly mocking forecasts by experts that the housing market simply can't keep rising, U.S. home buyers have displayed an endurance that six-time Tour de France champ Lance Armstrong would envy. In June, existing-home sales rose 2.1%, with the average house going for $191,800 — a record, according to the National Association of Realtors.

The question is whether the housing market is going to turn from blazing money-maker to a sad pile of smoldering ashes as the Federal Reserve squeezes credit by hiking interest rates.

Robert Shiller, a Yale economist and author of "Irrational Exuberance," thinks there's no question that the U.S. is in the midst of a dangerous property bubble fueled by years of easy access to cheap cash. Shiller, who famously called the dot-com bubble in the late 1990s, is planning to reissue his book in 2005 with a fresh chapter arguing that there's a property bubble not only in the U.S., but world-wide. When it pops, he says, a global recession may follow.

"We had a world-wide recession in 1991, and that was associated with drops in real-estate prices among many countries," says Shiller. "I think it's worse this time."

SmartMoney.com recently spoke with Shiller to find out exactly why he thinks there's a housing bubble, how bad it's going to be if it blows up and what people can do to protect themselves from the declining value of their homes.

SmartMoney.com: You're reissuing "Irrational Exuberance" next year, with a new chapter on a potential global property bubble. Do you foresee a hard landing in the housing market in the U.S.?

Robert Shiller: I think that it's quite possible. There's always the question about whether we're at the peak, and I don't know that. But in some cities, home prices have gotten quite high relative to income. It's supported by the sense that these prices can only go up, and that's a bubble. The unwinding occurs when people don't see them going up anymore. So I do think that it's quite possible that there's a bubble in a number of cities.

SM: Dean Baker of the Center for Economic Policy Research is predicting a loss of $2 trillion to $3 trillion in housing wealth, more than was lost in the dot-com crash. How likely is that scenario?

RS: I think that's possible. Right now, the total real-estate wealth of households is about $16 trillion. So $2 trillion to $3 trillion, which is proportionally bigger than anything we've seen nationwide, I believe, is possible because we're in a stronger bubble than we've ever seen before.

SM: The U.S. isn't the only country seeing a housing boom — this is a phenomenon impacting a number of fast-growing countries right now, including China, Australia and some countries in Europe. What's the global impact of a property bust?

RS: It could be a world-wide recession. We had a world-wide recession in 1991, and that was associated with drops in real-estate prices among many countries. I think it's worse this time. I think when home prices go down, that does have an impact on people's expenditures. China's rapid building spree has been driving up commodity prices, and that's been putting pressure on home prices all over the world. The other thing that's feeding this is that world-wide, interest rates are fairly low. The U.S. is at an extreme low, and if you look around the world, a lot of countries have cut rates, too. But many are starting to raise them now.

SM: Some economists are saying that we're not in a bubble.

RS: I know. There are a lot of people saying that. It's analogous to the stock-market bubble. In 2000, people were saying that the stock market has been underpriced historically and that maybe it's priced just right now. But I do think there's a bubble, and I think a sign of it is the extreme enthusiasm people are showing. It has all the psychological earmarks of a bubble. You have to understand that those psychological attitudes won't last forever, so that's going to have an impact on home prices. We just don't know exactly when it's going to happen.

SM: Forecasters have been saying for the past two years that there's a bubble and that it's going to burst, but prices keep on going up.

RS: That's part of the problem. When people keep saying there's a bubble and it doesn't pop, they look discredited. But this is all part of the argument that there is a bubble.

SM: With the economy growing at a roughly 4% pace right now and job growth coming back, won't that soften the impact of falling property prices?

RS: The housing market hasn't had much of a business-cycle correlation over history. If you look at the 1991 recession, it didn't really correspond much to the price declines in the housing market. The housing market started to turn in the late 1980s, well before the recession. What's happening right now is primarily psychological, although people don't know that. One of the things we learned in a questionnaire survey we did last year when we asked people whether or not the housing market is a psychological or a fundamental phenomenon, most people said that it is fundamental. Most people don't think of the housing market as being driven by psychology. That's why it will surprise people so much when it turns around.

SM: Existing-home sales hit a record in June as people are rushing out to get in the market before rates go up any more. How much of that is sort of herdlike behavior?

RS: I would definitely call it herdlike. More and more people are thinking of homes as a great investment. Homes really are replacing the stock market as investments. At the peak of the stock market, everyone thought stocks were the best investment. Now they're switching to housing. That drives a lot of thinking and profoundly influences behavior.

SM: If there is a bursting of the bubble, how much blame will Greenspan have to assume for allowing credit to remain so loose for so long?

RS: Greenspan is doing the best he can. He had to cut rates aggressively during the recession of 2001, and of course that has had an impact on the housing market. The real question with Greenspan is whether he's going to raise rates enough to harm the housing market substantially. There's a lot of vulnerability now with so many people with adjustable-rate mortgages and so many people strapped with difficulty making payments. If he were going to raise rates sharply, it would have a big impact. I suspect he's not going to do that. He doesn't like to disturb markets.

SM: How will the declining value of homes impact on the spending habits of consumers?

RS: I think that the wealth effect is stronger in housing than in stocks. More people own houses than stocks, and their house has a big psychological impact. So when people hear that home prices have gone up in their neighborhood, it gives them a real sense of well-being. And when they go down, that can have a big psychological impact, too, and that will spread into the economy. I don't want to exaggerate too much. I think we're talking a recession, nothing more than that. It could be a world-wide recession. If China falls into a funk, that would eliminate a big driver of the world economy. If the U.S. did it simultaneously, we could have a world recession.

SM: People who've use an adjustable-rate mortgages (ARMs) are the most vulnerable to rising rates, but the percentage of people using ARMs keeps rising. Is that a sign of irrational exuberance?

RS: Definitely. I think we do have irrational exuberance in the housing market. It's the same phenomenon that we saw in the stock market a few years ago. We're seeing this shift toward ARMs, and we're also seeing a higher mortgage-to-income ratio and weakening credit standards, all the earmarks of a bubble. What happened was, people got sick and tired of stocks, but there's still this desire to find the Holy Grail that will make them rich. The fact that people have made money on property is part of what drives the enthusiasm. Most people know someone who's made money on their house and is probably smug about it. That is part of the bubble phenomenon.

SM: Is there anything people can do to hedge against the falling value of their homes?

RS: That's what I've been trying to develop. I have this company called Macro Securities Research, and we're working with the American Stock Exchange to try to develop hedging products for single-family homes. We hope to have a product out within the year, if we can manage it. We have pairs of securities, a long and a short. So you can short Los Angeles, or long Los Angeles, and put it in your portfolio. If prices go up, the long does well and the short does badly. If it goes the other way, the short does well. If you combine that with your house, then you've pulled yourself out of the market somewhat. These securities would be traded in a relatively efficient market and would anticipate future movements.