Many observers—even, in his convoluted way, Alan Greenspan—are warning of a possible fall in housing prices. In some markets, especially on the coasts, homes are so expensive relative to rents that the prices only make sense if buyers expect further substantial increases in housing prices. In New York, Miami, and Los Angeles, for example, housing prices are about 25 times annual rents. In San Francisco and San Jose, the ratio has reached 35. (See David Leonhardt, "Is Your House Overvalued?" New York Times, May 28, 2005.) A risky asset that earns 3 percent per year only is attractive to a buyer who expects the price to rise (generating capital gains).

Such expectations-driven separation of the price of an asset—a house as much as a stock—from the underlying capacity of the asset to generate earnings is what we call a bubble. Eventually people stop believing that prices can only go up, and then prices are likely to go down, a lot. The hangover can last years.

How well prepared is the American public for the real estate party to end? One way to find the answer to that question is to look at the cost of debt service relative to income. By that standard, the American homeowner appears to be in pretty good shape.

Source: Federal Reserve Board, Household Debt Service and Financial Obligation Ratios http://www.federalreserve.gov/releases/housedebt/default.htm

Homeowners' financial obligations (monthly mortgage and consumer debt service obligations, homeowner insurance and real estate taxes, and car rental payments have not risen much relative to their disposable (after tax) income in the past quarter century, in spite of increased mortgage borrowing, both to purchase expensive homes and as a result of home equity loans. Renters, whose financial obligations include consumer debt service, housing and car rental payments, have seen a much steeper run-up in their financial obligations, to nearly a third of their income, twice the level of homeowners.

This positive assessment for homeowners ignores some troubling facts. Mortgage debt service obligations and therefore total financial obligations of homeowners have held steady only because interest rates have fallen so much since the early 1980s. If we look at the two underlying determinants of monthly debt service obligations—the amount of debt and the interest rate on that debt—it becomes clear that a lot more has happened than Figure 1 suggests. In fact, mortgage debt has risen from 46 percent of disposable income in 1980 to 58 percent in 1990, to 67 percent in 2000, and to 88 percent in 2004. The run-up of mortgage debt has been particularly steep since the stock market crashed in 2001.

But while mortgage debt was climbing in recent years, mortgage interest rates were falling, from 13.8 percent in 1980 to 10.2 percent in 1990, 8.1 percent in 2000, and 5.8 percent in 2004. Figure 2 puts the puzzle together to show how falling mortgage interest rates have offset the steep climb in mortgage debt in recent years to hold monthly mortgage debt payments steady since 1990.

Sources: Federal Reserve Board, Household Debt Service and Financial Obligation Ratios http://www.federalreserve.gov/releases/housedebt/default.htm, Mortgage Interest Rates http://www.federalreserve.gov/releases/h15/data/m/cm.txt, and Flow of Funds (for outstanding mortgage debt http://www.federalreserve.gov/releases/z1/Current/z1r-2.pdf); and Economic Report of the President (for disposable personal income) http://a257.g.akamaitech.net/7/257/2422/17feb20051700/www.gpoaccess.gov/eop/2005/B31.xls.

What might happen to families' financial obligations if the housing bubble burst and interest rates rose? The answer would differ from family to family. The most vulnerable households would be those with heavy mortgage debt (including most families who recently bought a home) and those who chose mortgages with adjustable interest rates, including those with home equity debt, which carries adjustable rates.

Figure 3 shows what would happen to mortgage financial obligations if interest rates were to return to levels of previous years. If interest rates were to return to the levels of 2000, mortgage servicing costs would be nearly 40 percent higher than they are now. If 1990 rates returned, the increase in monthly mortgage costs would be more than 70 percent.

On average, home-owning households pay about 10 percent of family income to service their mortgages, so even a 70 percent increase would be unlikely to spell default for the average family. But for a family with a new mortgage that requires, say, 25 percent of their income to service, a rise to 40 percent of income might well be too much.

Source: Federal Reserve Board, Mortgage Interest Rates http://www.federalreserve.gov/releases/h15/data/m/cm.txt.

If interest rates were to return to 1990 levels, monthly mortgage service obligations easily could jump by more than half. For recent home purchasers, or families who loaded up on home equity loans, such a rise in mortgage rates could well precipitate default and foreclosure. This would hardly make the mortgage lenders happy, since many recently purchased homes might end up worth less than the outstanding mortgage debt. Such a real estate bust would hurt recent home buyers and mortgage lenders most.

Renters have been struggling with heavy financial obligations for a number of years. If the housing bubble pops and mortgage rates rise, the average homeowner might be saddled with a similar level of monthly financial obligations. Those who loaded up the most on adjustable rate mortgage debt could face bankruptcy.

Bernard Wasow is a senior fellow at The Century Foundation.