Over the past year, the red-hot housing market has not cooled off as classic economic theory would anticipate. One big reason is that the world is experiencing a global cash surplus that has kept U.S. mortgage rates significantly lower than would have been the case if we were simply dealing with a domestic capital market. What does this say for the opportunities and risks that lie ahead?

In recent months the prices of higher-end homes--homes which cost $1 million or more--have softened. But overall, housing prices in the United States have continued to rise, climbing 14.5 percent in the year ending June 30. That's the fastest annual pace of increases in over 25 years. Because of this rapid growth, the risk of price declines has increased in 36 of the nation's 50 largest housing markets, according to the PMI U.S. Market Risk Index, featured in the Summer 2005 issue of the Economic and Real Estate Trends report from the PMI Mortgage Insurance Company.

The report suggests that six markets are more than 50 percent likely to experience some level of price declines in the next two years: San Diego, San Jose, Santa Ana, Oakland, Boston and Long Island. The supporting evidence behind this thinking is that home prices are appreciating without the any real gains in income, home affordability, or rent inflation, which are necessary components to sustain real home price increases. This is causing the current home price environment to diverge from long-term economic fundamentals, which cannot be sustained indefinitely.

Looking at the market as a whole, the study still predicts only a 21.3 percent probability of an average house price decline within the next two years, across the fifty largest housing markets. Nevertheless, the five markets mentioned earlier are definitely showing signs of bubble conditions and the broader markets are still moving in that direction.

How does the housing market become this so-called bubble? A big part of it is that speculators have inflated the market, purchasing homes and reselling them at a quick profit when prices go up. The National Association of Realtors estimates that 23 percent of homes purchased in 2004 were intended solely as investments.

Classical economic theory would have us expect long-term rates to have been driven up by now. The increases in short-term interest rates that we have seen, combined with the growing Federal budget deficit should have easily been enough to do that.

Consider the effect that a 7 percent, 30-year, fixed-rate mortgage would have on a typical real estate speculator--such a mortgage would have short-circuited the rampant speculation and caused prices to plateau nationwide by now. However, the global cash surplus has kept inflation and long term rates low. So the 30-year fixed rate is stuck at 5.75 percent.

What really may be fueling this bubble is the ability to obtain interest-only, adjustable-rate mortgages, with teaser rates as low as 1.9 percent. With a market full of creative mortgage options like that, the U.S. housing market remains a speculator's paradise teetering on a bubble.

These variable rate, interest-only loans are perfect for a speculator who believes the housing market will continue to go up and who plans on selling before the rate increases on a given home investment purchase. The potential flaw in the strategy is that it assumes that prices will continue to go up--and there is evidence that this won't continue for much longer.

Robert Shiller, an economist from Yale University, found that real home prices have historically grown only by 0.4 percent. Even when Shiller accounted for the strong increases in price during two real estate booms--in the period after World War II, and from 1998 to the present--his results still came out the same. In fact, without the two boom periods, real home prices have actually been flat or even declined.

In the new edition of his book, "Irrational Exuberance," Shiller uses the example of a house that was purchased in 1948 for $16,000 and sold in 2004 for $190,000. This seems like an amazing return on investment, but considering that the Consumer Price Index increased by 800 percent from 1948 to 2004, the investment seriously falls short of expectations. The cumulative real increase in value was only 48 percent, or less than 1 percent compounded annually. In fact, it would have been better to invest that money into a U.S. Savings Bond. Given the average real increase of 0.4 percent annually, the last year's 14.5 percent rate of appreciation cannot possibly be sustained.

There are a few things that we should expect to see as home prices continue to rise, continue to bubble, and eventually burst. Many smart investors will sell their homes and choose to rent instead. Currently, renting costs half of what it costs to own. By selling now, one can lock in the profit before prices inevitably fall or plateau and invest the money in the stock market.

Another expectation is that mortgage rates will most likely remain low and the collapse of housing markets in the most outrageously overvalued areas will have a chastening effect on speculators in the remaining markets, leading to a softening of prices nationwide, rather than a catastrophic price decline.

There is a strong possibility that we will see widespread foreclosures on interest-only mortgages, especially in transactions involving speculators. These creative, long-term loans are almost impossible to stay on top of, especially once interest rates go up or the payments increase to begin including principal.

One interesting effect is that the housing bubble is reinforcing the trend to relocate to the exurbs. In order to realize any real gain, one who sells their home in a hot market must buy a new one where prices are much less, often this means moving away from urban and suburban areas to smaller towns where houses do cost less. There may be a real opportunity here for new home construction in small towns, especially as housing prices continue to rise in the other areas.

As this housing bubble continues to defy classical economic theory, it is important to know what the market is really up to. This real estate market is beginning to look a lot like the tech stock bubble in the late 1990's. Many people took advantage of that situation and absolutely came out on top, but there also were many who weren't so lucky.