the graphs above as well as the quotes below are from the Economist (behind subscription wall)
NEVER before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?
According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries' combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America's stockmarket bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.
Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries.
See this graph:
These are relative numbers - the ratio of house prices to rents, so the absolute level is irrelevant. And the conclusion is unavoidable:
America's ratio of prices to rents is 35% above its average level during 1975-2000. By the same gauge, property is "overvalued" by 50% or more in Britain, Australia and Spain. Rental yields have fallen to well below current mortgage rates, making it impossible for many landlords to make money.
And the Economist addresses the issue that low nominal (apparent) interest rates may justify such higher prices:
A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency--though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.
Banks are fuelling the craze by providing ever riskier instruments:
New, riskier forms of mortgage finance also allow buyers to borrow more. According to the NAR, 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. Indeed, homebuyers can get 105% loans to cover buying costs
. And, increasingly, little or no documentation of a borrower's assets, employment and income
is required for a loan.
Interest-only mortgages are all the rage, along with so-called "negative amortisation loans" (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly, allowing the borrower to sell the home at a profit or refinance before any principal has to be repaid. Such loans are usually adjustable-rate mortgages (ARMs), which leave the borrower additionally exposed to higher interest rates. This year, ARMs have risen to 50% of all mortgages in those states with the biggest price rises.
Banks have loosened their standards to the point it is hard to find charitable ways to describe their behavior. But they are not totally stupid - at least they have emasculated the bankruptcy procedures that allowed people to dump the assets on them and take off, so the hardest pain will not be on them this time, but on the home buyers, who risk paying for today's follies for the rest of their lifes.
So what will happen?
A drop in nominal prices is today more likely than after previous booms for three reasons: homes are more overvalued; inflation is much lower; and many more people have been buying houses as an investment. If house prices stop rising or start to fall, owner-occupiers will largely stay put, but over-exposed investors are more likely to sell, especially if rents do not cover their interest payments. House prices will not collapse overnight like stockmarkets--a slow puncture is more likely.
The housing market has played such a big role in propping up America's economy that a sharp slowdown in house prices is likely to have severe consequences. Over the past four years, consumer spending and residential construction have together accounted for 90% of the total growth in GDP. And over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage broking.
Note these numbers again:
90% of GDP growth
40% of all new private sector jobs
The Economist provides the example of the Netherlands, who was hailed as a model economy in the late 90s, with low unemployment, strong growth, and yet a decent welfare system. Well, it was all an illusion. House prices were increasing by 20% per year. Than they stopped growing (and did not evne drop), and the economy has been in a recession ever since. And that's the best case scenario.
The more comparable scenario is the one pointed out in the graph above the fold, i.e. Japan:
Japan provides a nasty warning of what can happen when boom turns to bust. Japanese property prices have dropped for 14 years in a row
, by 40% from their peak in 1991. Yet the rise in prices in Japan during the decade before 1991 was less than the increase over the past ten years in most of the countries that have experienced housing booms.
Okay, the Economist has been bearish on housing prices for a number of years now, and they have been very wrong in their predictions a few times in the past (including predicting 5$/bl oil in 1999), and scary headlines on housing prices certainly will sell a few more papers, but are there rational arguments to say that:
- house prices are not totally out of whack with what people can afford to pay;
- the majority of financial instruments currently provided in the housing market are incredibly risky;
- housing price increases have sustained so much of the current economic growth that even a slowdown of that growth (a highly optimistic scenario) will create real economic pain;
- a drop in housing prices, like has already happened in Australia and the UK is very likely, and will have horrifying economic conseuqences in overextended America?
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