The global housing boom, and bust
The Economist has printed a pair of striking articles to accompany its striking cover predicting a drop in global housing prices. In typical dry British humour the leader, notes “Houses cannot be sold as quickly as shares, making a price crash less likely. It is true that house prices do not plummet like a brick. They tend to drift downwards, more like a brick with a parachute attached. But when they land, it still hurts.”
The housing bubble has been one of the big topics that we have been following over the last year or so, mostly offline, but it looks like things are about to come to a head as the mainstream financial press begins to go nuts on the issue. Fortune for instance had a cover story about the phenomenon a few weeks ago which unfortunately has moved into the subscriber only archive. The subtitle is telling though:
They snap up real estate, flip it, then chase the next hot market. They’re the new day traders—and they’re dancing on the edge of a volcano.
In the following issue, Fortune subtitled an article with the phrase “Yes, asset prices have gone wild. And nitwits are getting really rich.”
The Economist famously produced one of the best predictors of recessions but simply scanning Lexis-Nexus for the word “recession” and watching for sudden increases. This ‘wisdom of crowds’ approach to economics would be interesting to apply to financial bubbles to try to pinpoint the early stages of a blowout. As it is, I’ve been predicting the house pricing bubble to be ready to burst for well over two years, and like my predictions of a stock market correction in 1999, I’ve been correct, but way too early. In fact predicting the exact end of a bubble is notoriously difficult. Disgraced stock analyst Henry Blodget, famous for calling for Amazon’s stock to hit $400 in 1998, published an interesting article last week, also in Fortune, on the psychological aspects of bubbles.
In the middle of a bubble (which until it bursts, don’t forget, is a boom), individuals, executives, politicians, central bankers, journalists, and others are confronted with hard choices. Sometimes their decisions are aggressive: I want to make money. Sometimes they are defensive: I want to keep my job. Sometimes they are emotional: I just don’t want to be wrong anymore. What these decisions are not is “insane.”
One of the more enduring myths about bubbles is that participants are so besotted that they never imagine they might be in one. To debunk this, we need only glance at today’s real estate market. An expert a week opines that ballooning property prices are a disaster in the making (which they probably are). But for a variety of reasons—we need to live somewhere, the skeptics might be wrong, and the market keeps going up—we continue to participate. And so it was with the stock market. In April 1999, a full year before the crash, Barron’s asked professional money managers whether they thought the market was experiencing a speculative bubble. A resounding 72% said yes. And in the following 12 months, as the Nasdaq doubled and the Dow rose nearly 20%, many of those managers kept right on buying.
So what evidence do we now have that indicates that bad tiding await the global housing bubble. consider these facts from the Economist’s special report:
- In California, Florida, Nevada. Hawaii, Maryland and Washington, DC, [the average price of homes over the past year] soared by more than 20%.
- American prices have risen by less than those in Britain, yet this is still by far the biggest boom in American history, with real gains more than three times bigger than in previous housing booms in the 1970s or the 1980s.
- America’s ratio of prices to rents is 35% above its average level during 1975-2000 (see chart 1). By the same gauge, property is “overvalued” by 50% or more in Britain, Australia and Spain.
- A study by the National Association of Realtors (NAR) found that 23% of all American houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes.
- In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002.
- 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. But over the next five years, several countries are likely to experience price falls of 20% or more.
- Economists at Goldman Sachs point out that residential investment is at a 40-year high in America, yet the number of households is growing at its slowest pace for 40 years. This will create excess supply.
- Goldman Sachs estimates that total housing-equity withdrawal rose to 7.4% of personal disposable income in 2004. If prices stop rising, this “income” from capital gains will vanish.
- 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.
- All but one of those housing busts led to a recession, with GDP after three years falling to an average of 8% below its previous growth trend. America was the only country to avoid a boom and bust during that period. This time it looks likely to join the club.
- 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 (see chart 3).
This last bit of information is so incredible, that it deserves to be quoted fully:
But even if prices in America do dip, insist the optimists, they will quickly resume their rising trend, because real house prices always rise strongly in the long term. Robert Shiller, a Yale economist, who has just updated his book “Irrational Exuberance” (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004. And if the current boom is stripped out of the figures, along with the period after the second world war when the government offered subsidies for returning soldiers, artificially inflating prices, real house prices have been flat or falling most of the time. Another sobering warning is that after British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.
Greenspan argues that there are only localized bubbles in America, and he’s correct that the housing price trend has been largely focused on specific regions, with some areas (Houston for instance), actually seeing a drop in the ratio of houses to earnings.
The reasons for this are manifold, aside from explosive growth in specific cities, lax regulation in many states has contributed to massive localized booms. Florida for instance allows for property titles to be flipped before the new owner even takes possession. States also vary on how long a house must be lived in to avoid paying capital gains tax on the sale of a primary residence, as well as whether capital gains can be avoided on the sale of a second home. Clearly this uneven regulatory framework can lead to huge distortions in the national housing market.
All the same, the rise in housing prices has fueled an enormous amount of consumer borrowing which has fueled the economy and done a good deal to help America, and, in the current world economic climate, the world from experiencing much in the way of a recession after equity revaluation in 2001.
A theme that was very well covered last year on the Roger Arnold Show was the idea that the massive monetary pumping and dramatic lowering of interest rates and expansion of credit by the Fed from 2000 onwards was going to test the monetarist hypothesis that these instruments could, properly applied, mitigate the risk of a recession and move the economy into a new period of growth. In the last few years it has appeared to be working.
A competing business cycle theory, from the Austrian school of economics states that by making credit artificially cheap an over active central bank will subsidize unsustainable over-investment, prolonging the period of growth, but deepening the necessary and inevitable correction.
Only a naif or a genius would dare to make a hard prediction other that this is going to be an interesting year for amateur economists.