[OPE-L] "... the biggest bubble in history. Prepare for the economic pain when it pops."

From: glevy@PRATT.EDU
Date: Fri Jun 17 2005 - 08:24:43 EDT

The global housing boom

In come the waves
Jun 16th 2005
From The Economist print edition

The worldwide rise in house prices is the biggest bubble in history.
Prepare for the economic pain when it pops
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

The global boom in house prices has been driven by two common
factors: historically low interest rates have encouraged home buyers to
borrow more money; and  households have lost faith in equities after
stockmarkets plunged, making property  look attractive. Will
prices now fall, or simply flatten off? And in either case, what will
be the consequences for economies around the globe? The likely answers
to all these questions  are not comforting.

The increasing importance of house prices in the world economy
prompted The Economist to start publishing a set of global house-price
indices in 2002 (see  article). These now cover 20 countries, using data
from lending institutions, estate agents and national statistics. Our
latest quarterly update shows that home prices continue to rise by 10%
or more in half of the countries (see table). America has seen one of
the biggest increases in house-price inflation over the past year, with
the average price of  homes jumping by 12.5% in the year to the first
quarter. In California, Florida, Nevada. Hawaii, Maryland and
Washington, DC, they soared by more than 20%.

In Europe, prices have long been at dizzy heights in Ireland and
Spain, but over the past year have also spurted at rates of 9% or more
in France, Italy, Belgium, Denmark and Sweden. Both France (15%) and
Spain (15.5%) have faster house-price  inflation than the United States.

By contrast, some housing booms have now fizzled out. In Australia,
according to official figures, the 12-month rate of increase in house
prices slowed sharply  to only 0.4% in the first quarter of this year,
down from almost 20% in late 2003. Wishful thinkers call this a
soft landing, but another index, calculated by the Commonwealth Bank
of Australia, which is based on prices when contracts are agreed rather
than at settlement, shows that average house prices have actually fallen
by 7% since 2003; prices in  once-hot Sydney have plunged by 16%.

Britain's housing market has also cooled rapidly. The Nationwide
index, which we use, rose by 5.5% in the year to May, down from 20%
growth in July 2004.  But once again, other surveys offer a gloomier
picture. The Royal Institution of Chartered  Surveyors (RICS)
reports that prices have fallen for ten consecutive months, with a  net
balance of 49% of surveyors reporting falling prices in May, the weakest
number since  1992 during Britain's previous house-price bust. The volume
of sales has slumped by one- third compared with a year ago as both
sellers and buyers have lost confidence in house  valuations. House-
price inflation has also slowed significantly in Ireland, the
Netherlands and New Zealand over the past year.

Since 1997, home prices in most countries have risen by much more in
real terms (ie, after adjusting for inflation) than during any previous
boom. (The glaring  exceptions are Germany and Japan, where prices have
been falling.) 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.

The most compelling evidence that home prices are over-valued in many
countries is the diverging relationship between house prices and rents.
The ratio of  prices to rents is a sort of price/earnings ratio for the
housing market. Just as the price of  a share should equal the discounted
present value of future dividends, so the price of a  house should
reflect the future benefits of ownership, either as rental income for an
investor  or the rent saved by an owner-occupier.

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.

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. Rental yields have fallen
to well below current mortgage  rates, making it impossible for many
landlords to make money.

To bring the ratio of prices to rents back to some sort of fair
value, either rents must rise sharply or prices must fall. After many
previous house-price booms  most of the adjustment came through inflation
pushing up rents and incomes, while  home prices stayed broadly flat.
But today, with inflation much lower, a similar  process would take
years. For example, if rents rise by an annual 2.5%, house prices  would
need to remain flat for 12 years to bring America's ratio of house prices
to rents back  to its long-term norm. Elsewhere it would take even longer.
It seems more likely, then, that  prices will fall.

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
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.

Betting the house America's housing market heated up later than those in
other countries, such as Britain  and Australia, but it is now looking
more and more similar. Even the  Federal Reserve is at last starting to
fret about what is happening. Prices are being driven by speculative
demand. 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. Investors are
prepared to buy houses  they will rent out at a loss, just because they
think prices will keep rising—the  very definition of a financial bubble.
"Flippers" buy and sell new properties even before  they are
built in the hope of a large gain. In Miami, as many as half of the
original buyers resell new apartments in this way. Many properties change
hands two or three  times before somebody finally moves in.

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.

The rapid house-price inflation of recent years is clearly
unsustainable, yet most economists in most countries (even in Britain
and Australia, where  prices are already falling) still cling to the
hope that house prices will flatten rather than collapse. It is true
that, unlike share prices, house prices tend to be somewhat "sticky"
downwards. People have to live somewhere and owners are loth to accept a
capital loss.  As long as they can afford their mortgage payments, they
will stay put until conditions  improve. The snag is that eventually
some owners have to sell—because of relocation, or  job loss—and they
will be forced to accept lower prices.

Indeed, 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.

While America's housing market is still red hot, others—in Britain,
Australia and the Netherlands—have already cooled (see chart 2). What
lessons might  they offer the United States?

The first is that, contrary to conventional wisdom, it does not
require a trigger, such as a big rise in interest rates or unemployment,
for house prices to decline. British home prices started to fall in the
summer of 2004 after the Bank of England  raised rates by a modest
one and a quarter percentage points. Since 2002, the Reserve Bank of
Australia has raised rates by exactly the same amount and unemployment
is at a 30-year  low, yet home prices have fallen. The Federal Reserve's
gradual increase in rates by two  percentage-points over the past year
has done little to scare away buyers, because most still have fixed-rate
mortgages and long-term bond yields have remained unusually low. But  as
more Americans have been resorting to ARMs, so the housing market is
becoming more vulnerable to rising rates.

Rung at the bottom British and Australian prices have stalled mainly
because first-time  buyers have been priced out of the market and demand
from buy-to-let investors has  slumped. British first-timers now account
for only 29% of buyers, down from 50% in 1999.  And, according to the
National Association of Estate Agents, buy-to-let purchases are
running 50% lower than a year ago. As prices become more and more heady
in America, the same  will happen there.

British experience also undermines a popular argument in America that
house prices must keeping rising because there is a limited supply of
land and a growing number of households. As recently as a year ago, it
was similarly argued that  the supply of houses in Britain could not keep
up with demand. But as the expectation of rising prices has faded,
demand has slumped. According to RICS, the stock of houses for sale  has
increased by one-third over the past year. America has faster population
growth  than Britain, but its supply of housing has also been rising
rapidly. 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.

Another mantra of housing bulls in America is that national average house
prices have never fallen for a full year since modern statistics began.
Yet outside America, many countries have at some time experienced a drop
in average house prices, such as Britain and Sweden in the early 1990s and
Japan over the past decade. So why  should America be immune? Alan
Greenspan, chairman of America's Federal Reserve, accepts that there are
some local bubbles, but dismisses the idea of a national housing
bubble that could harm the whole economy if it bursts. America has in the
past seen sharp  regional price declines, for example in Boston, Manhattan
and San Francisco in the early 1990s. This time, with prices looking
overvalued in more states than ever in the past, average American prices
may well fall for the first time since the Great Depression.

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.

Another worrying lesson from abroad for America is that even a mere
levelling-off of house prices can trigger a sharp slowdown in consumer
spending. Take  the Netherlands. In the late 1990s, the booming Dutch
economy was heralded as a model  of success. At the time, both house
prices and household credit were rising at double- digit rates. The
rate of Dutch house-price inflation then slowed from 20% in 2000 to nearly
 zero by 2003. This appeared to be the perfect soft landing: prices did
not drop. Yet  consumer spending declined in 2003, pushing the economy
into recession, from which it  has still not recovered. When house prices
had been rising, borrowing against capital gains on homes to finance other
spending had surged. Although house prices did not  fall, this housing-
equity withdrawal plunged after 2001, removing a powerful stimulus to

Housing-equity withdrawal has also fallen sharply over the past year  in
Britain and Australia, denting household spending. In Australia, the
12-month  rate of growth in retail sales has slowed from 8% to only 1.8%
over the past year; GDP growth  has halved to 1.9%. In Britain, too, a
cooling of the housing market has been accompanied  by an abrupt slowdown
in consumer spending. If, as seems likely, home prices continue to fall in
both countries, spending will be further squeezed.

Even a modest weakening of house prices in America would hurt consumer
spending, because homeowners have been cashing out their capital gains at
a  record pace. 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.

And after the gold rush? 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.

One of the best international studies of how house-price busts can  hurt
economies has been done by the International Monetary Fund. Analysing
house prices  in 14 countries during 1970-2001, it identified 20 examples
of "busts", when real  prices fell by almost 30% on average (the fall in
nominal prices was smaller). 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.

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 (see
chart 3). And it is surely no coincidence that Japan and Germany, the  two
countries where house prices have fallen for most of the past decade, have
had the  weakest growth in consumer spending of all developed economies
over that period. Americans who believe that house prices can only go up
and pose no risk to their economy  would be well advised to look overseas.

Copyright © 2005 The Economist Newspaper and The Economist Group. All
rights reserved.

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