[A-List] The Economist: Biggets Bubble in History

["Sabri Oncu" <soncu@xxxxxxxxxxx>]

This is the Economist article mentioned in my previous post. Sabri

http://www.economist.com/finance/displayStory.cfm?story_id=4079027
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 history.

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 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. 

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. 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 spending.

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.