June 16, 2005
The trouble with bubbles
The Economist—which has a plummeting house brick on the cover of its new issue—reckons “the biggest financial bubble in history” is about to burst:
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 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.
… 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.
As I’ve written before, it’s the structural change in house financing that worries me most. A recent report from the Federal Deposit Insurance Corporation describes how the housing boom is being accompanied by a fundamental shift toward riskier forms of lending. In particular, it notes that sub-prime mortgage originations surged to almost 20% of all mortgage originations in 2004, up from just under 9%in 2003; that adjustable-rate mortgages accounted for almost 46% of the value of new mortgages, up from 29% in 2003; and that interest-only mortgages accounted for 23% of the value of non-agency mortgage securitizations. And the National Association of Realtors [link dead] estimates that 23% of all houses bought in 2004 in the U.S. were for investment rather than occupation. This, then, is a massively over-borrowed bubble.
So where will it all end? In tears:
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.
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.
The magazine also points to a study I mentioned in a previous post:
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.
This is going to be the major economic issue for the Republicans in 2008. And it may bring down their house.
Posted by Stephen at 7:17 PM in Economics | Permalink | TrackBack (0)
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