Saturday, November 1, 2014

Back to Housing Bubbles

NEW YORK – It is widely agreed that a series of collapsing housing-market bubbles triggered the global financial crisis of 2008-2009, along with the severe recession that followed. While the United States is the best-known case, a combination of lax regulation and supervision of banks and low policy interest rates fueled similar bubbles in the United Kingdom, Spain, Ireland, Iceland, and Dubai.

Now, five years later, signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.

Signs that home prices are entering bubble territory in these economies include fast-rising home prices, high and rising price-to-income ratios, and high levels of mortgage debt as a share of household debt. In most advanced economies, bubbles are being inflated by very low short- and long-term interest rates. Given anemic GDP growth, high unemployment, and low inflation, the wall of liquidity generated by conventional and unconventional monetary easing is driving up asset prices, starting with home prices.

The situation is more varied in emerging-market economies. Some that have high per capita income – for example, Israel, Hong Kong, and Singapore – have low inflation and want to maintain low policy interest rates to prevent exchange-rate appreciation against major currencies. Others are characterized by high inflation (even above the central-bank target, as in Turkey, India, Indonesia, and Brazil). In China and India, savings are going into home purchases, because financial repression leaves households with few other assets that provide a good hedge against inflation. Rapid urbanization in many emerging markets has also driven up home prices, as demand outstrips supply.

With central banks – especially in advanced economies and the high-income emerging economies – wary of using policy rates to fight bubbles, most countries are relying on macro-prudential regulation and supervision of the financial system to address frothy housing markets. That means lower loan-to-value ratios, stricter mortgage-underwriting standards, limits on second-home financing, higher counter-cyclical capital buffers for mortgage lending, higher permanent capital charges for mortgages, and restrictions on the use of pension funds for down payments on home purchases.

In most economies, these macro-prudential policies are modest, owing to policymakers’ political constraints: households, real-estate developers, and elected officials protest loudly when the central bank or the regulatory authority in charge of financial stability tries to take away the punch bowl of liquidity. They complain bitterly about regulators’ “interference” with the free market, property rights, and the sacrosanct ideal of home ownership. Thus, the political economy of housing finance limits regulators’ ability to do the right thing.

To be clear, macro-prudential restrictions are certainly called for; but they have been inadequate to control housing bubbles. With short- and long-term interest rates so low, mortgage-credit restrictions seem to have a limited effect on the incentives to borrow to purchase a home. Moreover, the higher the gap between official interest rates and the higher rates on mortgage lending as a result of macro-prudential restrictions, the more room there is for regulatory arbitrage.

For example, if loan-to-value ratios are reduced and down payments on home purchases are higher, households may have an incentive to borrow from friends and family – or from banks in the form of personal unsecured loans – to finance a down payment. After all, though home-price inflation has slowed modestly in some countries, home prices in general are still rising in economies where macro-prudential restrictions on mortgage lending are being used. So long as official policy rates – and thus long-term mortgage rates – remain low, such restrictions are not as binding as they otherwise would be.

But the global economy’s new housing bubbles may not be about to burst just yet, because the forces feeding them – especially easy money and the need to hedge against inflation – are still fully operative. Moreover, many banking systems have bigger capital buffers than in the past, enabling them to absorb losses from a correction in home prices; and, in most countries, households’ equity in their homes is greater than it was in the US subprime mortgage bubble. But the higher home prices rise, the further they will fall – and the greater the collateral economic and financial damage will be – when the bubble deflates.

In countries where non-recourse loans allow borrowers to walk away from a mortgage when its value exceeds that of their home, the housing bust may lead to massive defaults and banking crises. In countries (for example, Sweden) where recourse loans allow seizure of household income to enforce payment of mortgage obligations, private consumption may plummet as debt payments (and eventually rising interest rates) crowd out discretionary spending. Either way, the result would be the same: recession and stagnation.

What we are witnessing in many countries looks like a slow-motion replay of the last housing-market train wreck. And, like last time, the bigger the bubbles become, the nastier the collision with reality will be.

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  1. Commentedstanton braverman

    I HAVE BEEN INVESTING IN INNER CITY HOUSING SINSE 1972 and have gotten fantastic returns as the interest of many people to live in the city has increased. Some of the returns have been over 300% so I feel that I can speak with some authority. The problem with housing prices is in part a shifting demand from suburban to urban interests. But a more serious problem stems from a sever economic imbalance in the healthcare sector which is approaching 20% of the US GDP and should be closer to 10%. This shows that about 10% of the GDP is wasted and no economy can tolerate such a level of waste. It amounts to over $4000 per person. For a family of four people it amounts to $16,000 a year, $160,000 over ten years and over a 30 year period amounts to about $500,000. That is the money the American family needs to pay down student loans, to pay down the mortgage and to save for retirement. At the present time they cannot meet any of these needs. The government has reacted to this problem by resorting to below market interest rates and deficit expansion (which I see as "steroid economics") While history has shown that government supports for many different industries has always distorted the true competitive economic picture and will always exist there is a need to reshape it when it gets far out of balance and that is exactly what the healthcare industry has been and continues to do to us. The budget for the American family is stretched too far and that is one reason why they opt to walk away from a house when the mortgage payments get difficult to meet or if they are one of the two million people a year who file for bankruptcy because of the excessive cost of healthcare.

  2. CommentedDouglas Costello

    Home buyers or investors now see housing as a surer way to generate big returns on their investment than possibly the stock market where fast trading and the hedge funds dominate at their expense. With low interest rates and the belief that they can't loose they bid up knowing the market will pass them and they will make a profit when they sell.

    Simple maybe illogical but they invest.

  3. CommentedChristopher Gittins

    On the theme of policy tools that policymakers have no inclination to use, why not tax capital gains on home sales or, better yet, impose a home sales tax? I'd expect the latter to be particularly effective at reducing 'frothiness'.

  4. CommentedRishi Arora

    What is concerning is we are starting from a much higher debt level ratio. In the UK for example private sector debt is at its highest level in history - even taking account of 2008. The Bank of England are stuck between a rock and a hard place in the sense in the incentives are to continue borrow cheap money, but personal balance sheets are too indebted - leading to any rise in interest rates - say from oil prices rises (causing inflation) leading to either BOE to raise rates and effectively put people on the street or leave them causing what Dr Roubini has just mentioned.

    What is the solution? I believe higher requirements for lending - more proof and CGT on foreign purchases... closing loopholes in the system and incentivising savings but subsiding/ not taxing the first £10000 per year of savings.

  5. CommentedProcyon Mukherjee

    Some of unusual names (as the Goldman report also endorses) leave some doubt. First of all any serious housing bubble normally is accompanied by a construction boom, secondly the lending standards need to deteriorate. We do not see either of this happening in places like Norway, Switzerland or Canada. So a soft landing is perhaps on the cards. The point is however well taken that household assets are getting concentrated in the housing sector as financial repression leaves few other asset classes as a hedge against inflation, while no one wants to be deeply invested in fixed assets that have a lock-in for a longer tenure.

  6. CommentedRobert Snashall

    Cracking article mate!
    I often wonder about the supposed efficiency of the free market and deregulated financial markets when it results in most citizens not being able to afford to buy a house, whilst at the same time causing huge market instability.
    However, on the bright side, huge financial instability causes some massive recessions which in turn help democratisation movements quite a bit, as one saw in the Arab Spring, even if that has turned out to be a depressing bloodbath. Malaysia and Singapore with their huge property bubbles, and Malaysia with it's large public and private debt levels, are teetering on the brink of a proper functioning democracy, that with a nice old crash might move the political equilibrium in it's favour. That was the case in 1997 with Indonesia.