www.economist.com/agenda/displayStory.cfm?story_id=3886356
Apr 20th 2005 From The Economist Global Agenda House prices have been growing at a breakneck pace in many developed coun tries. This has encouraged householders to keep spending even during the global slowdown. But now that housing markets are looking soft, consume rs may be forced to retrench AMERICAN homeowners, particularly those who have just bought their proper ties, are full of reasons why the run-up in house prices in recent years will continue indefinitely. These days, however, this is beginning to s ound like so much whistling in the dark. The next day, the Mortgage Bankers of America (MBA), an industry gr oup, reported that mortgage applications had fallen the previous week, d espite a slight dip in interest rates. Investors who thought that real e state was a haven from the volatility of the equity markets might be get ting a little nervous. House prices have received an enormous boost in recen t years from falling interest rates, which enabled homeowners to sell th eir properties for a higher price without a commensurate increase in the buyers monthly mortgage payment. But as interest rates have started to rise, buyers have turned to increasingly risky forms of financing in or der to keep their monthly payment from bankrupting them. The MBA reports that over a third of new applications in recent weeks have been for adj ustable-rate mortgages, up from just 12% in 2001. Anecdotal evidence sug gests that interest only mortgages, which allow borrowers to make no p ayments on principal for a period of years, are also on the rise.
These changes have allowed more marginal homebuyers to clamber on to the housing ladder. But if interest rates rise as economists expect, many of those buyers will find it difficult to keep up their payments. And with many putting so little downa fifth of American mortgages in 2003 were for more than 90% of the purchase priceany fall in house prices could l eave a lot of them with negative equity, forcing them to default. The increasing riskiness of mortgages is not the only sign that America i s experiencing a housing bubble. The ratio of house prices to rents is w ell above its historical average, as is the ratio of prices to median in comes. And people seem increasingly to be basing their house-buying deci sions on the notion that the large capital returns of the past few years house prices in America are up by 65% since 1997will continue indefini tely. As with a stockmarket bubble, if this confidence is shaken, prices could begin to fall rapidly. Not merely an American folly America is not the only country that has been experiencing a big run-up i n prices. Between 1997 and 2004, house prices more than doubled in Australia, Britain and Spain, and near ly tripled in South Africa and Ireland (see table). And while Americas ratio of house prices to rents is 32% higher than its average value from 1975 to 2000, by that metric houses are even more overvalued elsewhere: by at least 60% in Britain, Australia and Spain, and by 46% in France. Inflated house prices may have been a key factor in helping these countri es weather the global slowdown in 2001. When household wealth is increas ing, particularly housing wealth, consumers respond by saving less and s pending more; Explosive house- price growth thus encouraged consumers to keep their spending steady des pite external shocks. It is probably not a coincidence that Germany, one of the few European countries where house prices have not been rising, fared far worse during the slowdown than its neighbours or America. Unfortunately, when housing markets decline, the same process works in re verse: consumers have to cut back their spending and save more to compen sate for lost home equity. Lower consumer demand generally means a slowd own in GDP. The sharper the correction, the greater the effect on the ov erall economy. Prices have already begun to sof ten in places like London and New York, particularly at the high end, bu t it is possible that in most places price increases could simply modera te, giving incomes and rents time to catch up. An IMF study on asset bub bles estimates that 40% of housing booms are followed by housing busts, which last for an average of four years and see an average decline of ro ughly 30% in home values. But given how many homebuyers in booming marke ts seem to be basing their purchasing decisions on expectations of outsi zed returnsa recent survey of buyers in Los Angeles indicated that they expected their homes to increase in value by a whopping 22% a year over the next decadenasty downturns in at least some markets seem likely. A fall in American house prices could be bad news not just for American h omeowners, but for the rest of the world. Robust American demand has sup ported export-driven growth in many economies, particularly emerging mar kets and Asia. If American consumers have to raise their abysmal savings rate, exporting nations will feel the pinch. And given the parlous stat e of the Japanese and European economies, it seems unlikely that they wi ll be able to pick up the slackparticularly if many European countries are coping with the fallout from their own housing bubbles. Most worryingly, a collapse in American export demand could trigger a vic ious cycle. In order to keep their currencies low against the dollar, an d thus boost exports to America, Asian central banks have been accumulat ing dollar reserves, which they have poured into Treasury bonds. This ha s increased the supply of capital in America, and thus been at least par tly responsible for the borrowing binge that fuelled the housing boom. I f house prices fall, and suddenly poorer Americans have to cut back on t heir purchases, this will shrink the supply of cheap credit from Asian c entral banks, pushing up interest rates and causing house prices to fall even further. Those who thought that housing was a haven may be in for a nasty surprise.
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