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Housing bubble holds the key

By Michael Coote

Friday 24th January 2003

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Is every man's castle about to crumble? Will 2003 become the year of the great residential property crash, when the roof falls in on the world economy?

The Economist seems to think the odds of it happening have shortened considerably.

What is going wrong? In response to the 2000-02 downturn, most countries followed the lead of the US Federal Reserve and slashed official interest rates. These rates are at 1.25% in the US, 2.75% in the Euro countries, 4.0% in the UK, and 0.001% in Japan.

Businesses by and large have not rushed to borrow and invest, not least because banks have turned tough on corporate lending criteria. It is households in the consumer economy that have boosted hire purchases and mortgage borrowing.

Cheaper mortgages have inflated house prices. As house prices have risen, homeowners have refinanced their mortgages to borrow more.

Indebted consumers have kept the sluggish world economy afloat on the back of the real estate boom. Households have more wealth in housing than in equities, so they are more sensitive to a downturn in real estate than in shares.

In the UK, mortgage equity withdrawal is estimated by Goldman Sachs to have reached a record 8.5% of personal disposable income. The US and Australia have set their own records at about 4%.

The UK figure is higher than in the housing bubble of the late 1980s, which preceded a property crash and resultant recession. Household indebtedness is more than 120% of personal disposable income in the UK and Australia and over 100% in the US.

One possibility is that house prices, having soared in the US, the UK, Australia, New Zealand and elsewhere, will reverse or even crash. Households that have borrowed heavily through mortgages could find themselves sitting on negative equity in their homes.

As a result, they slash spending and strive to quit excess debt. Down goes the economy into resulting recession or even depression. This has happened in Japan, Germany and Hong Kong, major economies where declining house prices have triggered deflation and recession or near recession.

The UK looks headed for a property crash. The signs are emerging in London, which accounts for 17.5% of British GDP.

It transfers wealth to other parts of the country via business, commuters and taxes. The city has rising unemployment. Another warning sign is slowing use of public transport.

Moreover, London house prices are starting to fall. It is not expected London will recover until 2005. Meanwhile, it could drag the rest of the country into recession exacerbated by a property slump.

But house prices don't have to fall to trigger the debt crunch effect that would usher in recession or depression. They could simply plateau.

The Economist cites Jan Hatzius, analyst for Goldman Sachs in New York, who argues that even if house prices go flat, neither rising nor falling, the ticking debt bomb could still explode.

He presents the case this way: suppose a householder earns $40,000 a year and has a $100,000 mortgage at 6% on a $200,000 home. Mortgage rates fall to 5%, so the householder can borrow another $20,000 without an increase in debt service costs.

The householder spends (consumes) the $20,000 in one year, boosting total spending power to $60,000, an increase of 50%. But once the borrowed funds are spent, the householder reverts to spending power of $40,000.

His spending contracts 33%, even assuming his house stays the same in value. Recession looms under this model.

Many investment commentators have sounded a note of cautious optimism about recovery in 2003. Some advocate switching out of defensive investments and into growth opportunities.

What in fact is going on is a race against time. Businesses had better start hiring and investing before indebted consumers get squeezed by overextended mortgage commitments.

Even if businesses do pick up their act, they could still be hit by the type of spending contraction outlined by Mr Hatzius or threatened in the case of London.

Further interest rate cuts by central banks will do little to change things as wage growth is minimal, so households are capped on how much more debt they can service. Layoffs are likely to continue into 2003.

For New Zealand, the position is intriguing. New Reserve Bank governor Alan Bollard is faced with a similar set of problems to that of his predecessor, Don Brash, when faced with an immigration boom driving up house prices in the non-tradeables sector.

To quash house price inflation, Dr Brash hiked interest rates, which boosted the currency, hurt the tradeables sector and appeared to trigger the antipathy of Finance Minister Michael Cullen to the then prevailing anti-inflationary policy.

Dr Bollard is in much the same bind but is supposed to avert a re-run of the Brash era, which will make 2003 a testing time for his new tenure.

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