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US housing bubble burst predicted within 18 months: implications for South Africa
Wednesday, December 6, 2006
Citing high levels of speculation in the US housing market as one of the main reasons for inflation-adjusted house prices in the US leaping well beyond their historic levels, US property economist Gary Shilling predicts that the “gigantic” housing bubble in the US is likely to burst within the next year and a half with dire consequences not only for the US economy, but for the rest of the world.
What has caused this overvaluation?
According to Shilling, for the first time since the 1920s, the US bubble is nationwide, and has mainly been driven by four national forces:
• The decline in mortgage rates;
• The loose lending practices aimed at those who have been priced out of the market under conventional mortgage terms, such as interest-only Adjustable Rate Mortgages (ARMs) and option ARMs that allow borrowers to make even lower monthly payments resulting in a rising mortgage principal, or "negative amortization";
• The unrealistically high property appraisals to justify oversized loans and the lack of full documentation that allows borrowers to overstate their ability to make mortgage payments;
• The accommodation of financially-weak borrowers with high loan-to-value ratios and piggyback loans, with lenders in effect financing more than 100% of the houses' prices.
Another factor that drove house-price growth was, of course, strong economic growth, which itself was reinforced by the wealth effects resulting from increased house prices.
Why has the bubble not yet burst?
Shilling notes that there are five reasons why the ‘grand disconnect’ that currently exists between the real world of goods and services and the financial world of asset speculation won't disappear unless forced by a significant event:
• The world has been awash in liquidity, which amply feeds speculation. It comes from the leap in house values, which have been liquefied by refinancing and home equity loans.
• Speculation feeds on itself, as was seen with the dot com bubble and, more recently, in gold and emerging market stocks. There's nothing like making money to insure speculators that their bets are correct and should be redoubled.
• Institutional and other investors yearn for huge returns. Their clients demand them. Money managers that don't produce consistent high gains lose money to those who do.
• The perceived risk, at least until recently, has been low. With roaring profits, junk-bond default rates remain low. The low anticipated volatility in stocks and bonds has desensitized many investors to the increased risks they are taking. So, too, is the conviction that the Fed will continue to bail out speculators.
• Loose mortgage lending has been encouraged by the development of mortgage-backed securities that allow lenders to package mortgage loans and sell the securities to yield-hungry investors. It's like a bookmaker who expands his business without adding risk by laying off his customers' bets to others.
How big will the crash be?
House sales in the US have been falling for over a year, and in September of this year, median prices of new homes were 9,7% down on the same period last year. Shilling argues that it would take a 35% fall to bring house prices back in line with the CPI and a 40% plummet to re-establish the stable level of real quality-adjusted house prices that held in the previous post-World War II era.
Bulls are ignoring the signs
Housing optimists, including former Fed Chairman Greenspan in earlier years, argued that housing can't experience a boom-bust like stocks because home-owners are house occupiers who need a place to live. Negating this place-to-live argument, speculators who own multiple single-family houses and condos have leaped in number. The National Association of Realtors' surveys reveal that in 2005, 28% of all home purchases were for investment and another 12% were vacation homes, for a total of 40%.
Related to their belief that massive speculation in houses was impossible, was the bulls' conviction that sizable excess inventories would not develop. With almost every house sold to an owner-occupier, they believed, and with major home-builders assuring everyone that they were only building to firm orders, how could unwanted inventories accumulate? But firm orders proved to be far from firm since they required little down-payments in many cases. So builders have been shocked when speculators walked away from those orders as prices flattened and they learned they were really building spec houses. Still, they're continuing to build to complete development sections, keep their employees busy, and keep overheads spread over as many units of output as possible.
Bubbles don’t burst in strong economies, do they?!
Many housing economists, realtors and homebuilders also don't believe housing can suffer big trouble as long as the economy is strong. With unemployment rates relatively low and job markets improving, how can sellers be pressed into accepting "giveaway" prices? They also note that interest rates aren't high enough to bother many buyers. But housing cycles always lead the economic ups and downs, not the other way around. Housing starts begin their usual 50% or greater decline before the peak of business, at which time unemployment starts to rise. Although housing slides are normally precipitated by interest-rate jumps, Shilling argues that these aren't normal times. With nationwide housing speculation at an extreme not seen since the 1920s, the gigantic bubble is set to burst from its own over-expansion with very little help from rising interest rates. Existing home prices in September fell 2,2% from a year earlier, the biggest drop in the 38 years of National Association of Realtors data. That matched the August decline, and was the first back-to-back fall since 1995. Sales nationwide were off 14% over the 12 months, but outside housing, the economy remained strong.
What will trigger the bubble burst?
Two scenarios can force house prices to step off their recent plateaus and catch up with the already severe declines in sales in the US.
1. The first calls for speculators to give up hope for appreciation, which for many is critical, since the rental income on their properties falls short of their mortgage, taxes, maintenance and other costs. As they dump their housing on the market, prices will nosedive, which will encourage other worried sellers to do the same and this then generates a nationwide rout.
2. The second price collapse-trigger, mortgage rate-reset shock, takes longer. Interest-only ARMs, accounting for 17% of all home mortgages in the first half, option ARMs, 9%, and ARMs with low initial rates, allow many to buy houses they otherwise can't afford. A survey by the US Census Bureau found that last year, 35% of Americans with mortgages spent 30% or more of household income on housing outlays while only 30% did so in 2003. Around 60% of sub-prime ARMs issued since 2004 have fixed interest rates for two years and float for 28 years thereafter. Their original rates in 2004 were 7,1% on average and, under their mortgage contracts, can eventually adjust up to 11,4% - about six percentage points over the current short-term benchmark of about 5,4% set by the London Interbank Offered Rate (LIBOR)
When America sneezes the rest of the world catches a cold
Rode & Associates CEO Erwin Rode says that a major decline in US house prices will in a flash reduce US consumers’ wealth, which would be devastating for consumer confidence and, hence, spending. As this would ultimately filter through to companies’ earnings, the US, and international stock markets in general, will take a knock in anticipation thereof.
A weakening JSE would, of course, adversely affect local wealth, confidence, and expectations, which would also have ramifications for consumers’ propensity to consume, and hence growth. Slower US growth would also result in a deceleration in the Indian and Chinese economies, which would push commodity prices lower; this would be especially harmful to commodity-exporting countries such as South Africa.
* The summarised extracts of Gary Shilling’s analysis are published courtesy of John Mauldin’s Thoughts From the Frontline newsletter Vol 1, No 29 of 20 November 2006.
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