Wikinvest Wire

Too Good to Last?

Monday, July 03, 2006

For many, many months some Americans have been skeptical of high real estate prices, concerned over the perhaps transient nature of the wealth that has been created for ordinary homeowners across the land. They have looked overseas at other Anglo Saxon nations in an attempt to divine their fate - nations that earlier in the decade led the way in what became a worldwide housing boom.

Housing in the United Kingdom, a sort of miniature United States with an outsized budget deficit to accompany an exceedingly large trade deficit, led The States up in price until sometime last year when things began to cool noticeably, but popping sounds were largely absent.

In this story($) from The Economist, they consider the possibility that real estate prices in the U.K., and around the world have reached a permanently high plateau.

The housing market appears to have stabilised at much higher valuations than were previously reckoned possible. A common measure of affordability is the ratio of average house prices to average earnings, since income must ultimately pay for the acquisition of a property financed with a loan. Looked at this way, homes are even more overvalued than they were at the peak of the boom in the late 1980s: the ratio stands at 6.0, compared with 5.2 in the third quarter of 1989. Much the same message emerges from another valuation method, which, rather like the price-to-dividends ratio for equities, measures the relationship of house prices to rents.

Yet such yardsticks are not the final word. When homebuyers work out whether a property is affordable or not, the cost of servicing a new mortgage as a chunk of take-home pay is more salient. On this basis, valuations are also stretched, but homes are still considerably more affordable than they were at the end of the 1980s (see second chart).

The decline in borrowing costs over the past decade goes a long way to explaining why house prices have proven so irrepressible. Most of the fall in interest rates has arisen from the collapse in consumer-price inflation. In itself, that makes no difference to the real cost of servicing a loan over its lifetime. It does affect the timing, though. When inflation is high, the burden is “front-loaded” in the early years of the loan, but then eases as the real value of the debt is swiftly eroded. When inflation is low, the initial payments are more bearable but more of the real debt persists, which shunts a bigger share of the costs into the later years of the loan.
It seems that the collapse in consumer price inflation, to a large extent driven by cheap imports from Asian trading partners with inflexible currencies, has lulled much of the West into believing that perhaps the best of all possible worlds has been achieved - permanently high housing prices and interest rates that will remain benign until the end of time.

For, without interest rates that are still low by historical standards, there surely would be popping sounds heard as one homeowner after another became unable to service their housing debt amid wages that have stagnated in recent years.

But, how long will interest rates stay low?
Monetary policy around the world is tightening to keep inflation at bay. The Bank for International Settlements—the central banks' bank—said on June 26th that the squeeze must continue. The Bank of England is expected to push the base rate back up to 4.75% later this year.

Britain's homebuyers are vulnerable to quite small increases in the cost of mortgages because they have taken on so much debt during the good times. Overall household borrowing has risen from 110% of disposable income in 2000 to 150% at the start of 2005. The burden of repaying so much more debt means that the total servicing charge is high even at low interest rates.

The most frightening words in the financial lexicon are that it's different this time. This refrain, a favourite of boomsters, was much in vogue at the time of the dotcom bubble. It remains just as suspect when applied to a housing market that is unnervingly priced to perfection.
It seems that much of what we have come to depend upon in the global economy is predicated on low interest rates - low interest rates that allow ordinary individuals to take on extraordinary amounts of debt in order to buy large houses and then fill them with cheap imported goods, somehow still making ends meet month after month.

But how long can this continue if interest rates continue to rise?

Isn't this really too good to last, and shouldn't we all have realized this some time ago?

8 comments:

agezna said...

It does seem too good to last. It seems obvious that low interest rates cannot go on indefinitely. Eventually, rates will rise.

My personal feeling is that higher rates will return sometime between 2015 and 2025.

Anonymous said...

These are the same wizards who declared the end of the world as we know it with supreme confidence just, what, a year or so ago, right? It's fun to watch doomesters slowly learn.

Anonymous said...

The access to the article requires a subscription. Will you post the entirety of it, or is it just too painful to read?

Anonymous said...

Priced to perfection

Jun 29th 2006
From The Economist print edition
An overvalued market is vulnerable to higher interest rates

DURING the past decade Britain's housing market has had its most sustained boom in post-war history. Between 1997 and 2006, house prices rose by 175%, one of the biggest increases among developed economies (see first chart). At its peak, in 2002 and 2003, house prices were soaring by over 20% a year.

A bubble had emerged, as Gordon Brown, the chancellor of the exchequer, acknowledged last autumn. By then, it was already deflating. In 2005 residential-property sales in England fell below a million for the first time since 1996. House prices stopped rising for several months.

On past form the slowdown seemed likely to presage a long slump. The boom was the fourth since the early 1970s, and on each of the three previous occasions a bust had followed. At the end of 2005, according to the OECD, house prices were about 30% above their trend level.

The market staged an unexpected recovery, however. Property transactions picked up. Monthly mortgage approvals for house purchase, which had slumped to 76,000 in November 2004, recovered to 117,000 in May of 2006. House prices have also perked up. Fionnuala Earley, chief economist at Nationwide Building Society, now expects house prices to rise by around 5% in 2006.

The housing market appears to have stabilised at much higher valuations than were previously reckoned possible. A common measure of affordability is the ratio of average house prices to average earnings, since income must ultimately pay for the acquisition of a property financed with a loan. Looked at this way, homes are even more overvalued than they were at the peak of the boom in the late 1980s: the ratio stands at 6.0, compared with 5.2 in the third quarter of 1989. Much the same message emerges from another valuation method, which, rather like the price-to-dividends ratio for equities, measures the relationship of house prices to rents.

Yet such yardsticks are not the final word. When homebuyers work out whether a property is affordable or not, the cost of servicing a new mortgage as a chunk of take-home pay is more salient. On this basis, valuations are also stretched, but homes are still considerably more affordable than they were at the end of the 1980s (see second chart).

The decline in borrowing costs over the past decade goes a long way to explaining why house prices have proven so irrepressible. Most of the fall in interest rates has arisen from the collapse in consumer-price inflation. In itself, that makes no difference to the real cost of servicing a loan over its lifetime. It does affect the timing, though. When inflation is high, the burden is “front-loaded” in the early years of the loan, but then eases as the real value of the debt is swiftly eroded. When inflation is low, the initial payments are more bearable but more of the real debt persists, which shunts a bigger share of the costs into the later years of the loan.

This fall in the initial debt-servicing burden on mortgage borrowers has underpinned the rise in house prices over the past decade. Homebuyers have also benefited from greater competition in the market. This has whittled down the margin between banks' deposit and home-loan rates, so lowering the cost of mortgages.

Buyers have also been encouraged by the Bank of England's quarter-point cut in the base rate to 4.5% last August. This followed a tightening in monetary policy that lifted the base rate from 3.5% in October 2003 to 4.75% in August 2004. A more important relief to homebuyers over the past couple of years, however, has come from unusually low longer-term interest rates.

British mortgages have customarily been at variable short-term rates, closely tied to the Bank's base rate. But since the start of 2004, the share of fixed-rate loans being taken out has risen from 30% to 70%. Most of these are for brief terms, typically two or three years, but they have allowed borrowers to exploit the fact that longer-term rates have been lower than short-term ones. The overall effect has been to offset about half the Bank's monetary tightening, estimates David Miles, chief UK economist at Morgan Stanley.
Too good to last?

The resilience of the housing market owes much to these exceptionally benign credit conditions. The recent upsurge in immigration may also be supporting the market. But purely domestic factors such as planning restrictions, by contrast, are less important than is sometimes suggested. Other countries—notably Australia—have also avoided a bust in their housing markets, and have instead seen price increases flatten out. This suggests a common cause: low interest rates worldwide.

But what has been given can be taken away. Monetary policy around the world is tightening to keep inflation at bay. The Bank for International Settlements—the central banks' bank—said on June 26th that the squeeze must continue. The Bank of England is expected to push the base rate back up to 4.75% later this year.

Britain's homebuyers are vulnerable to quite small increases in the cost of mortgages because they have taken on so much debt during the good times. Overall household borrowing has risen from 110% of disposable income in 2000 to 150% at the start of 2005. The burden of repaying so much more debt means that the total servicing charge is high even at low interest rates.

The most frightening words in the financial lexicon are that it's different this time. This refrain, a favourite of boomsters, was much in vogue at the time of the dotcom bubble. It remains just as suspect when applied to a housing market that is unnervingly priced to perfection.

Anonymous said...

Anon,
Thanks much.

Anonymous said...

I would like to present to you an argument that is quite compelling in it's starkness. You may find a more detailed look , complete with supporting graphs, made by a poster on other forums by the name of Hypertiger. ( I believe that name represents the ultimate outcome : hyperdeflationary implosion )

You can try googling it , or find his recent postings on Goldismoney.info

Again, I put this out for discussions sake and thought provoking consideration. Not that I necessarily buy into his total argument.

If you step back and take a look at monetary policy from another perspective .. the macro view.

In a fiat monetary system all money is
created by debt , yes? Furthermore, it is a compounding intererest debt inflation. Simplified, all new money that comes into existance is at the request of the borrower.

All the money that is in use today, due to the fractional reserve nature of the monetary system, was from previously created debt.

The problem arises , in the instance of the US "dollar", is that there is an accelerating exponential increase in the money supply debt. The first trillion dollars took a couple of centuries, then decades, then years .. you get the picture.

To continue this defacto Ponzi scheme, requires arithmatically impossible increases in the debt money ( credit ) supply OR THE SCHEME IMPLODES IN ON ITSELF.

There is no other recourse for the Fed than to inflate. At the same time it is at the "end of the rope" or very close to it. That is why, up to the implosion point, prices must continue to rise. Housing, commodities priced in US dollars etc.

People MUST continue to take on more debt or ..

So, the question is .. how is this any different than your historically typical Latin American economy of the past?

Anonymous said...

Jesus wept.

Anonymous said...

Yes, hypertiger gets it.

In our debt-based money, more and more money must be borrowed into existence simply to pay interest on the old money. eg. If you borrow $100, where do you get the $5 for your interest payment?

We're near the limit of our capacity to borrow and Bernanke has been set up to take the fall. Have you noticed how Greenspan and Volcker have been increasingly distancing themselves from the Fed?

Did you know that all Fed chairmen since its inception were members of the Council on Foreign Relations? Except Bernanke. Read a book: The Shadows of Power. The author was a congressman, not a conspiracy nut.

Regardless, we need to be watching for the replacement money and the replacement organization. The Amero maybe? A purely electronic version that can be easily tracked and controlled and taxed? A world currency? Who's behind it and will it be another debt-based ponzi scheme where the creators of money can print as much as they like?

Ultimately the choice of money is made by the public and we need to make sure the next one we pick isn't based on organized theft.

How about 2 currencies? One for wealth storage that can't be created or printed by anyone. One for transactions. Possibly an expiring currency to stimulate growth? We'd need a money expert to design an honest structure.

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