House bubbles, froth and dry rot

Both termites and dry rot can silently and invisibly devour a house. A house price bubble can be far easier to recognise, and yet ten times more difficult to accept, and also ten times more destructive, leading to utter loss of property, house and ownership. Termites and dry rot can be insured against, but there is no premium big enough to buy a stupidity policy.

Ironically, it takes no expert in economics, finance or anything else to gather up the basic information pointing to a global house price bubble that’s building up to unsustainable, freakish levels. Fear and greed will continue to drive prices up until the bubble bursts, leading to countless real tragedy and even more tragicomedies.

The story goes back a decade, but can be started out this week, when the US Commerce Department reported that the world’s biggest economy grew a better-than-expected 3.8% in the first quarter. One news service attributed the outcome to propulsion “by a sizzling housing sector.” The so-called “Greenspan real estate bubble” added about 0.6% to the 3.8%. Alan Greenspan is, of course, chairman of the Federal Reserve, the US central bank.

The problem for house owners in a great number of countries is that the massive influence of US monetary policy has spread like dung fumes to all corners of the globe. The exact nature of the phenomenon has been discussed in exhaustive detail by many talented people, but has apparently gained few, at best, subscribers. The nature of the beast was handily captured in an essay, “The Original Sin,” penned by Stephen Roach, chief economist of investment bank Morgan Stanley, on April 29 this year.

Roach argued that the asset-based spending model developed by Greenspan has given rise to many of the distortions and imbalances evident in the US today. “That’s especially true,” wrote Roach, “of low saving rates, the housing bubble, high debt loads, and a runaway current account deficit.”

The US equity bubble burst, in March 2000; today, the Nasdaq is still a massive, monstrous 59% off its high. However, “asset-dependent American consumers barely skipped a beat,” according to Roach. “Courtesy of an extraordinary shift to monetary accommodation, the pendulum of asset depreciation quickly swung into property markets; US house-price inflation has since surged to a 25-year high.”

US residential fixed investment comprises a paltry 5% of the US economy. It advanced in size, however, by 11.5% in the first quarter of 2005, more than triple the 3.4% rate seen in the fourth quarter of 2004.

The high overall US economic growth figure for the first quarter of 2005 reflected higher US exports than earlier thought (thanks to a weak dollar), and stronger residential fixed investment; “things,” as one newspaper put it, “like home construction and sales, which are running red hot as low borrowing costs entice buyers.”

US investors, crippled by the equity bubble bursting in March 2000, turned to heavily depreciated property. There, argues Roach, “to the extent that equity extraction from ever-rising property appreciation was viewed as a substitute for organic sources of labor income generation, hard-pressed consumers went deeply into debt to monetize the windfall. As a result, household sector indebtedness surged to nearly 90% of US GDP - an all-time record and up over 20 percentage points from levels in the mid-1990s when the Asset Economy was born.”

For reasons that remain fully unclear, global inflation has surprised on the downside for months, if not years, driving two key effects. First, many professional investors have continued to buy government bonds (thus pushing bond yields down, all around the world). Second, central banks have been able to cut core interest rates to multi-decade lows, spurring consumer spending and borrowing.

In the US, the core interest rate hit a five decade low of 1% in mid-2004. The rate has been hiked since to 3%, and is almost certain to rise to 3.25% on Thursday night. Just about everywhere else, however, rates are looking to be cut. Since the middle of 2003, South Africa’s Reserve Bank has cut its core interest rate by 6.5 percentage points to 7%, driving commercial interest rates to 24-year lows.

Last week, the Swedish Riksbank cut its core interest rate. There are fresh signs that the European Central Bank and the Bank of England could cut rates later this year. Meanwhile, even in emerging economies, such as South Africa, bond rates remain on the decline. A study by the Bank Credit Analyst shows that the average bond yield in the G7 countries (the seven richest in the world) has fallen from about 9% some 15 years ago to less than 4% today. In several markets, yields are at post-2003 lows, while in Germany and Canada, they are at generational lows. South Africa’s benchmark R153 bond currently offers a yield of around 7.5%, sharply lower than the 10%-plus yields seen in mid-2004.

Despite its modest status within the overall economy, housing is now punching way, way above its weight. US real estate lending is now more than 50% of bank loans (a record), housing accounts for some 30% of total household assets (a record), and investment in residential real estate is 35% of private investment (the highest in 30 years).

For Roach, the Greenspan-driven Asset Economy has enabled consumers and businesses “to draw on the pixie dust of a new source of purchasing power -- asset appreciation -- as a means to augment what has since turned into a stunning shortfall of organic domestic income generation.”

The fact is that, as the Bank Credit Analyst has put it, “housing has assumed a giant role.” According to statistics from the US Office of Federal Housing Enterprise Oversight, in the year to March 31, 2005, the average house price in (for example) California increased 25.4%, a figure that is utterly unsustainable. The real tragedy is that the ever-growing speculation in housing – and not by any means in the US alone – includes both lenders and borrowers, the very quintessence of fear and loathing.

Article by: Barry Sergeant -