Friday, June 18, 2004

Bang or a Whimper? Buttonwood Makes The Bang Case

Buttonwood a regular columnist for The Economist makes a case that the asset inflation bubble is going to go out with a bang rather than a whimper. As my readers have known I have made the case for a mild recession and a retrenchment of the property price ranges through a slow unwinding accompanied by high inflation.

Although inflation is unlikely to surge just yet, it is clearly picking up. While there will doubtless be inflationary scares aplenty in coming months, the Fed may not have to push up rates as fast as some suppose to keep it in check, and perhaps by less than most think. American consumers, whose heroic lack of thriftiness has kept the economy afloat these few years past, are now so hugely indebted that a rise in rates is likely to have a bigger impact on their spending than in the past. It is, after all, that very indebtedness that has stayed the Fed’s hand in raising rates from their present, derisory level. Unfortunately, keeping them so low for so long has made a bad problem worse, because it has caused a stampede into assets—houses—that are now horridly expensive by any reasonable measure; and because a big chunk of those assets is now financed with floating-rate rather than fixed-rate mortgages.

Extraordinarily low interest rates have encouraged extraordinarily huge borrowing. In 1994 and early 1995, the period in which the Fed doubled interest rates to 6%, households’ financial obligations swallowed about 9% of their disposable income. Despite much lower interest rates, the figure now is double that, as consumers have piled up debt. Ominously, the only time that it was anything approaching this was in 1987, the year the stockmarket crashed. And a startling commentary earlier this month by Benjamin Tal and Avery Shenfeld of CIBC World Markets spells out just how exposed these debts are to rising interest rates.

Historically, Americans have generally plumped for fixed-rate mortgages, which can be swapped, with no penalty, for cheaper ones when mortgage rates fall. Traditionally, only about a fifth of new mortgages have been of the variable-rate variety. That proportion has been climbing sharply in recent years, however, because short-term interest rates (and thus variable-rate mortgages, which follow them) have been so much lower than long-term rates (on which fixed-rate mortgages are based). In April, fully one-half of all new mortgages were variable-rate—the highest total on record.

The rise in variable-rate loans has been greatest in areas such as San Francisco, where house prices are highest, presumably because that is the only way that would-be buyers can afford to get their foot on the property ladder. And almost 10% of those taking out such mortgages—more than double the figure of ten years ago—are dodgy borrowers, though in one of the euphemisms for which American financiers are justly famous, they are known as “sub-prime”. Personal bankruptcies, it is worth noting, are already at record highs.

Fuelled by cheap mortgages, the housing boom has also enabled America’s less-than-thrifty consumers to cash in the equity on their homes. Home-equity lines of credit (helocs) have soared even faster than house prices, are rising at 30% or so a year and now amount to more than $250 billion. Most helocs are variable-rate loans. Add in the surge in non-mortgage household debt in recent years, say the two CIBC economists, and almost a quarter of all household debt would immediately be affected by higher rates—70% higher than in 1994.

All of which would be bad enough, but there is worse. According to The Economist’s house-price indices, property prices in America have risen by more than half since 1997, leaving them at record levels compared with rents and wages. Though property prices there are not as frothy as in some countries (even the normally staid governor of the Bank of England was moved this week to warn about Britain’s giddy house prices), at current interest rates, house prices would need to fall 10% or so to be anything appoaching fair value. They are, in other words, expensive—and in some places very expensive. Together with the prospect of higher rates, perhaps that is why in America they rose by only 1% in the first quarter, the smallest quarterly increase in six years, and fell in some areas.

Were house prices actually to fall across the board, it seems safe to assume that, at the very least, consumption that was paid for by borrowing on the back of rising property values would evaporate. Consumers would also feel poorer, though how much poorer would depend on how much property prices fell. A study by Goldman Sachs reckons that, were house prices to fall to fair value, consumption would fall by 1.5%. The study does, however, have a decidedly finger-in-the-air feel to it. And, as the authors say: “There is, however, a risk that the necessary correction in housing markets accelerates into something worse.”

Isn’t there just? There is absolutely no necessary relationship between low interest rates and buoyant property prices. In real terms, prices in Germany are the same as they were in the early 1970s. But the most striking exception is Japan. If you believed the argument in its most simplistic form, property prices should have gone through the roof in Japan since 1995. They have, in fact, continued their remorseless decline: since 1997, they have fallen by more than a fifth. Japanese consumers, it is worth pointing out, are a lot more flush than their American counterparts. In his idle moments, Buttonwood wonders what would happen to the American economy were property prices to tank, at the same time that oil prices soared and the fiscal stimulus ran out. It wouldn’t look pretty, that’s for sure.

Buttonwood argues for a sharp asset price devaluation and default scenario that keeps inflation under control. What we both agree on is that (a) This can't go on forever (b) interest rates won't rise that much and (c) the correction will happen when the long end of the interest rates yield curve rises some more - as they've already started doing. It will be interesting to see whom is right, Buttonwood or the oldman. It's like we're two old seahands taking bets whether the Titanic will sink fast or slow. Buttonwood is hedging his bets on fast. I think slower. We both concur that the ship is almost as good as sunk already however.


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