The Economist: Bricks and Slaughter

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The Economist has published an excellent article entitled Bricks and Slaughter (h/t Financial Insights for the link). It is part of a series by the Economist exploring the lessons to be learned from the global housing bubble.

Below are some key extracts; although I recommend that you read the article in full for yourself.

A sharp turn in the property cycle is a serious matter. The five big banking blow-ups in the rich world before the latest crisis (Spain in the 1970s, Norway in the 1980s and Sweden, Finland and Japan in the 1990s) had property at their heart. Banking crises in the developing world have also tended to happen at the peak of housing booms or just after a bust in prices…

Why is property so dangerous? One obvious answer is the sheer size of the asset class… Property is so big that when credit conditions loosen it is likely to absorb a lot of the extra liquidity; and when something goes wrong the effects will be serious.

An even bigger reason to beware of property is the amount of debt it involves… In many pre-crisis housing markets buyers routinely took on loans worth 90% or more of the value of the property. Most had no way of bringing down their debt short of selling the whole house…

With only a small sliver of their own capital to protect them, many owners were quickly pushed into negative equity when property prices fell. As borrowers defaulted, the banks’ losses started to erode their own thin layers of capital. “Banks are leveraged and property is leveraged, so there is double leverage,” says Brian Robertson, who runs HSBC’s British and European operations and used to be the bank’s chief risk officer. “That is why a property crash is a problem for the banks.”

Property bubbles almost always start because fundamentals such as population growth, interest rates and economic expansion are benign… These fundamentals explain why many market participants are able to persuade themselves that huge price rises are justified and sustainable…

For the lenders, property is attractive in part because it attracts lower capital charges than most other assets. That makes sense—the loan is secured by a tangible asset that will retain some value if the borrower defaults—but it can also lead to overlending. Indeed, one of the bigger ironies of the property bubble was that lenders and investors probably thought they were being relatively prudent…

Collateralised lending offers a degree of protection to the individual lender, but it has some unfortunate systemic effects. One is the feedback loop between asset prices and the availability of credit. In a boom, rising property prices increase the value of the collateral held by banks, which makes them more willing to extend credit. Easier credit means that property can sell for more, driving up house prices further. The loop operates in reverse, too. As prices fall, lenders tighten their standards, forcing struggling borrowers to sell and speeding up the decline in prices. Since property accounts for so much of the financial system’s aggregate balance-sheet, losses from real-estate busts are likely to be synchronised across banks.

Borrowers, too, contribute to the inefficiency of property markets, particularly on the residential side… Unlike other assets, housing is seen both as an investment and something to consume… This mixture of motives can be toxic for financial stability. If housing were like any other consumer good, rising prices should eventually dampen demand. But since it is also seen as a financial asset, higher values are a signal to buy… the experience of buying a home is a largely emotional one, similar to that of buying art. That makes it likelier that people will pay over the odds…

Once house prices start to rise, the momentum can build up quickly… The value of any particular home, and the amount that can be borrowed against it, is largely determined by whatever a similar house nearby sells for. One absurd bid can push up prices for lots of people.

As prices rise, property is arguably more likely than many other asset classes to encourage speculation. One reason is that property is so much part of everyday life. People do not gossip about the value of copper and tin, but they like to talk about how much the neighbour’s house went for. They watch endless TV shows about houses and fancy themselves as interior designers, able to raise the price of their home with a new sofa and artful lighting. Eventually the temptation to take a punt on property becomes overwhelming…

Even the risk-averse may well respond to rising prices by entering the market… People [have] an incentive to buy early in order to protect themselves against the risk of future price increases that would make houses unaffordable…

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The Economist has once again fired a great big warning shot across the bow of Australia’s housing bubble.

In particular, the section on collaterlised lending is highly relevant to Australia’s banks, which have continually expanded their residential loan books on the back of rising housing values, increasingly funded via heavy offshore borrowings in the wholesale debt markets (see Deep Throat’s article, The Capital Rort, for an in-depth explanation of how Australia’s banks have used collateralised lending to bolster their mortgage lending). And with such a high exposure to residential mortgages, Australia’s banks are now at risk of incurring heavy losses in the event of a significant housing correction.

The Economist’s explanation of bubble psychology also has clear parallels to Australia, particularly the rampant buying of negatively geared investment properties by speculators, as well as the ‘panic buying’ by first time buyers after the stimulus-induced house price surge in the wake of the GFC.

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One area where the Economist article perhaps goes missing is that it does not mention the role played by artificial supply restrictions (e.g. strict planning/zoning laws) in creating housing bubbles. As explained in previous articles (for example here and here), the US housing bubble was confined to jurisdictions with unresponsive supply caused largely by artificial regulatory constraints, whereas those with lighter land-use regulations never experienced a bubble/bust.

Below is an audio interview with the author of the Economist article.

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Cheers Leith

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.