The 2008 banking crisis: Why the housing bubble? Why the crash?

by Peter de Waal Over the last three decades the economies of the western world have been driven by an expansion of credit rather than wage growth. And suddenly access to credit is now being switched off overnight as fear grips the rich over the US sub-prime mortgage losses. The house price boom was a global phenomenon coinciding with the low interest rate policies of the central banks of big economies, particularly the US, after the dotcom bust and 11 September 2001. However, a report published by the OECD in 2006 warned that the boom was out of step with economic fundamentals. (See http://www.olis.oecd.org/olis/2006doc.nsf/linkto/ECO-WKP(2006)3) Figure 4 shows how the price to income and price to rent ratios have shot past the trend line since 2001.) As with most other countries you can see that the NZ rents and income curves follow each other closely. So if house prices are rising it does not follow that rents will increase if incomes are static or falling (a fact apparently lost to many amateur property investors). Typically though, falling rental yields have been masked by asset appreciation. Many landlords who have moved into “property investment” in the last five years have only been breaking even, many have been losing money from day one on the basis that capital appreciation will see them right. However, once the asset class price starts stagnating or falling (e.g. studio apartments in Auckland) the illusion of capital gain can no longer mask the cash drain. Yesterday’s cheery “can’t go wrong with property” speculator is today’s stressed seller, buying food for his family on his credit card because all his income is sucked up by an empty property he can’t let at a rate that covers the mortgage on it. NZ Housing Severely Over-Valued The New Zealand economy has been sustained by two things: farming income from primary produce sales and attracting successive waves of cashed-up migrants to hold up the inflated values of the local housing stock. Why should a house in Auckland be worth as much as a house in London or Sydney when the local economy is many times smaller? Global warming is bringing increased instability to the farming sector, as this years’ exceptional drought has shown, and migration is tending to zero as the world economy slows. Historically the long term value of housing in New Zealand (and UK, USA, Canada) is around 3-4 times the average wage. This would make the average New Zealand house worth $120,000 to $160,000. Now that so many home owners have been hooked into “betting the farm” on speculative investment in unliveable apartment space in central Auckland, it must flow on to the assets securing these loans: the suburban 3-4 bedroom house market. (See ‘Mortgagee auctions put valuations in spotlight’, Sunday Star Times, 24 February 2008, http://www.stuff.co.nz/4413930a13.html) A few months ago NZ economists were talking of a two year correction in the housing market. A recent article gives five years as a likely correction period. (See ‘Snapshot of a slump, Auctions fail to fire, 10% drop predicted’, Sunday Star Times, 2 March 2008, http://www.stuff.co.nz/sundaystartimes/4422356a6005.html). So will the housing market come down with a thump, or will it remain stagnant for 5-10 years as wages catch up with inflated values? Given that wages would have to at least triple to restore the long-term price to income and price to rent ratios, which is unlikely, I suggest that a grinding collapse will happen in stages. NZ Home Values A nasty correction is looming. A fall from an average value of $400,000 to $160,000 could see many people thrown out of their homes as they move into negative equity. This situation is no accident. According to local investment expert Brian Gaynor: Aggressive lending by the trading banks has played a major role in the housing boom. Between January 2002 and this January bank mortgage lending surged by 115.2 per cent, from $68.6 billion to $147.6 billion. This has been encouraged by bank capital adequacy rules that allow banks to lend twice as much on residential property for any given amount of capital compared with most other types of loans. For example, banks have been able to lend $200 million on residential mortgages for every $8 million of capital but only $100 million to businesses for the same amount of capital. This has encouraged the Australian-owned banks to focus on housing loans in NZ because it minimizes the amount of capital they have had to commit to this country. The housing market has a huge impact on the New Zealand economy because in terms of the total housing values/share market capitalisation ratio and total housing values/GDP ratio we are far more dependent on residential property than any other western country. There has been a great deal of comment and analysis about the wealth effect of sharemarket falls on the United States economy but we should be much more concerned about the wealth impact of a decline in house prices on retail spending and the New Zealand economy. (‘Falling house prices start ripple effect’, NZ Herald, 15 March, 2008, http://www.nzherald.co.nz/section/3/story.cfm?c_id=3&objectid=10498271&pnum) The government’s capital-adequacy rules were a cornerstone of this particular south seas housing bubble – a state-sponsored housing Ponzi-scam! (See http://en.wikipedia.org/wiki/Ponzi_scam) What a gift to the banks! NZ Savings + Re-Financing Loans New Zealand has an abysmal savings record, mainly brought about by the pitiful wages paid here and the very high real cost of living. So NZ bankers have turned to the lucrative Japanese Yen-NZ Dollar carry trade to provide funds to inflate house prices (and their profits) to their current astronomical levels. However this convenient trade is collapsing: The yen “carry trade” - borrowing cheap in Tokyo to chase yields from New Zealand, to Brazil, Iceland, and above all Britain - has juiced the global asset boom this decade by $1,000bn. It is perhaps the biggest liquidity pump of them all, yet it stopped pumping in August. Indeed, it is sucking the money back out again. The yen is soaring. (‘Japan is the next sub-prime flashpoint’, Telegraph, 13 February 2008, http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/02/10/ccjapan110.xml) And, The currency has appreciated by 19pc against the (US) dollar to yen103 since July as Japanese investors retreat from global markets. Foreign hedge funds that borrowed at near zero-rates in Tokyo to chase higher yields abroad are scrambling to unwind ‘carry trade’ positions, estimated at $1.4 trillion in its varied forms. Fukoku Life, the giant life assurance company, said it planned to ‘pull out’ of US bonds in preference for Japanese debt, a move underway across the Japanese corporate sector as the US yield advantage vanishes. ‘People are reconsidering the risks (in the US), and see the subprime problems as not being solved at all,’ said Yuuki Sakurai, the group’s finance chief. (‘Japan may cap yen to stave off slump’, Telegraph, 5 March 2008, http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/03/04/ccjapan104.xml) The question for all those New Zealand mortgage holders, many of whom will be refinancing this year, is where will the money come from? Now that the capital is being drawn back to the “saving” economies (Japan, Russia, the Middle East oil states and China) following the huge losses on US sub-prime loans, the Australian and local banks are going to have a hard time finding money to lend to NZ homeowners. So brace yourself for painful rises in interest rates as money becomes much harder to borrow. Although it will be a world-wide deflationary crisis, interest rates will rise sharply in New Zealand. NZ Landlords Response: Fleece the poor The NZ Herald describes the reaction of one landlord to the fall in house prices and rising interest rates: Withers, who has been investing in property since his university days, said rental property owners should look at improving their properties and reviewing their rents. He estimates some properties in Auckland have rents that are up to 15 years out of date. All the landlord is doing is subsidising someone else’s living costs. (‘Expert advice: Hold on tight for the housing crisis sales’, NZ Herald, 9 March 2008, http://www.nzherald.co.nz/section/1/story.cfm?c_id=1&objectid=10497016&pnum) Perhaps Mr. Withers should also note that most workers’ wages in NZ are 24 years out of date! House prices rose into the stratosphere while real wages are a fraction of what they were. That’s why there is a ‘correction’ taking place! Negative Equity The problem for the average worker will be if the value of the house they “own” falls below the amount the bank has mortgaged over the property. Banks are then entitled to ask for cash to restore their equity in the mortgage. In past slumps (UK early 1990s) they typically gave 30 days for such money to be produced before resorting to mortgagee sales. In the UK in the early 1990s there were 3000 such sales every week. Whether the banks resort to such practices again depends on how panicked they become. Much of banking practice seems to be a matter of whim, for example widespread lending with no reference to borrowers’ ability to pay, mortgages for 95%, 100% or more of the value of the property. Last year, another Sunday Star Times article stated that such essentially unsecured lending accounted for over 40% of the New Zealand mortgage market: Wellington-based Mike Pero broker Tony Sule estimates that about 40% of first-time homebuyers are opting for 100% loans as they are desperate to get into the market in case it becomes even less affordable. Adam Parore, founder of Adam Parore Mortgages, agreed saying buyers with cash deposits were becoming rarer. “I suspect another 50% are at 5% deposit, 10% at 10% deposit and almost none with a bigger deposit than that. The number of first home buyers with the standard 20% is basically zero you get one every now and then, but they are like hen's teeth.” The rise of the 100% mortgage, now available from all major banks, began in late 2005. They have become increasingly popular as house affordability drops a recent Massey University report found it had declined 70% in the past five years. New Zealand’s mortgage market is worth about $148 billion, of which about 40% matures each year and must be re-fixed. It is not known how much of that is 100% mortgages. (‘100% loans new norm for buyers’, Sunday Star Times, 7 October 2007, http://www.stuff.co.nz/stuff/sundaystartimes/4228640a6442.html) The availability of such mortgages allows the cheapest houses to be “bided up” by buyers who previously would not have been able to enter the market. Low or no deposit mortgages further raise the profits of the estate agents and the banks. Liquidity Crisis The sub-prime housing crisis has been characterised as a glut of mortgage lending to people who couldn't afford it. The US housing market has fallen 9.1% on a year-to-year basis, and 18% in the last quarter. (See ‘Ninja loans explode on sub-prime frontline’, Telegraph, 4 March 2008, http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/03/ccsubprime103.xml) In the UK building societies and banks are raising the minimum deposit for a new mortgages to at least 10% and as high as 25%. This will further collapse the market. (See ‘Buyers who do not have 10% deposits are left out in the cold’, The Times Online, 29 February 2008, http://business.timesonline.co.uk/tol/business/money/property_and_mortgages/article3456174.ece) Many other people in NZ with substantial amounts paid off their mortgages are also at risk, should the banks decide that with a collapsed lending market and falling house prices the banks’ equity is under threat. If negative equity becomes widespread expect a letter asking for the difference between what you bought the house for and what it is now worth, payable in 30 days! Failure of the Stock Market & the Flight to Commodities The failure of stocks, bonds and housing as investment vehicles has caused a speculative flight to commodities: It is taken for granted that China will continue gobbling up the world's resources with a limitless appetite, the world faces an inflationary fire and that the dollar will slide further. However, these assumptions are less certain than they look. “The strength of base metals is absolutely bewildering given that the US is falling into recession,” said Stephen Briggs, a metals analyst at Société Générale. “America matters. There is economic contagion in Europe and it is spreading to emerging markets as well, yet people don’t seem to care. They are taking no notice of the economic fundamentals, or they’re betting that supply will continue to fall short even if demand slows. This is dangerous. Base metals are highly cyclical. Sentiment can change overnight,” he said. Is China really big enough to offset construction slumps now engulfing the US, UK, Japan and much of the Eurozone? One cannot ignore 60pc of the world's economy. (‘Fears of a commodity crash grow’, Telegraph, 4 March 2008, http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=A1YourView&xml=/money/2008/03/04/cccomms104.xml) Will today’s high commodity prices be transformed into tomorrow’s collapse as demand slumps? It appears that the deflationary crisis is gathering speed. Calls to slash Federal Reserve interest rates to 1% as a massive decline in demand across the whole US economy driven by the sub-prime housing crunch is eerily similar to what happened in Japan 20 years ago. Land/house prices have not recovered in Japan to this day. What started as a crisis in one particular sphere of the market has extended to all others. A general crisis of capitalism is in the offing. For example the entire US mortgage market has entered a negative-equity crisis: The Fed is becoming increasingly concerned about the “wealth effective” as plummeting house prices and losses on the stock market combine to crimp spending. Its “Flow of Funds” report this week showed that household assets had dropped 1pc to $57.72 trillion in the final quarter of 2007, the first fall in six years. Mortgage debt is now greater than home equity for first time since records began. (‘US Fed pins economic hopes on $200bn liquidity boost’, Telegraph, 9 March, 2008 http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/08/cnusfed108.xml This is spinning off into the larger US economy with devastating results. Workers are being hit hard as the US ruling class attempt to avoid ruin: Grim jobs data released by the Labour Department showed that employers had cut the workforce by 63,000 in February, the sharpest drop since the dotcom bust. (‘US Fed pins economic hopes on $200bn liquidity boost’, Telegraph, 9 March, 2008 http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/08/cnusfed108.xml Decoupling Theory Some economists have been pushing the idea that the economies of the emerging “third world” countries have become self-sustaining: the so-called “decoupling theory”. They asserted that they would be able to ride out the financial storm in the West. OECD reports of declines in India and China show this is not true: Japan’s machine orders dropped 2.8 per cent in November and a further 3.2 per cent in December. January housing starts fell to the lowest in 40 years, down 18 per cent on the year. Tokyo property was off 22 per cent. Can this still be blamed purely on a change in building rules? “Recession is a clear and present danger in Japan,” said Tetsufumi Yamakawa, chief Japan economist for Goldman Sachs. “The leading indicators are deteriorating very sharply. Inventory is piling up at a rapid pace. There are clear signs of deceleration in exports of steel and semi-conductors to China,” he said. Yes, China. It turns out that the intra-Asia trade that was supposed to immunise the region against a slump is a disguised supply-chain ending up in the US market. American shoppers still make 30 per cent of global demand, just as it did a decade ago. Nothing has really changed. (Telegraph, 13 February 2008, http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/02/10/ccjapan110.xml A Generalised Crisis The UK banks are struggling to borrow money, despite having a strong well diversified economy: Bear Stearns is perhaps the most severely exposed American bank to the sub-prime mortgage crisis sweeping the world's biggest economy. Peter Spencer, economic adviser to the Ernst & Young Item Club said: “I'm afraid this is now tending towards the apocalyptic scale. This is really the second stage in the credit crisis. This will have a definite impact on British households. The point is that mortgage lenders here were until recently raising around a quarter of their funds from international markets. These are now frozen, as we can see from what happened to Bear Stearns. And if the international banks aren’t lending to anybody that money’s not coming back. I'm afraid this is now tending towards the apocalyptic scale.” (‘Bear Stearns crisis sparks UK recession fears’, Telegraph, 14 March 2008, http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/14/nbearsplash114.xml) This does not bode well for the safety of the New Zealand banking system. In a remarkably candid comment the Herald noted: Arguably, the prospect of further bank failures overseas and by extension here in New Zealand - where more than 90 per cent of the banking system is owned by foreigners - is more likely than it has been for years. New Zealand and Australia remain the only two OECD countries that do not have some form of insurance to protect depositors' cash should their bank go belly up. (Adam Bennett, ‘Are our banks safe?’, NZ Herald, 15 March 2008, http://www.nzherald.co.nz/section/3/story.cfm?c_id=3&objectid=10498295&pnum=0) Given all of the above you would have to say that no bank is safe in this environment, particularly not a New Zealand one, relying heavily on the goodwill of foreign lenders. What to Do Although capitalism achieved a massive reduction in real wages in the 1980s and '90s, that victory now poses a grave danger to the system. In the previous crash of 1987 residual levels of savings and mass home ownership meant that the working class had both the means to survive the crisis and could also be tapped for more money to prop the system up. This was done by the ruthless imposition of “user pays” schemes and the reduction of the social wage, such as the ending of free education, attacks on the right to public housing, the rationing of medical care, attacks on unemployed and the harassment and punitive case management of the injured by the Accident Compensation Corporation. Today most families survive on two, three or more jobs and credit cards. Earlier this year we saw the collapse of many finance companies. These organisations are in effect private banks with draconian terms and usurious rates of interest. Like the money that flowed to third world investments internationally, these companies were a local means of recycling the surplus cash piling up in the bank accounts of the rich. It should have been obvious to any economist that paying people less than they need to survive and then forcing them to borrow those stolen wages back at high interest had to be an unstable situation. The necessity of this “compensatory borrowing” of consumer credit had a useful spin-off for the system: it sustained mass consumption in the face of stagnant or falling wages. But there is also a political bonus – it reduces pressure for higher wages by allowing workers to buy goods they couldn’t otherwise afford. Having a large monthly credit card or finance company bill is a great conservatising force, making strikes and other forms of rebellion less attractive. The sub-prime housing crisis is tearing the world economy apart and will hit New Zealand very shortly. It is more than likely that many of thousands of homeowners could face eviction when massive interest rate rises and falling property values force them into negative equity. There must be a political response to this crisis from the left, calling for a moratorium on mass foreclosures. Ordinary people who worked hard and played by the rules imposed on them should not be made to pay for the criminal greed of the slick conmen and finance sharks, or their apologists in government.