The Long Housing Crisis

The current global crisis is in many ways the direct consequence of the credit-fueled model of economic growth that put housing at the centre of investor and consumer aspirations in much of the Western world. A steady increase in household leverage levels was tolerated as booming property prices created the impression of asset appreciation. At the same time, securitisation, combined with a growing credit default swaps industry, produced the illusion of effective risk management. But ultimately, it was the excesses of this system that brought about the implosion of the US housing bubble starting with the most obvious aberration of all, the subprime mortgage industry.

Almost four years on, the story is showing no convincing signs of reversing. Following something of a stimulus-driven rebound in 2009-2010, housing markets have once again relapsed. The widely cited Case-Shiller Home Price Index in the US fell by 4.2 per cent in the first quarter of the year, following a 5.1 per cent decline in the course of 2010. The cumulative decline from the pre-market peak is now 33 per cent, ahead even of the 31 per cent recorded during the Great Depression. As a result, US house prices are at a nine-year low.

Similar bubbles have imploded elsewhere, most strikingly in the case of Spain and Ireland but also effectively in the UK where real prices have been steadily eroded while concerns are mounting of an even sharper correction. UK house prices by April were down 1.3 per cent year on year. But the outlook is becoming increasingly somber with new mortgage approvals falling to their lowest level since records began in 1993. After an 8 per cent annualised drop in April, new mortgage approvals stood at just over 45,000, as compared to a peak of over 129,000 in November 2006. At the same time, refinancing of old mortgages, which in the past was a popular way of realizing equity from home price appreciation, fell by 10 per cent month on month. UK house prices are estimated to have fallen by 11-20 per cent from their peaks but they are still not at affordable levels by historical standards. Estimates of overvaluation range up to 25 per cent and the median house price is 4.4 times the average income, clearly above the historical average of 4.0 since 1983.

Nonetheless, market weakness remains most obvious in the US where the housing market was such a central source of national income. 3.45mn American homes have been foreclosed between 2007 and 2010 while potential new foreclosures are estimated at 4mn or more. Some 28 per cent of US homeowners are in negative equity, while vacant homes number some 10mn. Close to 2mn properties are estimated to be in bank ownership, something that would take three years to place on the markets. About a third of all property sales in the US are distressed properties which tend to sell at some 30 per cent below normal market prices.

The difficulties of fixing these housing markets highlight the endemic structural nature of the problems. Moreover, while it is doubtful that the pre-crisis model can be fixed, it is also far from obvious that it should be. For instance in the US, the architecture of the mortgage sector was in essential ways the direct result of the nation’s previous massive housing correction – the Great Depression. Fannie Mae was originally established for the explicit purpose of freeing up bank balances for other types of lending. The assumption of government guarantees allowed Fannie Mae and Freddie Mac to cheaply raise funds for purchasing mortgages, which is turn helped keep housing finance at a low level. With the ultimate decision to place Fannie and Freddie into government conservatorship, the securitisation model was broken and the positive market dynamic reversed. Given the massive backlog of housing stock and weak economic fundamentals, it is unlikely that a housing market recovery can materialise without direct government support.

Problematically, the troubled housing markets discussed here all face a generally bleak outlook due to essentially the same combination of problems, albeit to slightly differing degrees. The main challenges are as follows:

• Leverage levels are high and cut across the economy. Even though some relief may have been brought about by the nationalisation of many losses, private sector players remain risk averse and faced with severe challenges.

• The potential of monetary and fiscal stimulus has been largely exhausted. Interest rates are close to zero and in real terms negative. Additional government spending is virtually impossible due to high levels of debt. The fact that these housing markets are struggling in such an exceptionally permissive environment means that their tolerance of higher interest rates is minimal. Yet the tightening cycle has begun and, even if it proceeds with caution, inflationary pressures are beginning to force the hand of the authorities. Especially UK mortgages are typically priced on the short end of the curve, which makes them particularly vulnerable to policy tightening.

• The general economic outlook is weak, which is depressing household disposable incomes and confidence. Spanish unemployment is at 21 per cent and the budget deficit at 9.3 per cent of GDP. Fears about the US recovery have mounted marked in recent weeks. Hence, in spite of major uncertainties about the federal government debt ceiling and the potential end of quantitative easing, US Treasury bond yields have fallen to their lowest level this year.

• There is concern about the financial sector outlook in all the affected economies, although the situation is most acute in Ireland. But Moody’s recently warned of possible downgrades of a number of leading US banks while the Federal Deposit Insurance Corporation’s watch list of troubled banks is at a record high. Bank results have in many cases become increasingly reliant on the release of reserves as their basic business has struggled to develop traction. Ongoing efforts to force buy-backs of troubled mortgage securities are another major risk.

Under the circumstances, a swift return to ‘business as usual’ looks virtually impossible in a number of Western countries. A slow muddle through is much more likely but restoring housing to its erstwhile position as an engine of growth now seems like a distant dream, something that is probably just as well, given the extraordinary diversion from investment in productive resources that the housing boom represented.

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