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Your Economic Future: Bubbles, Bail-outs and Bail-ins?
Damian Lillicrap
September 2014
www.barenakedeconomist.com
page 2
Important information
This information is for general purposes only, without taking into account your financial objectives, situation, or needs, so it may not be appropriate for your circumstances.
These views are my views as an author, not my regular employer’s, whose views may or may not align on various subjects
www.barenakedeconomist.com
• Reflect on housing bubbles:
– China
– US
– Australia?
• Monetary policy & house price relationship
• Consider proposed “solutions”
– Increased bank capital
– Macro prudential – limit excessive loan to value ratios
– Risk sharing
Today
www.barenakedeconomist.com 3
Who thinks property returns over the next say 5 years will be:
a) 6% to 10% per annum or better
b) Better than cash returns up to 6% per annum
c) Cash like
d) Less than cash to slightly negative
e) Due for a significant fall
Poll the room
www.barenakedeconomist.com 4
• Easy reading but not dumbed down;
• The more you know the more you’ll find in it.
Some forecasts in the book - published Jan 2013:
• “it is also hard to see rates rising significantly above current levels for a number of years; that is, rising and staying much above 2.5 per cent in the United States.”
• “My sense is that...growth in China will slow”
About me & my book
5www.barenakedeconomist.com
page 6
Why an interest in housing
– 2006/2007 I was worried about share market prices (especially the US)
– Came to believe:
• While there wasn’t a PE bubble
• There was an earnings bubble
• Funded by credit bubble related to a housing bubble
• Influenced by low interest rates
page 7
China
Has a housing bubble:
– The government has told us:
‘There are structural problems in China's economy, which cause unsteady, unbalanced, uncoordinated and unsustainable development.’
Premier Wen Jiabao 2007
Chinese Premier Wen Jiabao said that home prices remain far from a reasonable level and relaxing curbs could cause “chaos” in the market, indicating no imminent relaxation of cooling measures.
“We must not slacken our efforts in regulating the housing sector,” Wen said at a press conference in Beijing Wednesday, according to an English translation. A bursting property bubble would hurt the entire economy, and the government wants “long-term steady and sound growth” in housing, he said. March 14, 2012, Financial Post
page 8
China’s housing bubble
But:
– Gearing is low
– High savings – lots of parental and grand-parental help
– Little or no sub-prime
– They have macro prudential measures in place
No subprime, NINJAs.
Are there a common, simple set of
factors that are sufficient to produce
housing bubbles?
page 9
China’s housing bubble
It is a very populous country but:
– There are huge vacancy rates possible 30% to 40%
– People are happy to buy properties and leave them empty
Why? People have believed that housing will produce good (significantly better than cash) returns
page 10
China’s housing bubble
Market just over a decade old:
– It has mainly gone up, with 5% to 10% most years
– Shares have gone badly in recent years
– “Everybody” has wanted to invest in property
– “Everybody” believed property was destined to go up
page 11
China’s housing bubble
It has low credit but:
– Even 50% leverage is enough to double the price of housing (incrementally of course)
– Which would require a 50% fall to get back to fair value
Credit seems important for bubbles
but doesn’t have to be excessive.
page 12
Vested interests - Authorities
Provincial/State Governments:
– Measured on GDP (historically)
– Development of land good for GDP
– Infrastructure funded by lending funded by land sales
Governments prefer property prices to
go up, they aren’t a good control
page 13
Vested Interests - Lenders
Banks* really don’t care if you pay too much for your home:
– The risk is on you
– They have a buffer
– Then they have a claim on you.
Banks control the price of houses:
– Most of us use debt to buy a house
– It is often the amount that we can borrow that determines what we pay
– What if banks said “We won’t lend if you pay that much!”: Prices capped?
– Banks test a house against the market, not the market itself.
*I’ll generalise and use the term banks to cover all lenders, given their dominance
Banks control the price of housing but
have little vested interest
page 14
Recipe for house prices
So China suggests for a house price bubble you need:
– People believe house prices will go up
• The more this happens the more they believe!
– Credit – but even 50% Loan to Value ratios is more than enough credit
– A lack of alignment between those controlling prices and those taking the risk.
– A mis-alignment of interest with other potential controls
Let’s see if it works elsewhere?
page 15
The US story
Recipe for a house price bubble – learnings from China:
– People believe house prices will go up
– Credit
– A lack of alignment between those controlling prices and those taking the risk.
– A mis-alignment of interest with other potential controls
Common causes blamed for the US house crisis
– Excess lending 100% loan to value ratios
– Financial engineeringI’d suggest that these commonly
blamed factors are symptoms of the
problem, not the cause.
page 16
Securitisation
Sub-prime loans
– Brokers made loans, sold off to banks so didn’t hold risk
– Investment Banks packaged up loans into “securitised products” and sold off so didn’t hold risk
– Ratings agencies rated risk but didn’t hold risk.
– Buyers often relied on ratings so didn’t assess risk themselves, but held risk themselves.
All care but no responsibility.
No alignment!
page 17
Securitisation vs traditional banking
Traditional Banking
– Bank manger assesses loan
– Bank manager responsible loan
Securitisation
Sub-prime a symptom of lack of
alignment
Loan originator Banks
Ratings Agency
E.g. Local Governments In
Australia
RiskRisk
Creator/ Risk Creator Risk Assessor Risk Taker
Short Term Incentive
Higher through-put
Higher through-put
Higher through-put
Higher prices good, buy more
Better alignment of interest:
The bank manager cared if he
wrote a bad loan!!
page 18
Monetary Policy – Central bank alignmentUS Debt to GDP
Since ~1987 pretty much the only measure of economic imbalances for the Fed has been inflation
Source: US Federal Reserve, BEA, ‘The Statistical History of the United States, FromColonial Times to the Present’, Ben Wattenberg, Morgan Stanley Research
No infla
tion no pro
blem???
page 19
Rates down, debt up – who’d have thought
page 20
How is the debt utilised?
In theory, people borrow to build productive assets:
– Economy slows
– Central bank lower rates
– Businesses borrow more to build productive assets (e.g. Car plants)
– More productive economy
– Boost to the economy
Central banks like to pretend
this is the primary mechanism,
but...
page 21
But the debt mainly goes to buy existing assets
http://www.positivemoney.org/2014/03/creating-money-purpose-adair-turners-latest-speech/
How very low rates is
stimulating the UK economy.
Sustainable??
page 22
How is the debt utilised?
In reality most debt goes to buy existing assets!! For example:
– Economy slows
– Central bank lower rates
– People can pay more for the same house on the same salary
– House prices up
– People selling (generally older) more cashed up (than they would have been)
– Funded by people buying (generally younger)
– Cashed up people spend – boost to the economy
Not quite houses as an ATM
but not far off
page 23
Problem
Using debt to buy existing assets may boost the economy:
– But if rates revert to previous levels
– This boost is reversed!!
Solution:
– Don’t move rates back to previous levels
– In fact keep moving rates lower (the chart earlier)
Impact:
– Record low rates
– Record high debt
– Record high asset prices
The central bank was just
doing its job, but their
incentive is to boost, not to
control house prices – when
push comes to shove!
page 24
What was sufficient in China was present in the US:
Our house price bubble recipe:
– People believe house prices will go up
– Credit
– A lack of alignment between those controlling prices (banks) and those taking the risk (home buyers).
– A mis-alignment of interest with other potential controls
• Governments
• Central banksEveryone is one the same side
Over very long periods house prices match inflation:
– Logically this makes sense
– House prices really can’t go up faster than wages to support those prices for ever page 25
How much should house prices go up?
From http://baobab2050.org/2011/04/02/the-herengracht-canal-perspective/
Here are US house prices against this chart page 26
How much should house prices go up?From http://baobab2050.org/2011/04/02/the-herengracht-canal-perspective/
page 27
What the central bank said at the time
'We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilise, might slow consumption spending a bit. I don't think it's gonna drive the economy too far from its full employment path, though.‘
Ben Bernanke July 2005
'House prices have risen by nearly 25 per cent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.’
Ben Bernanke Oct 2005
Great. No problem then!
‘It is difficult to get a man to understand something, when his salary depends on his not understanding it.’ Upton Sinclair 1935
page 28
You know what happened next!!
“Real estate” is a “real” asset.
Real returns (i.e. Inflation adjusted returns)
can’t be large over the long term.
http://www.all-the-news.com/world-news/how-did-canadas-middle-class-get-so-rich
page 29
But Australia is different?http://www.debtdeflation.com/blogs/2009/04/06/steve-keens-debtwatch-no-33-april-2009-lies-damned-lies-and-housing-statistics/
Sure is different!!
Let’s step through the list.
Do you think most Australians think
house prices should track inflation
nowadays??
page 30
Have we got credit?http://www.afr.com/p/business/property/house_prices_flash_red_record_debt_MPI3fve6eztNMyT62R4P1J
Yes we have credit!
page 31
Does anyone really limit the prices?
Buyers:
– most of us don’t have a long term view
Banks
– They could turn off the tap
– They haven’t had teams that look to understand the fair value of the housing market – it’s not their risk
The RBA
– Has pushed back a little against bubbles, but monetary policy is a blunt tool
– But when push comes to shove they want to prime the economy.
Governments:
– Benefit from growth, and taxes when the market goes up
Risk taker – not qualified
Price controller – not their risk
Authorities tend to favour managing short term over long term risks - in a pinch
page 32
What ruins the party?
Typically
– Higher interest rates; and/or especially
– Higher unemployment
Post the mining construction boom:
– Ironically RBA seems to be hoping for housing to support the economy (and in turn support the house prices) – i.e. home building providing jobs.
But more houses probably isn’t good
for supporting a housing bubble in the
long run!
page 33
What happens if house prices fall
The economy will tend to slow, then...
Interest rates will drop (even lower), which:
– Supports the price of assets at higher levels - so those that paid too much for assets are bailed out (too some degree).
– Means lower returns for those saving (e.g. for retirement) so they are bailed in – they are worse off so that some one else is better off.
There are no good outcomes at this point, which is
why it is best to prevent bubbles
Bail outs!!
Bail-ins!!!
page 34
What needs to happen to prevent bubbles?
Not:
– Macro prudential (e.g. Limits on loan to value ratios) – China shows these slow bubbles but doesn’t prevent
– Capital adequacy – Makes banks marginally safer doesn’t prevent house bubbles
– Supply and demand – arguably house prices do find equilibrium due to market forces, but they experience massive swings taking 50 years – the lesson from Amsterdam
page 35
What needs to happen to prevent bubbles?
Yes:
– Education – will help a bit: i.e. That housing (if not overvalued) is a store of wealth, not a high returning investment.
– Lending could be more targeted – want money to go to new productive assets – not existing assets – probably best achieved by taxes not monetary policy.
– Risk sharing by the lenders – e.g. Fines if a house or group of house prices falls more than 10% in the next X years.
Housing is just too important to the economy
to keeping doing things the same way
page 36
The summary
House price bubbles are the result of similar base causes from China to America.
The Australian market is subject to the same weaknesses.
This suggests a bubble is inevitable – when not if.
House prices, when compared to inflation and wages, look high.
What is high can always go higher – it may not all be over – yet!
Better to prevent than try to fix up.
Best prevention is risk sharing.
I don’t believe risk sharing will really happen unless
we have a property crash.
page 37
Risk sharing by lenders – a plea!
I don’t believe that this will happen in the near term – not enough people understand/believe the risks.
Most of the audience probably doesn’t think that we
will have a property crash in the next decade.
If there is a significant sell-off:
The thing we will have missed is the need for better
alignment by those that control the price of houses
and those that take the risk for house prices.
Please ensure there is alignment going forward, so
we don’t do the whole thing over.
page 38
Thanks
Questions
page 39
Back pocket slides
page 41
Lower rates boost prices but lower future returns
Consider if rates fall from 10% to 5%:
– A property that was collecting rent of 12% may now look attractive at 7%
– The price of the property then rises
– But the rent falls relative to the price from 12% to 7%
– If we look at history, we might expect higher returns (based on one off capital gains) but we should expect lower returns.
As a rule: Returns higher, future returns
lower... But it appears human to be sucked
into believing in last year’s winner.