Miraculous recovery or last gasp?

Dec 21st 2005
From The Economist Global Agenda

After soaring for years, housing markets throughout the rich world have been looking wobbly for some time. But surprisingly strong data on mortgages and house-building released this week in America and Britain seem to signal at least a temporary reprieve. How long can this go on? And what will happen to the economy when it finally stops?

IN RECENT years, housing has been a peach of an investment in many rich countries. The Economist’s latest house-price index shows that since 1997 prices have soared by more than 85% in America, 100% in France, 112% in Australia, 150% in Spain, 166% in Britain and a whopping 208% in Ireland. And hot urban markets, such as London and New York, have far outstripped their national averages.

But recently anxious homeowners—and anxious central bankers—have begun to wonder if the market isn’t running out of steam. A decline that started in Sydney has spread to other Australian cities, as a result of which house prices rose by a measly 1% nationwide in the year to the third quarter of 2005. Britain’s market has also begun to look sickly: the Nationwide building society’s price index has risen by only 2.4% in the year to November. Could Australia and Britain be the canaries in the coal mine? Is America next?

Well, not yet. On Tuesday December 20th, new data released by America’s Commerce Department showed that after a decline of 6.6% in October compared with the month before, housing starts increased by 5.3% in November, a much stronger showing than expected. The number of new housing permits, which had been expected to fall, also increased, by 2.5%. John Snow, the treasury secretary, touted this as proof of the American economy’s strength.

Even the British canary seems to be waking from its coma. This week, the Royal Institution of Chartered Surveyors reported that house prices had risen in the three months to November, the first time this has happened in 15 months. Mortgage activity is also on the mend, according to the British Bankers’ Association, which announced on Tuesday that November had brought the biggest increase in mortgage lending since July 2004.

But this may be less miraculous recovery than last gasp. A recent report by the Organisation for Economic Co-operation and Development (OECD) indicates that house prices in Britain remain overvalued by more than 30% compared with rents. Britain’s economy, which has grown steadily for over a decade, has been flirting with recession in recent months. In response, the central bank cut interest rates, which may have sparked a temporary recovery in the housing market. But without faster growth, consumers cannot pay ever-higher prices for their homes.

Though the relationship between house prices and rents is less outlandish in America, consumers there are seriously overstretched. According to the Federal Reserve, the ratio of debt-service payments to disposable income was 13.75% in the third quarter, an historical high. Since 2000, the level of outstanding mortgage debt has almost doubled. While lower interest rates have helped consumers to meet these obligations without much additional pain, those rates are now creeping back up.

Not only is the Fed not done tightening, but the flood of cheap capital flowing into America from abroad could reverse itself at any time. This is bound to hurt consumers, especially since soaring house prices have forced many of them into adjustable-rate loans to keep their payments low.
Indeed, a lot of desperate homebuyers have turned to interest-only loans, or even negative amortisation loans (where the payments don’t even cover the accrued interest). As interest rates rise, many of these marginal buyers will be forced out of their homes, and the supply of new buyers will fall, which may result in a sharp decline in house prices. The Federal Deposit Insurance Corporation, which regulates America’s banks, indicated on Tuesday that it was considering stiffer guidance for banks that grant these sorts of loans.

If the housing market does turn sour, it would be bad news for the American economy, as it has been for the economy in Britain, where the recent slowdown has been partially attributed to a weak housing market. In both countries, consumers have become dangerously dependent on strong house prices to keep them feeling wealthy enough to spend. Housing markets may be the canaries that signal the fate of the broader economy. And, as any miner will tell you, canaries don’t live all that long.

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