Buttonwood
With a pfffffffft or a fizzleNov 8th 2005
From The Economist Global Agenda
SourceThe air is coming out of America’s property-price bubble. Will it pop or go quietly?ON CHESTNUT AVENUE in a leafy, middle-class suburb of Baltimore, signs declaring that “War is NOT the Answer” outnumber the For Sale notices. But local property agents are in no doubt that prices are levelling off or rolling back.
In prosperous Annapolis to the south, houses priced at $1.5m or more are taking longer to sell than they did a couple of months ago. A large, modernised Victorian house in a close-in city neighbourhood “went like a firecracker” on three previous occasions but its owner had to cut his asking price by 10% to sell it for a fourth time this autumn, says Barbara Tower of Coldwell Banker Residential Brokerage. “With all the talk that the bubble can’t go on forever and other uncertainties in the world, people are afraid of overpaying,” she says.
This isn’t the stuff of which dramatic crashes are made. But Buttonwood, on a visit to her esteemed pa in this neck of the woods, is struck by how precarious America’s housing market is beginning to feel. It has been powering along mightily for the past four years on super-low interest rates and ever-higher house prices. Homeowners have borrowed against their paper wealth and spent it, fuelling economic growth. But none of that now looks likely to continue at remotely the same pace.
The first reason is that the Federal Reserve’s monetary tightening is beginning to bite. With yields on ten-year Treasury bonds finally rising a bit, the interest rate on the average fixed 30-year mortgage hit 6.31% last week, its highest in 16 months. The cost of an adjustable-rate mortgage linked to one-year Treasury notes has risen even more steeply: to 5.09% last week, up from 4.91% a week earlier. It is now at its highest level since 2002.
Neither rate is the end of the world. They are still relatively low, and most Americans have fixed-rate mortgages or variable-rate ones that do not reprice every year anyway. But house prices have risen faster than both income and inflation for years, and houses are distinctly less affordable than they were. Enthusiasm is cooling.
Mortgage applications were down by about 5% in October compared with September, and were lower than the same month a year earlier. The stock of unsold new houses is rising. The only bullish sign is that homeowners continue to take equity out of their homes at a healthy clip: in the third quarter, they withdrew more than $60 billion, on figures from Freddie Mac—about the same as the previous three-month period.
Interest rates and related woes are one problem. Tax reform is another. The rather odd clutch of recommendations that George Bush’s tax-reform commission came out with last week goes a little way towards a flat tax, a little way towards a consumption-based tax and quite a long way towards roiling the housing market. The commission suggests replacing the current deduction for mortgage interest, which in America’s progressive tax system benefits rich borrowers more than poorer ones, with a flat 15% tax credit on mortgages up to a certain limit. The credit would be worth the same whatever the borrower’s tax bracket, and the cap on mortgages to which it would apply limits the tax hand-out for the rich.
Not a bad plan, in its modest way, if the goal is partly to let the hot air out of house prices and partly to redistribute benefits. The National Association of Realtors reckons it would knock 15% off house prices across the country, about the amount by which they have appreciated over the past year, economists at Merrill Lynch point out. And it would likely do so by lowering the price of top-end houses and raising the price of more ordinary dwellings. (Fine for ordinary folk who are looking to sell; not so fine for ordinary first-time buyers.)
But before the housing industry’s lobbyists get their knickers in a twist, there are the politics to consider. It would be madness for an unpopular president to try to force through an unpopular tax change in an election year. And this is a president whose most heeded constituents are among those who stand to lose from the proposal. The reform is most likely going nowhere in anything approaching its current form.
Leaving aside possible changes in mortgage-interest deductibility, are house prices set to fall or just to rise less quickly? The latter looks more likely, but even that would be bad news for the economy. Consumer spending accounts for 70% of growth these days, so closing down even part way the home-equity cash machine that has fed consumption would put the economic brakes on sharpish. And the construction sector provided half of the (disappointing) total of new jobs last month. Bill Gross, boss of bond house PIMCO, reckons that if house-price appreciation merely slows to a more rational number, economic growth will drop to 1-2% next year, down from an annual rate of 3.8% in the third quarter.
Subprime real estateWhat could give this scenario an uglier twist is the sharp increase in funny loans to funny borrowers over the past few years. “Subprime lending” to people who would not normally be able to make the grade is running at about $500 billion a year. Much of it takes the form of variable-rate, interest-only and negative-amortisation loans. Both debtors and creditors are now more exposed to interest-rate changes.
Banks have been happy to lend to marginal debtors, safe in the knowledge that they could unload many of the loans either on one of the quasi-governmental housing agencies (Fannie Mae, Freddie Mac) or to private investors in asset-backed securities. Many of these loans end up in collateralised debt obligations (CDOs, which slice up bundles of referenced loans into tranches of different riskiness for different investors). Japanese and European investors have been especially enthusiastic buyers of this sort of paper, but there are signs of battle fatigue now: spreads have widened sharply over the past couple of weeks.
Delinquencies have been very low too, thanks to low interest rates and fast-rising prices, but they may not remain so for much longer. In mid-2005, less than 5% of borrowers had loans worth more than 90% of their property’s value. If a dodgy debtor ran into trouble repaying his loan, the bank would let him withdraw equity from his upwardly-mobile house and refinance the rest, terming it “voluntary pre-payment”. That will become less practicable as interest rates rise and the value of the equity remaining in a property approaches its market value.
So it all comes back to interest rates, and to how determined the central bank is to keep raising them until house prices retreat. Alan Greenspan clearly has housing “froth” in his sights, but his designated successor, Ben Bernanke, may be made of different stuff. In any event, the housing market reacts to monetary tightening after a lag of one to two years, it seems, so the temptation will be to overshoot. In which case the Fedsters will bring down house prices and the economy itself not with a whimper but a bang.
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