Racy Cases 42 Will the housing bubble burst?


 By A V Vedpuriswar and V Pattabhi Ram

“Is there a Ponzi here?” wondered Wafers.   She was alarmed at the housing market becoming suddenly hyper active.  Property prices were piercing through the roof.  There was a renewed rush for real estate.  Was this for real?  The one person, who could sort out here doubts, China, was busy with his semester exams.  Oh, if she called him he would definitely come down to the coffee pub for a chat.  The two were chums from their early school days. But she felt that it would be better if she first researched before speaking to the walking encyclopedia called China.

Wafers logged on to the net for answers.  And what a veritable storehouse of information the Internet turned out to be.  She learnt that in the last three years the total value of residential property in developed economies had increased by $20 trillion, to touch $60 trillion. Wow!  The smart CA intern that she was Wafers quickly realized that it was a 50% increase.  In contrast, global share values had risen by only $10 trillion. She noted down the first question that she should ask China “Is this housing boom sustainable? Or will it turn out to be the biggest financial bubble in history?”  And more importantly, what would be the ramifications in India.

If the macro picture had stunned her, there was more of it to come in the micro scene.  She learnt that it in the year 2004 prices in South Africa rose by 35%.  And that in Hong Kong they jumped up by 31%.  Among developed countries, Spain saw a rise of 17%, followed by France at 15% and US at 13%.  Prices had jumped up at double-digit rates in half of all American states. In India too there had been a big real estate boom after a long spell of lull. Only in a few countries like Australia and Britain, house prices were now falling.  Wafers scribbled Question No 2 for China: “Why do house prices shoot that way in some countries and not in a few others?”

Wafers dad had always told her to read the Economist. Today she did that and lo there were a few pointers.  An article in that magazine suggested that taking the average “ratio of house prices to incomes” in 1975-2000 as a baseline, American house prices are today overvalued by almost 30%.  A companion piece indicated that structural changes in an economy could justify higher real estate prices in relation to incomes. For example, real interest rates in Ireland and Spain came down sharply when they became members of the Euro zone. But lower interest rates cannot explain all of the surge in house prices crowed another article.  For Wafers things were beginning to get a bit hazy!

She clicked the mouse and landed on an information goldmine.  A blogger had written, “The current global housing boom is unusual. Never before have so many countries had housing booms at the same time”. The World Economic Outlook had the IMF playing Dr. Doom.  It carried a warning that just as the upswing in house prices was global, so would the downturn.  The IMF offered some statistics to back its claim. It seems that between 1991 and 2004 the Japanese property prices had dropped every year by a total of 35% from their peak in 1991. Yet the 36% rise in real house prices in Japan in the seven years between 1984 to 1991 was less than the increase over the past seven years (1997-2004) in most of the countries that are seeing a boom today. Even Wafers with her flair for numbers was finding this numbing.  She admired these statisticians.  Her professor had once famously told the class that  “A statistician is a person who when he has one foot on a hot stove and another on ice cold water concludes that on an average he is comfortable.”

Even as her thoughts wandered along those lines she remembered her professor speak highly of a certain Alan Greenspan.  Ha, the big boss of US treasury.  And here he was quoted on the Internet giving a spin different from that of the IMF.  Greenspan claimed that the growing concerns about an American housing bubble are exaggerated. His argument was that the housing market is less prone to bubbles than the stock market, because home owners cannot buy and sell their houses as easily as speculators can buy and sell shares. People have to live somewhere and large transaction costs discourage trading in houses.  Nice argument, Wafers told herself; but she wasn’t exactly convinced.

She wondered, “How would China respond to Greenspan’s point?” Ha, the answer lay in Economics. Greenspan or no Greenspan bubbles can develop in housing markets, as well she told herself.  That’s because of imperfect information. Her argument was simple:  “No two houses are alike.  There is no central exchange where property prices are determined every second by the forces of demand and supply. (Ha, “the two blades of the scissors”, her Economics teacher had sounded out.) And there is no short-selling in the real estate market. When bullish investors push stock prices up, the price rise might get moderated by other investors selling short in the hope of buying more cheaply later. Nothing like that happens in real estate. Buyers’ expectations about future house prices tend to be based on recent trends. So a rise in prices will boost demand further. Banks also unwittingly encourage bubbles as they have an incentive to lend heavily when property prices rise. This pushes prices even higher. But when prices fall, banks pull out, amplifying the fall”.  She patted herself and told that even China would be impressed by her logic.

Wafers believed that in India house prices were getting unrealistic.  She remembered her friend from Hyderabad.  He had said that a flat which fetched a monthly rent of Rs. 7000 costs Rs. 25 lakh. The EMI (Equated Monthly Installment) on a 15 year loan of Rs. 20 lakh for that flat worked out to Rs. 18,000.  Surely it made more sense to rent than to buy a house. Many people were buying property, in the hope of capital appreciation.  Her friend had argued that people were looking at housing less as a place to live in and more as an investment. If selling pressures increased as investors tried to book profits, the bubble might well and truly burst.  If that happened, the consequences can be catastrophic.

Wafers knew that once China’s exams were over she would have to invite him for a cup of tea to get more answers to these issues.

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About Pattabhi Ram

A chartered accountant by profession, a writer by passion and a teacher by accidental choice.
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