Beware the housing debt bubble

A decade after the subprime mortgage crisis, there’s too much property debt again. Warning lights are flashing.

Never include an equation, they say.

In particular, don’t start with one. It switches off the audience straightaway.

But today, I’m breaking the rules. Here we go…

Higher house prices = more debt

That could be written the other way round. For most of the time, it doesn’t matter which way you say it. If both lenders and borrowers are making money, everyone’s happy as the bubble keeps inflating.

The problem occurs when this process goes into reverse. Losses can start appearing everywhere. That’s when the risks of too much property credit become all too clear.

And we could soon see these dangers materialising – with potentially devastating consequences for us all…

A History lesson (sorry!)

Remember the great financial crisis (GFC) a decade ago? It all started in the US subprime mortgage market. As house prices surged and banks handed out money like confetti, a debt bubble inflated. Then more and more people realised that when interest rates rose, they could no longer service their home loans.

Defaults soared and money lenders’ balance sheets were mangled. A giant domino effect developed, damaging the global financial system so badly that it eventually needed the biggest bail-out ever.

It’s the old story: can’t repay the bank to whom you owe £100, and you’re in trouble. Can’t repay the bank to whom you owe £100m, and the bank is in trouble. Can’t repay the bank to whom you owe £1bn and the country – the one that’s since been forced to bail out the bank – has now found itself in trouble.

Yet surely we’ve all learnt our lessons from 10 years ago?

No one would be so stupid as to let it all happen once again?

Err…err…well, now you come to mention it…

…some more-than-slightly worrying signs are now appearing.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price Index does what it says on its (very wordy) tin. It measures residential property values in America’s top 20 cities. In the wake of 2008/09, it stayed in the doldrums for a long time. But then in 2012, spurred by rock-bottom interest rates, it began to rally. And now it’s just topped the levels it reached just before the GFC.

US mortgage debt, meanwhile, has… you’ve guessed it… also been growing again.

Though 2018’s second–quarter figure of $9.4 trillion hasn’t quite caught up (yet) with 2008’s $10 trillion peak, according to the New York Fed’s Center for Microeconomic Data, overall US household debt at $13.3 trillion is now at an all-time high.

To repeat: higher house prices = more debt (or the other way round).

OK, US mortgage delinquencies have declined steadily since the GFC and are now at 2006 levels. “Foreclosures remain very low by historical standards”, notes the Centre for Microeconomic Data. But back in 2006, it wasn’t widely realised that a huge future problem was brewing. This only became clear a couple of years later – and how!

And warnings lights are flashing again. The US 30-year fixed mortgage rate, which bottomed two years ago at around 3.6%, has now gone up to more than 5%. That’s the highest since 2011. Adjustable-rate home loans have also become more costly. Sooner or later, rising rates will catch up with most borrowers.

The effects of higher loans costs are already starting to materialise. “Despite the strength of economic growth this year, there has been a clear slowdown in housing activity”, notes Andrew Hunter at Capital Economics, as “the single biggest factor appears to have been the surge in mortgage interest rates”. Further, there’s a “steady decline in the share of households saying that now is a good time to buy a home”.

Property problems appearing elsewhere

But this time around, it may not be the States that starts the rot. Let’s look at Canada.

“Canada had no major fall in house prices during the Global Financial Crisis”, notes News.co.au. “Interest rates fell, making borrowing very cheap. House prices soared and household debt went with them. The epicentres of the boom were Toronto, Canada’s biggest city, and Vancouver, on the Pacific Coast. Their enormous house price boom continued until 2017. Then… Toronto suddenly stopped.”

House prices dropped back sharply. They’ve since partially recovered. But the locals have discovered that residential property is not a one way upward street. Demand isn’t endless. In fact the number of homes sold in Vancouver in October 2018 is more than a third lower than October 2017, says News.co.au.

Zoom across the planet to Australia, and what do we see?

“Australian homeowners are waking up to find the roof over their head is worth less than it was yesterday”, says Callum Wood in The Trumpet“Or the day before. In fact, across Australia, house prices have been falling since August 2017 (by 8% in Sydney and Melbourne). The inflation of house prices that helped stave off recession in 2008 is over. As bloated prices deflate, homeowners are facing a financial crisis of literal biblical proportions.”

Biblical proportions? Sounds a bit strong. Until you read on…

The average household debt-to-income ratio in Australia is now 199%. It’s another dangerous borrowing bubble. In fact it makes the UK (of which more later), with an equivalent ratio of less than 140%, seem like a bastion of financial rectitude.

And the strain is already showing. Six months ago, one in six Australians was freely admitting to missing mortgage payments, according to a survey by Finder.com.au.

“We’ve got a debt bomb”, says data scientist Martin North to News.com.au“We’ve got a debt crisis. And at some point, it is going to explode in our face.” Maybe that’s not far from happening. North reckons that just a 0.15% hike in interest rates could push another million Australians to default on their home loans.

The flipside is that the country’s lenders currently hold $1.7 trillion-worth of mortgages issued to owner-occupiers and investors, says the Trumpet, higher than any country in the Western world. “Aussie banks are at the mercy of the real-estate market. Up to 60% of loans are for mortgages. If interest rates rise, already-burdened homeowners will struggle to pay their debts. It could lead to a banking crisis.”

What then?

“Expect a major home builder bust along with an accompanying recession”, says analyst Mish Shedlock.

And this is the key to my equation.

As it keeps growing while it’s being funded, debt isn’t a concern.

The big problems start when it starts to fall, along with home values.

This is when borrowers aren’t repaying their debts – simply because they can’t. In turn, the banks who’ve lent out the money have to write down the value of these loans (their assets) in their own balance sheets. Which then don’t balance, because those banks still have the same obligations to both their depositors and also to their bondholders. At that point, the banks get into trouble.

And that’s when we all become affected. Like we saw in the GFC, as taxpayers we then turn into the ‘lenders of last resort’.

It’s also when distress selling of houses crushes property prices against a backdrop of cratering stock markets and all the other nasties associated with a financial crisis.

And if the situation in Australia is bad, Hong Kong is potentially worse, according to a new study from UBS.

Then there’s China – again bad news – which justifies an article all by itself.

Finally, of course there’s the UK.

Property prices are a national obsession. Sure, household debt-wise we’re not in as poor a financial state as some other countries. But the same rules about house values and borrowings still apply.

What Britons owe on houses, or ‘total secured lending on dwellings’ as the Bank of England rather coyly calls it, is now at an all-time high of £1.23 trillion. Meanwhile, house prices are now falling year-on-year.

According to Rightmove, the average asking price slipped 0.2% to £302,023, marking the first annual drop in 7 years. 

OK, maybe the country as a whole isn’t in uber-dangerous debt bubble territory (though London looks very overvalued) But let’s be aware that the UK could soon be facing the same dangers as elsewhere in the world.

And when house prices start falling worldwide, watch out. A financial crisis won’t be far behind…

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