Where is the housing crash?

Back in May 2004, MoneyWeek economist James Ferguson predicted a housing crash. Since then, the annual rate of house price growth has fallen dramatically - but a full-scale crash has yet to materialise. So will a flat market be as bad as it gets - or are there harder times ahead?

Regular readers of MoneyWeek might remember that I've been warning about an impending housing slowdown in the UK since my first article on the subject appeared in May 2004.

By most measures, the year-on-year rate of house-price appreciation peaked the following month, in June 2004. Since then, house price growth has headed south but has only ever gone into negative territory in real (inflation-adjusted) terms. Most housing bears have got bored, hung up their spurs and gone away.

But I'd like to remind readers that the last housing crash happened over a seven-year period, much like a falling line of dominos. So far, our domino effect has halved mortgage equity withdrawal, the rate of personal spending and economic growth in the space of just a few months.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Arguably, the contagion has been halted by the Bank of England cutting interest rates to 4.5% last August. But consumer price index inflation is at the top of the Bank's allowable range and rising, there's a global trend towards monetary tightening and, most worrying of all, the contagion has spread to the United States.

The Anglo-Saxon housing markets all rose together, buoyed by a wave of cheap and accessible credit. Now there are signs of a concerted, possibly even coordinated, monetary tightening by the world's central banks, maybe they will all explode together too. So far, the bubbles in Australia and the UK have deflated, if not exactly burst, but US house prices had continued to rise. Until now.

US housing heads south

The data for sales of new family houses in the US in February was shocking. US new home sales fell 3.4% to 1.08 million annualised and prices were down 2.9% as higher mortgage rates started to bite. The average 30-year fixed mortgage rate, according to Freddie Mac (the US mortgage agency), was 6.25% in February, up from 6.15% in January. In the economically vital Western US, new home sales in February plummeted 29% compared with the same period last year.

According to David Rosenberg at US investment bank Merrill Lynch, in the last 30 years there have been eight such double-digit drops in new home sales. Six times, these drops signalled recession the next year and one drop led to GDP growth halving from 4% to 2%.

Only once in 30 years did such a sharp deceleration in new-house sales not lead to an economy-wide slowdown and that was in 1987, when for most of the year there was a huge boom in equity prices. With US GDP growth currently at 3.2% and a flat equity market, it seems the Fed's 3%-3.5% growth forecast can only be revised one way: down.

The truth is that while Americans have been building new houses so fast you'd think house building was going out of fashion, they haven't been able to sell them nearly so easily. US privately owned new house-building starts were up 15% in January compared with December to the highest level since 1973 but the National Association of Realtors' inventory data for existing homes for sale is at a two-decade high of nearly three million dwellings. New-built home inventories are now at a record 544,000 homes, equivalent to more than six months of sales. At a median price of $230,400, the total value of this unsold inventory overhang is an almighty $125bn.

Problems ahead for the US economy

US economic growth might seem quite strong over the next few weeks as first-quarter personal consumption figures are reported, but this is mainly due to a very weak fourth quarter due to weather-related reasons. Behind the scenes, the debt-financed spending spree is being stretched to breaking point.

With new Fed chairman Ben Bernanke keen to show his inflation-fighting mettle, and with headline inflation figures at 13-year highs, the financial markets are, understandably, betting that interest rates will keep rising.

The European Central Bank is joining in and even the Bank of Japan has announced an end to its "zero-interest rate" policy so we are suddenly living in a global tightening environment. And it is happening just when everyone's guard is down, when stockmarket volatility expectations and investors' cash positions are both at new lows and when higher-risk assets such as emerging markets have been performing well. That could all be about to change.

American borrowers' rush into debt has been accelerating. It took more than 30 years to raise the debt-to-income ratio 30 percentage points, from 40% to 70%. It then took only 15 years to raise it the next 30 percentage points to 100%. But it has taken just five years since the end of 2000 to jump the most recent 30 percentage points, to a new all-time high of 129%. This has surely been one of the most remarkable debt-financed spending sprees in the world, ever.

At risk is US personal consumption. Just as mortgage equity withdrawal has been keeping consumption going in the UK, mortgage refinancing has been supporting the US consumer.

The household debt-to-net-worth ratio is at a new all-time high of more than 22% nearly double the level of 30 years ago. More seriously for the wider economy, Americans have increasingly moved away from the safety of their treasured 30-year fixed-rate mortgages, into the high-risk world of interest-only and adjustable-rate mortgages (ARMs).

Survey evidence reveals that Americans are generally unfamiliar with the consequences of rising interest rates on ARMs, and many seem unaware that their monthly payments can, and will, be increased after the re-set period. This is especially worrying since loan delinquency (payments that are more than three months overdue) and default data usually happen after (or lag) housing-market slowdowns.

But in this economic cycle, mortgage-delinquency rates are already at a 20-year high, according to US investment bank Merrill Lynch. As many as 3% of sub-prime borrowers (that is, those who don't qualify for loans from cheaper, mainstream lenders) are already more than 90 days in arrears. This will worry lenders, encouraging them to apply more stringent lending criteria. Stockmarkets don't like it when lenders have to raise their loan loss provisions either.

Mortgage refinancing is falling sharply in the US, just as it is in the UK. This has caused real spending on consumer goods to drop into negative territory. With more than 70% of the economy reliant on the consumer and the consumer dependent on credit, the US can't be expected to pick up the slack in global demand this year, unless there's a huge surge in capital expenditure (capex) by corporations.

And although corporations are certainly cash-rich, they are so far sitting on their hands, and the delayed launch of Microsoft's replacement for XP (Vista) from this summer into next year doesn't bode well, especially given that about 50% of US capex is usually spent on IT.

At the start of the year, The Wall Street Journal canvassed 56 economists and found only one of them forecasting an end to the 14-year economic expansion. Yet America is sailing directly into the same sort of economic headwinds that in this country forced Gordon Brown (humiliatingly) to halve his 2006 economic-growth forecast at the end of last year.

At the moment, US consumers are dipping into their savings, but that can't continue for long. Indeed, 2005 was the first year since 1933, in the Great Depression era, that the US personal-savings rate was actually negative.

The Bureau of Labor Statistics data show that the number of jobs has grown by just 0.5% a year during this expansion, compared to about 2.5% normally. The quality of those jobs is also worryingly poor, with real wages growing just 1.9%, compared to nearly 4% in the previous five expansions since 1960. Throw in 14 quarter-point increases in the Fed funds rate, which push up debt costs, and you can see that the US consumer is getting squeezed.

And 2006 is going to be harder still. Oil price rises to date are adding an estimated $1,000 this year to the cost of car ownership for the average household, compared to 2005, and 25% more to heating bills.

Just scaremongering?

Perhaps you'll be thinking that there's little to worry about. Scaremongers warned that all these housing bubbles would burst, but both the UK and Australian examples show that prices can slow without a meltdown. The most recent Nationwide house-price survey for the UK showed prices were 5.3% up on last year, suggesting to many that the housing cycle may have already bottomed. Besides, house prices can't crash when the economy is strong, can they?

But, of course, the first thing to say is that these things take a long time to unwind. The early Eighties housing-market crash' took seven years to unfold. House prices may be up 5.3%, but that's the lowest growth rate for a decade. Prices were growing at nearly 27% three years ago.

What's more, the house-price surveys are lagging indicators they reveal the truth too late. Houses that can't sell, or won't sell until the price is cut, don't appear in the data until later.

The second problem is that, although house price collapses only seem to coincide with economic recessions, the cause and effect is probably the other way around. Weaker house prices feed into economic slowdown. In the summer of 2004 the last time house price growth was more than 20% UK retail sales by volume were growing at 6%-7% year-on-year.

Now, 18 months later, house price growth, adjusted for inflation, has gone to near zero (not everyone's numbers are as optimistic as Nationwide's) and there's also been a drop in mortgage equity withdrawal (MEW). MEW as a percentage of disposable income had previously peaked at an even higher level than the 1988 high. This affected personal consumption. Retail sales volumes in February grew just 2.1% and hence the UK real GDP growth rate halved to +1.8%, the lowest since 1993.

The core of the problem is that households have been getting as stretched by their debt-service costs (as a percentage of disposable income) as they were at the top of the 1988-1999 housing cycle. So we've got this far: house prices have stopped rising (much), so MEW has fallen, which has led to debt-financed consumption dropping and economic growth halving. The process hasn't ended indeed, it has possibly barely begun. If this is a vicious, spiralling circle, what should we expect to see next?

What next?

This sort of contraction in the economy should start to alarm lenders (who fear default) and borrowers (who decide they should save more). So, the next thing we would expect to see is a big contraction in overall lending. Sure enough, total loans, mortgages and credit on plastic from banks have dropped sharply.

The trend is now negative for the first time in 12 years. Without the oxygen of debt, consumers can't spend, so no wonder more than a third of retailers reported falling sales in March. Of course, it may be that consumers not only can't borrow so freely as before, but they don't want to.

A recent survey by Bristol University suggested that 70% of people have no savings to see them through a "sudden drop in income", while a contact at a major high-street bank told me the average balance in their accounts was just £750. Economic slowdowns lead to precautionary saving', when people stop spending and start saving as they anticipate at least a few rainy days ahead.

It's this drop in lending and borrowing and pick-up in saving that historically has always choked off consumer-credit-financed economic-growth models. In the third quarter of last year, personal bankruptcies were up 46% year-on-year, a record high. As the chances of default increase, banks are less willing to lend, especially for property speculation, buy-to-let and higher-risk mortgages. As the economy worsens, people become more afraid of over-extending themselves, especially on large mortgage payments.

So far, UK house price growth has almost stopped, which is hitting high-street sales and creating a tougher debt environment. Even unemployment has been rising since last September's 4.7%, to 5%. If all that washes back into the housing market and pushes prices lower again, the vicious circle will feed on itself, with recession the inevitable consequence.

US Federal Reserve governor Ben Bernanke would be well advised to follow Bank of England governor Mervyn King's lead and stop raising interest rates soon. This one still isn't played out by any means.

What can we do?

My advice remains the same as it ever was. If you have any investment property, you should sell it unless it delivers a very powerful income stream. Anecdotal evidence reports that off-plan and buy-to-let investors are already choosing to return their keys to the mortgage lender rather than face a rental stream that doesn't cover the interest, especially now that capital gains are a pipedream.

As for householders, I wouldn't presume to forecast where interest rates go next, but it's almost always best to try to pay down your mortgage ahead of any other strategy.

But to prospective new buyers, I'd advise this: don't assume that because house prices don't appear to have fallen yet as evidence to suggest they can't or won't. The three-year trend in prices is still downwards, prices and debt service burdens are still record multiples of incomes, and economic growth has already slowed to a 13-year low.

By housing market standards, the situation is deteriorating rapidly and yet no one either wants to believe it or feels they can do anything much about it. Yet the simple answer is you can do a lot just by not getting over-extended.

If you or anyone else you know is buying a house right now, make sure you can comfortably cover the mortgage payments even under adverse circumstances. If you can't, you're paying too much and that could spell trouble ahead.

The storm clouds are gathering, taxes and utility bills are rising while job security is falling. We're on the cusp of what could still yet turn into a full-blown recession and things could get a lot worse before they get better. In such an environment it pays to look forward with a bit of imagination rather than base your forecasts on what happened before.

Remember the famous Gary Larson cartoon, which shows a dinosaur addressing a symposium of complacent-looking peers from the lectern: "Brains the size of walnuts, large lumbering bodies, a rapidly changing environment. Gentlemen, the outlook is bleak."

James Ferguson is an economist and stockbroker at Pali International. He has also launched his own investment advisory service, Model Investor, especially for MoneyWeek readers. To find out how James could help you click on the Shop' page.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.