Housing Affordability – The Shift From Fantasy To Reality – Hugh Pavletich

The UK Financial Times article Painful Adjustments Ahead for Banking System by John Plender should be read closely, to gain a sense of the magnitude of the unwinding currently underway within the global financial system. And it is all “happening” rather quickly.

Dr Alan Greenspan was the architect of the financial liquidity bubble – and before too long will be widely recognised as such. History will likely be very harsh on him. But the liquidity bubble was exacerbated by poor urban regulatory performance as well - strangling supply and creating further massive asset bubbles – fuelling even greater excess liquidity. This did not happen in the open urban markets of middle North America, as the Annual Demographia Surveys clearly illustrate.

Much of the so called “global boom” (in reality a bubble) we have had since the late 1990’s – has been caused by these two key factors.

What is important about this UK Financial Times article, is that it explains how a (perceived – not real) virtuous cycle can so quickly turn in to a vicious one. The reality is that no one knows the extent of the losses that will be incurred as this whole unfortunate and indeed unnecessary urban inflation process unwinds. After all “assets” (across the board) are only worth what people are “willing” to pay for them – and lending institutions are prepared to lend on them.

Plender explains it very well within the article when he says –

“Equally to the point, the banks year-end preoccupation with liquidity distracts attention from the big difficulty for 2008, namely that everyone in the financial system is capital – constrained.Also capital constrained are households in those economies that have suffered from explosive house prices, which is where the linkage with the broader economy could all too easily precipitate recession (my emphasis)”.

He goes on to say………..

“Estimated system wide losses of $300 billion plus are largely based on marking banks trading books to market. The real cash losses and defaults are yet to come (my emphasis). And the defaults will not be confined to the residential mortgage markets, where teaser rates are set to rise. In countries such as the UK, Ireland and Spain, lending to commercial property has been soaring as a percentage of the overall loan book. The initial yield on the property is below the banks cost of funds, so defaults at some point are inevitable.”

It could be said that Southern California (with the help from other US coastal markets) is “leading the way” as this article Southern California home prices tumble in November | Reuters illustrates – where it states that median house prices have declined about 10% November year on year.

Then the question needs to be asked – “If previously they were lending on artificially inflating housing prices, where household income was either of little or no consequence – what do they lend on now - in an environment of declining house prices?” it cant be “assets” any longer of course – because they don’t know what these will be worth going forward.

It simply has to be “income” - as it should have been all along – had there not been these massive “regulatory failures” at both national and local level.

The urban inflation we have seen in too many markets over these past few years has been “unprecedented” To gauge the extent of the inflation component – one would need to adjust current pricing back to a reasonable Median Multiple of 2.7 (the “swing multiple in normal open urban markets – where the “floor multiple” is 2.5 and the “ceiling multiple” is 3.0).

We know from the 2007 3rd Edition Demographia International Housing Affordability Survey that the median Median Multiple for the major urban markets of the 6 countries surveyed were – Canada 3.2; USA 3.7; UK 5.5; Ire 5.7; NZ 6.0 and Australia 6.6. It is simply a matter of multiplying the housing stock by the average (not median) price to arrive at the current total inflated values of individual markets – then adjusting them by how elevated they are above the normal open market “swing” Median Multiple of 2.7, to get some sort of grasp on the quantum of “artificially inflated value”.

It is not a pretty sight – and should have been “obvious” to politicians, bankers, regulators, economists, property professionals, urban planners and others ten and twenty years ago.

It needs to be borne in mind too – that as markets “adjust” – they do not simply move casually and conveniently back to their “equilibrium value” (in the residential sector to the open market swing Median Multiple of 2.7) – but tend to “overshoot”. We do know from the Harvard University Median Multiples Tables that historically most US urban markets were between 2 to 3 time’s annual household earnings.

It is difficult to accept the idea that somehow this adjustment can be “gentle” as the criteria for debt financing moves rather quickly from that based on “ever inflating values” to the “tried and true” historical convention of lending based on income – which had been at 2.5 to 3.0 times (and slightly higher) gross annual household income and no more than 80 - 90% of the “true worth” (not artificially inflated pricing) of the property being secured. It seems likely that “assets” through this adjustment phase will be considered “secondary” to incomes. It is likely too lenders will now be making hurried efforts to adjust lending criteria within the urban markets they are lending in to – to “affordable” levels (i.e. 2.7 Median Multiple).

Banks and other lending institutions are currently learning the hard lesson of just how “disloyal” property owners can be to inflated lending, when reality property pricing emerges as a bubble unwinds.

Property Appraisers / Valuers will need to adjust to this “renewed reality” rather quickly as well.

Through the “bubble phase” - lending at 4, 5, 6 times household income was common – even to the extent of 11 times household income in California ($US90,000 household income / one million dollar debt) as explained by a Mark Hanson within Herb Greenberg » Blog Archive » Straight Talk on the Mortgage Mess from an Insider . This article with the generally high quality 600 plus comments that follow by practitioners (not economists / property appraisers and valuers - with sadly too often – a “textbook” understanding of markets) provides an excellent overview of the irresponsible lending practices which blossomed through the bubble phase.

I would like to say that it has surprised me (but it hasn’t) – that Banks and other lending institutions have not protected themselves, by clearly differentiating between “true value” and “inflated value” of urban markets – in pressing Governments at all levels, to take the necessary regulatory steps to ensure urban markets did not inflate.

Instead – they chose to act as “cheerleaders” (and with others who should have known better) to this rampant inflation – as they clearly saw it as a short term opportunity to generate enhanced revenues, profits and particularly bonuses. I cannot recall hearing the “voice” of one senior Banking official – anywhere – warning of the dangers of this artificially induced urban inflation.

To add insult to injury – many Bank economists branded these artificially inflated values as “household wealth”. Hardly surprising when they were “selling” artificial property inflation as growth – something that can only be described as gross misrepresentation and blatant professional negligence.

It is to be hoped that they are now examining closely where the quantum of household debt sits in relation to the quantum of inflated value and the true value of individual urban markets. They may well find that the quantum of the true market values in many markets is uncomfortably close to the quantum of household debt within these markets.

On the issues of alleged “misrepresentation” and “professional negligence” - it will be interesting to see how this all plays out in the Courts around the world going forward, A media statement by the attorneys and case summary and class action complaint vs UBS and a number of its senior officers, is already underway. It is impossible to predict how the vast range and numbers of “aggrieved” seek justice from the Courts and other forums. There will no doubt be different approaches taken in different jurisdictions.

How “protected” public officials are in jurisdictions with the Westminster system – where the civil service at all levels of government is expected to act with impartiality – will be most interesting.

It would be fair to predict however – that we are likely to see rapidly increasing pressures to restore regulatory and commercial disciplines within our urban markets.

It is the politician’s role to react to these pressures and they are ultimately judged on how they manage these events, as the recent election in Australia clearly showed - and reported December 8, 2007 in the Sydney Morning Herald Fear of losing homes drove Labor win by Stuart Washington. The SMH requested Fitch Ratings to research the swing to the new Australian Federal Labour Government and found that those suffering “mortgage stress” voted strongly against the former Howard Government to elect Labour.

The new Australian Government will know full well – that it must – with the States and Local Government – focus on opening up affordable new fringe land supply to urban markets – or face the consequences at the next election. It would appear the current New Zealand Labour Government has yet to learn this lesson.

Mr Tim Gattrell, Australian Federal Labour Party National Secretary noted that the swing to Labour was not confined to one single group but that the party had made significant inroads among home loan borrowers. Mr Gattrell went on to say that “people with mortgage repayments of between $Aust1400 and $Aust1600 a month, just above the average repayment, stood out as one group that moved solidly to Labour”.

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