'Biggest bubble in history' may burst

Investors need to be on guard, because there is currently a large bubble in the United States property market and if it bursts, it could have repercussions for the global economy, Michael Power, a strategist at Investec Asset Management, told the Personal Finance/Fairbairn Capital Investors' Club this week.

A bubble in the United States residential property market is in danger of bursting, and declines in the US's biggest housing markets are likely to trigger a major economic slowdown, Michael Power says.

US house prices have risen by an average of 13.4 percent over the year to the end of the second quarter of 2005, and in some areas prices have risen by more than 25 percent over the past year, Power says. Las Vegas currently has the hottest property market in the US and prices there are up 33 percent on a year ago.

The value of new and existing home sales has increased by 280 percent in eight years.

Power says the dot.com bubble of 2000 morphed into a real estate bubble, because despite the Wall Street crash that year, house prices did not skip a beat and have in fact increased at a faster rate.

House prices have increased, mainly because the real cost of borrowing has remained low, Power says.

However, prices have also been driven up by politically expedient tax cuts, the 1997 relaxation of capital gains tax on property sales and "a slew of creative financing schemes", which have made it easier for buyers with very little equity to enter the house market.

Home loan or mortgage companies are offering loans equal to 125 percent of the value of the property, and mortgages are being extended to Americans with bad credit records, he says.

In addition, some companies are offering fixed-rate loans, which, when interest rates rise, will result in the difference between the repayments and the higher interest rates being capitalised and added to the value of the loan.

Power says an indication of how hot property is in the US, is the fact that more than 40 percent of the properties traded are bought and sold before they have been built. When owners move into a new property, they may be the first occupants, but the fourth owner, he says.

Alan Greenspan, the chairman of the US Federal Reserve, is in denial about a national house price bubble, Power says, referring only to "signs of froth in some local markets where home prices seem to have risen to unsustainable levels" and "a lot of local bubbles".

Higher prices fuel spending
The increased property prices have in turn been used to fuel consumer spending. Power says Americans have been treating their homes like ATMs. In 2004, they withdrew $700 billion from their mortgages to spend on things such as holidays and imported goods.

Owners' equity in real estate - or the portion of Americans' homes that is not mortgaged - has declined over the past 20 years from a high of 70 percent to a low of about 55 percent. Over the same period, home mortgage debt as a percentage of gross domestic product (GDP) has increased dramatically from just over 30 percent 20 years ago to more than 60 percent at the end of last year.

The reduction in US home equity last year was equal to seven percent of the country's GDP, Power says.

Power says that instead of taking away the punch that American consumers were drinking, Greenspan spiked it with negative real interest rates, thereby fuelling the spending spree. Americans have been drinking to keep away the hangover ever since, he says.

The Economist magazine has described the situation in property markets in developed countries as "the biggest bubble in history". Power says The Economist has reported that the total value of residential property in developed economies has risen by more than US$30 trillion over the past five years to over US$70 trillion, an increase equivalent to 100 percent of those countries' combined GDPs.

The bubble, The Economist says, "is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80 percent in GDP) or the US's stockmarket bubble in the late 1920s (55 percent of GDP). In other words, it looks like the biggest bubble in history."

Rate hikes have little effect Power says that despite recent interest rate increases in the US, long-term interest rates and therefore mortgage rates, have stayed low, because central banks in Asia, and particularly in China, have been investing their surplus dollars in the US bond market, thereby subsidising US mortgage rates. (Mortgage rates depend on long-term borrowing rates such as bond rates.)

Asian countries have earned these surpluses from US consumers' spending on Asian imports.

But, Power says, this cycle can be likened to a hamster on a wheel and eventually the hamster - either China or the US consumer - will get too tired to run.

The US, he says, is running up the largest bar bill in history. "For how long will the China Country Club fund this tab?"

How this affects you
The global train depends on the US consumer being the locomotive. If there is a slowdown in spending, he says, it will be bad for all of us.

Power says in his view the first signs of distress in the US property market have already appeared, with investors in the market feeling uneasy. Affordability has decreased markedly in the past two years and first-time buyers are finding it increasingly hard to enter the housing market.

On average, mortgage repayments as a percentage of income has risen to 20 percent, which, Power says, is still manageable, but one in three Americans spends 33 percent of his or her income on his or her mortgage repayments, and one in 10 spends more than 50 percent. As US interest rates rise, these people will have little room to manoeuvre and will be forced to sell or will default on their loans.

More and more borrowers with "impaired credit records" have been lent money to buy homes and their loans now represent 17 percent of all home lending in the US, Power says.

About 18 percent of US home loans are for more than 90 percent of the value of the property.

The after-shock of the increase in interest rates in the US will only be felt next year, Power says, and borrowers with impaired records will be the hardest hit.

Household debt in the US now exceeds US$10 trillion and has in-creased from 45 percent of the US's GDP 20 years ago to more than 85 percent today.

And more than 75 percent of that debt is housing-related, Power says.

At the same time, more properties are still being built.

Signs of distress
Signs of distress include the fact that the share prices of companies which provide mortgages to Americans, such as Fannie Mae, are 34 percent down over the past 12 months.

And the housebuilders' index has fallen 17 percent in three months, he says.

Power says there are some arguments as to why property in the US may not be overvalued. These arguments are:

# The US population has grown and this has resulted in an increase in demand for housing;
# People are living longer and this has also resulted in more people needing homes;
# People are getting married later, resulting in more single people needing homes and there are also more single-parent families;
# Rising standards of living have lead to demands for bigger and better homes;
# New financing techniques have put trapped capital to work; and
# There has been a decline in inflation, which has lowered financing costs and the risks of lending.

However, Power says the risks of lending have turned negative and could ultimately affect the US market.

Widespread effects
The effects will be more widespread than just the property market.

Power says more than 50 percent of the US's banking assets are exposed to property. There will also be job losses as at least 50 percent of new jobs that have been created since 2000 are housing-related, he says.

Power says property market crashes often last longer than equity market crashes. The Japanese property bear market is now 15 years old and it took seven years before property prices in the United Kingdom recovered from the 1989 crash there. If history is a guide, Power says, property prices can halve in four years.

But if the US property market crashes, it won't be just property investors who suffer.

"Over the past four years, 90 percent of the growth in US GDP was accounted for by consumer spending and residential construction. De-clines in the nation's biggest housing markets are likely to trigger a major economic slowdown," the Orange County Register newspaper in California says.

"It is not a question of whether this will happen but when, how dire will be the consequences on economic growth and how long it will take to re-stack the blocks and begin again."