Bao Ba (protect 8)

When the bubble bursts:

Is China in a housing bubble? Personally I believe so. House prices are being pumped up by artificial demand; investment opportunities outside real estate are limited and also the credit spending spree is keeping growth artificially high. Discounts on new housing are perhaps a sign that the bubble is bursting. So what are the consequences? Well the Chinese government has at least acknowledged there’s a problem and is trying to deflate the bubble gradually. But with the stimulus package of 2008, the Chinese government has fallen into the trap of compensating real growth for artificially fuelled credit growth (and we saw were that led the US). GDP growth has been kept extraordinarily high and now, as they try to curb house prices, GDP growth could take a battering (see Reuters article). Housing investment makes up 13% of GDP so any house price declines will make a difference. And due to loss spirals, once the prices start falling, it can be hard to stop them. The other factors which make up GDP can’t be relied on to fill the growth gap. Consumption is hard to force, government expenditure may have to be cut back due to failing loans, and net exports will be hard to increase as the government appreciates the Yuan to combat inflation. Falling GDP is bad not only for the single party state who is scared of unemployment and potential public disorder (minimum 8% growth regarded as necessary for stability) but also for many countries like Australia who export construction materials to China.

                                          Picture courtesy of designerlythinking.


China’s own subprime crisis:
Officials’ progression is based on beating GDP targets and this has involved huge spending sprees by local governments with limited probability of payback. Local governments rely on land sales to fund themselves. Developers use land as collateral and rely on rising land value to repay loans. As house prices fall, and demand for land dries up, defaults will be inevitable and the Chinese banks will take a battering (although they apparently can withstand 50% drops in prices). Already China is extending loan maturities to prevent a huge default. Chinese banks may be better prepared with higher deposit ratios (approximately 10% more than the US for large banks) but bad loans still have the same basic effect: banks are more cautious in lending and state intervention could lead to austerity. China’s stimulus package I believe simply delayed and perhaps worsened the inevitable; GDP growth is going to fall. From America to China, easy credit causes artificial growth which will correct itself one way or another (the bursting of a bubble). Thank you for reading my posts and I hope they have been informative. 

China 2012; the year of the dragon – but is the fire burning out?

A Minsky and Kindleberger approach to the development of the possible Chinese housing bubble:

Displacement: In the early 1980s, the Chinese government experimented with the idea of revolutionising the housing market away from the socialist system (where housing was provided by employers) to a more market orientated system. In 1998, housing reform was passed. As privatisation swept the country, housing prices started to take off. Another displacement moment came in November 2008, when in response to the global crisis, the Chinese government unveiled a $586 billion stimulus package and shortly after revealed a huge interest rate cut, the 4^th in a matter of months. The fixed exchange rate pushed inflationary effects into non-tradable goods such as real estate.

Boom: Since privatisation started in China in 1978, GDP growth took off. The nation was becoming wealthier and the privatisation of housing, with strong urbanisation growth saw house prices increasing. Low interest rates at the start of the decade allowed for cheap credit.

Euphoria: Speculative borrowers exist to capture the huge price gains (although the government is clamping down on this) but Ponzi household borrowers can’t really exist as first time mortgages are given only to those with a minimum of 20-30% down payment. According to PIIE “mortgage debt at the year-end 2007 was the equivalent of 18 percent of household disposable income in China, while it was 100 percent in the United States” and around 80% of the value of a house was financed with cash. The government provides schemes to help low income families. Any subprime crisis in China, comes from excessive lending to local authorities rather than to individual households.

                                          Picture courtesy of Earthsky

New economy: There has been a cultural change away from socialism towards status and the desire for larger and better housing.

Swindles: in America, it was the banks; in China, it’s been government officials accepting bribes in exchange for building permits.

Overtrading – Due to capital controls and a poorly developed financial sector, Chinese investors have little choice but to invest in real estate. And with negative interest rates (inflation higher than interest rates) where else is there to stick the cash?

Profit taking – As of yet, we can’t even be sure if this stage has passed or still ahead. Yes, property prices have been declining slightly recently (“0.18% in January compared to December” according to Forbes) due to measures to ease the housing price boom (such as increased down payment for second time mortgages and gradual interest rate increases) but this doesn't mean they're about to plummet. However house price declines will make an impact; a topic I shall look at in next week’s post. But as we ponder, the authorities just keep on building!

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” Chuck Prince, former CEO of Citigroup

Panic (see Brunnermeier 2009):

The music stops:

Banks had moved from “originate and hold” to “originate and distribute”. Due to securitisation, moral hazard problems arose of careless loans being made to everyone and anyone (even those with no income) through risk shifting and because house prices were considered to keep rising. As mortgage defaults rose, write downs increased. Mortgage related securities became very difficult to price and the market for asset backed commercial paper (ABCP) fell away. SIVs dried up and liquidity backstops took them out of the shadows and on to banks' balance sheets.

Interbank fear:

The TED spread ("risk indicator") shot up on the 9^th August 2007 (BNP Paribas moment), until the 20^th, then calmed down before soaring after the collapse of Lehman’s to a staggering 463 basis points on 10^th October 2008 (during the boom years it was around 20-30bp). The uncertainty of counterparty risk meant interbank rates increased and eventually the banks preferred to hoard liquidity. A loss spiral arose where funding problems forced banks to reduce their assets, leading to fire sales and therefore higher margins. Margin spirals caused banks to deleverage, worsening the problems further.

                                          Picture courtesy of Dreamstime

Government intervention:

Government bailouts were targeted as those institutions too interconnected to be allowed to fail (e.g. Fannie Mae, Freddie Mac and AIG), where a default would have led to huge write offs by other institutions further hurting the system.

Aftermath:

Chaos; the butterfly effect:

Due to the interconnectedness of the money markets, defaults in Ohio turned up on balance sheets across the Atlantic (through subsidiaries and securitisation). America and Europe had moved in tandem over the decade, with low interest rates fuelling growth. The subsequent interest rate hikes to curb inflation facilitated domestic property bubbles bursting (e.g. Ireland). The asset side of banks’ balance sheet was hit with defaults and the liability side was hit with problems in the interbank market. Economies slowed, governments bailed out banks (e.g. RBS in UK) and soon countries experienced huge sovereign debt problems. Austerity became the new focus and economies have been aching ever since (UK unemployment rate is currently the highest for 16 years). The interconnectedness of European banks holding each other’s sovereign debt means a default such as that of Greece could cause severe contagion. Until Greece is sorted the markets remain cautious. China is artificially keeping growth high, but new buildings are lying empty and trade with Europe and America has weakened. Next week’s post looks at the causes of the Chinese housing bubble.

“Success breeds a disregard of the possibility of failure” (Hyman Minsky)

Causes of the US housing bubble:

From 1996 to 2006 the ratio of median house prices to median income rose from approximately 3 to 5 in the United States. Minsky’s “financial instability hypothesis” (an alternative view to the efficient market hypothesis) and Kindleberger’s seven stages of asset bubbles trace beautifully the events that unfolded. Minsky stages: displacement, boom, euphoria, profit taking and panic. Kindleberger stages*: displacement, credit expansion, new economy, swindles, overtrading, panic and aftermath.

Displacement: Fed fund rate goes from 6.5% mid-2000 to 1% mid-2003. By mid-2003 mortgage rates had fallen considerably from a peak in 2000, with 1 year ARMs as low as 3.45% (approximately a 50% drop in 3 years). The dot com crash means people view housing as a safer investment than stocks.

Boom: Massive growth in securitisation. Asset backed securities increased by approximately 360% to December 2007 from 10 years prior (fuelled by triple A credit ratings). Between the second quarter of 2002 to the third quarter of 2006, the monetary policy was overly accommodative compared to the Taylor rule. Asian countries especially China artificially weakened their currencies by buying US dollars. This kept the long run US interest rates artificially low. Alan Greenspan believes this rather than the short term fed fund rate is the most likely explanation for the housing bubble (blame shifting?!)

Euphoria: Growth of speculative and Ponzi borrowers (those who relied on housing price increases to refinance). A new economy: living the American dream; a push by the Clinton and Bush administrations to ensure every American could own a home. From March 1998 to March 2006, real house prices increased by 80%.

                                          Picture courtesy of predatorhaven

Swindles: some households lied to get a mortgage and mortgage brokers extended loans to unqualified households due to risk shifting with securitisation. 

Overtrading: both subprime borrowers and creditors were relying on house price increases; effectively a giant Ponzi scheme (although with limited fraud).

Profit taking: this is the time to get out; just before mid-2006 in the US housing market. Demand was slowing as ARM rates had shot up due to fed fund rate increases and when people came off their initial low interest rate period they could no longer afford the new higher payments. Delinquency and foreclosure rates on subprime mortgages started to soar from mid-2005 (subprime ARM foreclosure rates increasing by 370% over the next 3 years).  Then on 9 August 2007, according to Paul McCulley of PIMCO, the Minsky moment occurred; BNP Paribas prevents withdrawal from three investment funds which had specialised in US subprime mortgage debt. The market panics and the crisis begins. Next week’s post is on this panic and the aftermath.
*the paper originally accessed through the link, entitled The US housing bubble and the current financial crisis (US congress joint economic committee 2008) is currently unavailable online but was a great source of inspiration for writing this post.