A profound inflection point?

[Dimebag]

For several years I have followed developments in the property market with interest, and, at times, with regret for having remained on the sidelines, as prices have spiralled ever higher and higher. Finally we are starting to witness the beginnings of a reversal in prices, but the mainstream opinion amongst property investors at this point seems to continue to be that property prices will merely "slow" and that we are in for a soft landing.

However, the more I read and think about this, the more I wonder whether property investors have not come to grips with the profundity of what is happening globally in credit markets and the implications this holds for property prices globally. We could well be in the early stages of one of the biggest property market crashes in history with profound implications for the global economy.

At the inflection point of a huge bull market participants often are blind to profound changes that are taking place and are too slow to change their views. Often by the time they figure it out its too late to act and catestrophic losses have been realised. This is particularly the case for market participants who have not lived and invested through multiple cycles, and the problem is that cycles can take a long time to play out. The good times for property investors have lasted so long that it has come to be perceived as normal. This has played itself out time and time again in the stock market but never before have we seen something potentially of this scale in global property markets. Investors talking about a mere 'slowdown' and even perhaps looking at picking up bargains only a few months into the downturn have, to my mind, completely missed the fact that we have passed a pivotal inflection point.

Over the past last two to three decades, and especially during the last six years, we have had one of the biggest global property bull markets in history, with the amounts of money involved eclipsing the dot-com boom and indeed any other bubble to have ever come before it. Prices have risen by 10% a year or more (in some cases significantly more), but this is not normal! By virtually every metric property prices are unbelievably expensive, and history shows that every bubble has eventually reversed itself. This one is unlikely to be an exception.

People have misunderstood exactly why prices have risen by this much. (I have challenged many to explain what law of the universe mandates that prices should go up at 8-10% a year and not one has been able to offer a plausible explanation). Absolutely the biggest driver of this boom has been the willingness of banks and investors (in the case of securitization) to lend more and more money to people to invest in property on loose terms and at low interest rates. When banks start offering 50 year mortgages and 100% finance and the like, it becomes clear that peoples' ability to borrow yet more amounts of money has come to an end. And all this franetic lending activity has of course been accelerated by an unprecedented level of speculative activity in property markets in recent years.

An abundance of cheap credit and ever-loosening credit standards has driven property prices higher and higher. This is what has driven the dramatic increase in demand/money flowing into housing, as the natural economic growth cycle can only support growth in real house prices of about 1-2% at best (very long term measures have put house price growth at slightly less than 1% in real terms). Property price have gone up a long, long, way, and most property investors do not seem to appreciate that this has been driven almost entirely by debt-fueled demand and low interest rates. This is cyclical not structural!

What is most dangerous is that this trend becomes self perpetuating (which George Soros has pointed out), as higher property prices increases the level of perceived collateral to re-lend against, so more lending ensues. All this leads to a significant underestimation of the level of systemic credit risk built into the system, and is also why the developed west has been running such dangerously large current account deficits for so long!

Also important, rising prices also act to reinforce the perception that property prices always rise and is therefore safe to lend against aggressively. This belief is now being revealed to be erroneous and the implications are potentially huge because what we could see is a reversal of this credit-driven boom in prices. As prices fall, banks get more nervous and willing to lend less money, so prices fall further etc and the cycle can become self-perpetuating on the downside. This has already happened before in Japan where property prices have fallen for 14 consecutive years as it continues to unwind.

It always takes a trigger to turn things around and we have now seen this. The unravelling of the US sub-prime crisis has been the trigger, and now that the debt tap has been suddenly turned off its seems to me that a collapse in prices (not just a "slowing") is now virtually inevitable. We are already seeing this.

Furthermore, this could well be a global phenomenon not just a US phenomenon. The boom has been global and driven by globalised financial markets, and consequently the bust must therefore also be global. Already we see in the UK that prices are absolutely collapsing. Sentiment and psychology are central to booms and busts, and what we are beginning to see now is a reappraisal by banks globally about the riskiness of real estate lending which will now begin to play out for several years. Access to funds from "securitization" is now a thing of the past with the incentive problems of separating ownership and origination of loans revealed, and to top it off, the devastating credit losses in the US now mean the balance sheets of the global financial system has taken a big hit and credit rationing has begun. NZ and Australia will not be unharmed. Yes, NZ has not participated in sub-prime lending and securitization, but prices have nonetheless undergone the same debt-fueled bubble dynamics with valuation metrics absolutely off the charts. With the trigger flipped there is no going back and sentiment has turned.

What most concerns me about this is the level of debt involved. People investing in property have become completely oblivious to the tremendous amount of risk they have undertaken. A collapse of this nature has the potential to completely undermine western consumption and threaten the stability of the entire banking system.

Look at stock prices! Share market investors are waking up to the problem. The real risk is that with a reversal of lending and the wealth effect, consumption slows right down, slowing the economy and leading to job losses. This in turn further increases pressure on property prices etc. And to add insult to injury, inflation is now getting out of the bag. If inflation kicks up interest rates of 15% or more are not impossible (they are already 10% for floating mortgages). The fallout could be huge. I could well be being too alarmist here, but certainly for the timebeing there seems to be little justification for having any exposure at all to property given the considerable downside risks that are emerging and the still-stratospheric level of prices.

I hope I'm wrong. I wish money-for-nothing was the way the world works and everyone could get rich just borrowing lots of money and buying property. But unfortunately that is not the way the world works, and unfortunately history shows that when everyone comes to believe the contrary that a huge collapse is usually nigh. I believe the 'get-rich-quick' pundits who have populated global property markets in recent years are going to get their comeuppance. The scene is absolutely set for a devastating crash globally.

I'm interested in peoples opinions on this. This has really only just dawned on me and I've been slow to realise the ramifications. I'm not one to usually scaremonger but occasionally the doom and gloom merchants are right, and their case seems compelling. It may well be that they were right all along.

Dimebag,