Not a Short Downturn

Two months ago, I suggested that markets were overly exuberant after Fed's first rate cut, which if you recall sent US and local stock markets to record highs - as if the subprime problem never occurred. The market rallied, and for two months I was wondering if I was missing out on something. But the problems associated with the US housing market have not gone away. The US financial system and overall economy cannot return to good health before the housing market problems are worked off.

Property as a Collateral

Compared to other assets, housing property is very unique. A large section of the population own it, with most people taking out mortgages in the process, using the purchased property as the collateral. If you buy a $1 million house and borrow 80 per cent, your net worth is $200k. A 10 per cent increase house prices will increase your net worth by 50 per cent, while a 10 per cent fall in price has the opposite effect of minus 50 per cent.

Conversely, a 10 per cent decline in the stock market does not have the same macroeconomic ramification since not many people own shares directly. More pertinently, not many people borrow or leverage to buy shares.

The effect of using property as a collateral is that small changes in house prices can have a large impact on the net worth on many people, and its macroeconomic impact therefore significant. As the net worth of individuals falls, many activities in the economy are dragged down with it. For example, if an entrepreneur has taken out a loan against his property to fund his business (like many small businesses initially do), a housing downturn will have financial consequences for the business itself.

For most consumers, the wealth effect - and even the psychological impact of falling house prices - will lead many to cut back on consumption. The bad loans on the banks' books will force them to cut back on lending as well, hence the credit crunch.

Feedback

What compounds the problem is the feedback effect. The effect of more foreclosure is to send housing prices even lower, hitting the net worth of families with previously healthy financial balances. A LSE Professor Kiyotaki - now in Princeton - modelled this effect. Because of this feedback effects, the initial shock is propagated, resulting in dramatic, and prolonged, negative impact on the rest of the economy which is unlike stock market corrections. It is for the same reasons why Japan took so long to recover from the asset bubble. If you recall, Singapore's economy also took rather long to work of the excess of the last property bubble.

Alan Greenspan has repeatedly warned that the housing inventory in the US is still very large. There is still an estimated 9 months' worth of excess supply, not including those property put on fire-sale in the market. Overall, US housing prices have fallen only very little (average of about 5 per cent or so), and there is therefore a long way to go potentially. Some metropolitan areas in the US are expected to see at least a 20 per cent price decline. It is going to hit the families, banks and financial system hard.

On and off, we will no doubt get some good news to push the markets up a little but have no illusions about it: this US downturn will not be a short one.