Tuesday, November 17, 2009

Predicting House Prices and Economic Crisis

Readers Question: Many experts assert that the assumption of ever increasing property prices is the main factor that has led to the credit crisis. Do you think that the events that led to the crisis would still unfold even if all the lending institutions over the world had predicted falling property prices?

Firstly, I'm not convinced that the boom in house prices was the most important factor that led to the credit crisis. In the 1980s, the UK experienced a similar boom in house prices (prices rose over 30% towards end of 1980s) But, despite the boom and subsequent bust, we didn't experience a credit crunch to the same extent.

I feel, the main reason for the credit crunch is that the rapid rise in US house prices was fuelled by unsuitable mortgages. It was the growth in unprincipled lending that led mortgage companies and banks to be exposed to significant losses. (see: Credit Crunch Explained - for more on causes of credit crunch.)

Mortgage companies were lending vast sums to people who had little if any chance of paying back the mortgage when the introductory term ended.

Of course, rising house prices (and the expectation of future house price rises) was a key factor in encouraging companies to lend to all and sundry. The expectation (or let us say blind faith) house prices would rise for ever encouraged:
- Mortgage firms to lend with little scrutiny of affordability / ability to repay
- The monetary authorities played little attention to the housing bubble. In fact they never referred to it as a bubble until after crisis started.

If House Price falls had been predicted would things Have Been Different?


One assumes that if lending institutions, knew house prices were going to fall 20% - 25% from 2006, they would never have lent the mortgages they did. It is true some mortgage salesmen were paid on commission, regardless of suitability. But, if house prices could fall, presumably, the lending institutions would have been stricter in giving mortgage salesmen to lend to anyone who asked for a $200,000 loan.

When mortgage companies / banks expect house prices to fall, they become very strict on mortgage lending. They require large deposits and are much more strict on income multiples. If you expect house prices to fall, a bank is not going to lend 100% mortgages, but will ask for a say a 25% deposit. This would have protected banks from mortgage defaults which was the prime cause of the credit crunch. If banks had predicted house price falls (or even seen it as a realistic possibility), they would (should) have made much better decision in lending and avoided the losses which, through CDOs were compounded around the global financial system)

It is difficult to Predict House Prices.

In 2000, few would have predicted how much house prices would have risen by 2006.
At the start of 2006, not many lending institutions were predicting 20% house price falls.
At the start of 2009, few would have predicted the house price rises we are seeing this year.

But, in the 2000s, there was a collective amnesia (especially from those lending mortgages) forgetting that house prices can fall as much as often rise. Examples of Japan, and previous busts were ignored in a good example of irrational exuberance.

If lending institutions were able to predict house prices, they would never have made so many bad loans, which subsequently defaulted causing bank losses across the world.

I don't think it is a question of being able to predict house prices. But, avoiding bubble hysteria and being more realistic about potential house price falls.

I also feel the credit crunch could have been avoided if there was very good regulation of mortgage markets in the US. If the government had abolished self-certification mortgages, and mortgages several times income, then the raft of bad mortgage lending would have been considerably less.

1 comment:

Anonymous said...

If banks and other financial institutions avoided lending reqlessly to many homebuyers(as we know high risk lending carried high returns)what other alternative investment instead would these institutions undertake to multiply their income( they had borrowed vast sums of money from emerging economies as a result of low interest rates). Would they not still take risk in some other surging bubble, if it wasn't in the housing market?