The Morgan Kelly Opus - Part II

2007 - PDF

On the Likely Extent of Falls in Irish House Prices.
Morgan Kelly
February 14, 2007

Looking at house price cycles across the OECD since 1970, we find a strong relationship between the size of the initial rise in price and its subsequent fall. Were this relationship to hold for Ireland, it would predict falls of real house prices of 40 to 60 per cent over a period of 8 to 9 years. House price falls tend not to have serious macroeconomic consequences, but the unusually large size of the Irish house building industry suggest that any significant house price fall that does occur could impose a difficult adjustment on the economy.

The purpose of this paper is to look at the likely behaviour of Irish house prices based on the experience of economies that have gone through similar booms. Looking at nearly 40 booms and busts in OECD economies since 1970, we find that the size of the initial boom is a strong predictor of the size and duration of the subsequent bust.

Typically, real house prices give up 70 per cent of what they gained in a boom during the bust that follows. This is a remarkably robust relationship, holding across very different OECD housing markets over more than 30 years.

Were this relationship to hold for Ireland, it would predict a fall in real house prices of around 40 to 60 per cent, over a period of 8 or 9 years. Assuming an inflation rate of 4 per cent, this would translate into an annual fall of average selling prices of around 5 per cent.

Falls of this magnitude and duration are not unprecedented internationally. For example, the real price of Dutch houses fell by 50 per cent between 1979 and 1987, while the price of houses in Britain relative to real income also fell by 50 per cent between 1948 and 1957.

Britain and the Netherlands illustrate a general point: house price falls, although uncomfortable for some households who bought around the market peak, do not usually have serious macroeconomic effects. Consumption falls as household feel less wealthy, banks experience an increase in bad loans, and fewer houses get built for a while; but the cumulative effect on growth tends not to be large or long-lasting.

Internationally, house prices boom and crash frequently, as economic theory predicts they should. Anytime an economy experiences a period of prosperity and low interest rates, house prices boom for a while, and then fall. The only unusual thing about Ireland in the past is that, thanks to the success of governments in insulating the economy from any risk of economic growth, it has never had a housing boom before.

While house price falls tend not to have serious macroeconomic consequences (the one exception is Finland at the start of the 1980s, where bad housing loans caused the banking system to collapse), they may pose some risk for the Irish economy. Typically, an industrialized economy gets around 5 per cent of its income from building new houses, around the same that it gets from household spending on recreation. Ireland currently derives nearly 4 times this amount from building and selling houses. Any sudden fall of residential investment to normal international, and national historical, levels, could have a substantial impact on national income.

What might trigger a house price collapse? The answer is that nothing is needed: price falls can occur endogenously as buyers revise their expectations of the distribution of reservation prices of other buyers. The increase in Irish housing prices has in large part been driven by expectations of future price increases: this is why house prices have doubled relative to rents since 2000.

Potential buyers can now rent for less than the interest cost of a mortgage (a million Euro house, which involves a monthly interest payment of around e4,000 can be rented for under e2,000) and need be in no hurry to buy once they no longer expect prices to keep rising. Similarly, owners of rental properties are getting returns below the rate of interest: 4% if they rent, or zero if, as in many cases, they leave the property empty (Fitz Gerald, 2005). Once they no longer expect capital gains, they should sell. The decision of potential buyers to wait and see, and for investors to sell, while supply continues to grow rapidly, will put pressure on prices. It is interesting to note that the collapse of housing booms in several US cities in the last few months was not triggered by any economic slowdown, or increase in mortgage interest rates (while US short rates have risen, long rates, on which mortgages there depend, have not), but by the feeling that houses had come to cost more than they were worth.

The rest of this paper is as follows. Section 1 rehearses the relevant economic theory of rational frenzies and wisdom after the fact in asset markets. Section 2 looks at the nearly 40 cases since 1970 where OECD economies have experienced house price rises followed by falls, and shows that the magnitude of the boom is a strong predictor of the size and duration of the subsequent bust. Section 3 shows how the stagnation of rents since 2000 while house prices doubled means that the Irish housing market has not been driven by strong fundamental demand but by a bubble. Section 4 looks at the possible magnitude and duration of house price falls, and their potential macroeconomic effects.

1    Economic theory.

The familiar efficient markets hypothesis predicts that changes in asset prices are unpredictable. The price reflects individuals’ information about asset’s present value, and changes as this information changes. Agents with good information buy, driving up the price, and those with bad information sell, driving it down.

However, instantaneous revelation of information through trade is not possible in house markets due to the very large transaction costs involved. In addition, the market lacks means for individuals to convey negative information through short sales.

As a result, housing markets are better modeled as information cascades: the actions of other agents signal their private information and can cause individuals to ignore their own signals and follow the herd (Bikchandani, Hirshleifer and Welch, 1992). Two models in the cascade literature are particularly useful for understanding the dynamics of housing markets: the rational frenzies model of Bulow and Klemperer (1994) and the wisdom after the fact model of Caplin and Leahy (1994).

Bulow and Klemperer (1994) model rational frenzies in auctions where partici- pants reveal their valuations by bidding. Suppose that there are k items available. If individual reservation prices were known with certainty, everyone would wait until the price fell to just above the reservation price of the k + 1-th highest person, and then all buy together. In practice, only the probability distribution of reservation values is known, and by bidding, or failing to bid, individuals reveal information about their valuations, allowing all participants to update their estimates about the value of the k + 1-th highest reservation price.

As a result, bidders with very different valuations have very similar willingness to pay. Price drops until one person bids. The information this reveals about the true distribution of willingness to pay can set off a bidding frenzy among the other bidders, driving up price again until it becomes clear that price is again above willingness to pay. Bidding then stops, causing prices to collapse until another bidding frenzy starts. To the extent that individuals depart from Bayesian rationality, altering reservation values in response to observed trends in prices, these effects will be amplified.

Caplin and Leahy (1994) look at investment where individuals have Gaussian signals. If the true state is bad, individuals continue to invest, driven by the domi- nating effect of past actions. Eventually, however, because signals are not bounded, a few agents get sufficiently bad signals to induce them to stop investing, causing priors rapidly to move to a belief that the state is bad, leading to a market crash and “wisdom after the fact”.

2    Mean Reversion in House Prices.

Economic theory then predicts that house prices should not follow a random walk, but should be a mean-reverting process of booms and crashes around a slowly increasing trend reflecting the growth of household income. This is what the international data show.

Large falls in real house prices in the aftermath of housing booms are common internationally. Table 1 shows the 18 cases since 1970 where OECD economies have experienced falls in real house prices of at least 20 per cent, along with the previous price rise, and the duration of the fall. It can be seen that, in contrast to stock or currency markets, falls are prolonged, usually lasting 5 to 7 years, with the Netherlands, Switzerland, and Japan all experiencing more than a decade of falls. This reflects the reluctance of sellers to cut nominal prices, meaning that inflation does most of the work in reducing real prices.

Shiller (2006) looks at three long series of real house prices: Amsterdam from 1628 to 1973, Norway from 1819 to 1989, and the United States from 1890 to 2005. In all cases he finds that although there are substantial and long lasting peaks and troughs, there is scarcely any upward long-run trend in prices.

Figure 1 shows the same pattern for smaller OECD economies: the Nordic countries, the Netherlands, and New Zealand, since 1970. The diagram shows the ratio of average house prices to disposable income but real house prices show a very similar pattern. Again, as economic theory predicts, there is considerable volatility and no sign of long-run trends. In contrast to stock price data, the tendency of prices to return to their long run average means that the size of price falls can be predicted from the size of the price rise that preceded them.

Figure 2 plots the size of increase in house prices for 17 OECD economies, against its subsequent fall.1 To estimate the peaks and troughs in each series for each country, we first calculated percentage changes for each quarter. A Friedman supersmoother (implemented in the R statistics package) was then applied to the percentage changes to eliminate short-run fluctuations. Peaks and troughs were then identified as the end of runs of positive or negative changes in the smoothed series, and actual price changes calculated between these points.
Percentage rises and subsequent falls are calculated relative to different values: troughs and peaks respectively. Remember that a rise of p per cent only needs a fall of p/(1 + p) per cent to reverse it. To eliminate this complication, all rises in Figure 2 and subsequent regressions are expressed as a percentage of peak values: for example a rise from 50 to 100 is treated as a 50 per cent rise, rather than a 100 per cent one.

Figure 2 shows that there is a strong linkage between rises in real house prices and subsequent falls. There is one evident outlier corresponding to a dip in house prices in Spain that occurred in the early 1990s in an otherwise continuously up- ward trend that saw real prices quadruple between the mid 1980s and the present.

Table 2 shows a regression of the percentage fall in house prices against their previous rise, both including and excluding the Spanish early-1990s outlier, for real house prices and the house price to income ratio. The slope of −0.7 for real house price means that 70 per cent of the rise during a boom (expressed relative to the peak value) is lost during the subsequent bust.

What is notable about the diagram and regressions is how strong the relation- ship between price rises and falls is. Across very different housing markets in very different economies over a period of more than 30 years, there is a common relationship between the magnitude of booms and subsequent busts. Rent-price series show similar mean reversion but because of the small size of the rented sector in many economies, and the presence of rent controls in part of the period, the data are not as reliable as the real price and price-income series.

As always, national averages conceal substantial variations across regions and types of property. During the last British housing crash, for example„ while selling prices nationally fell on average by 10 per cent, they fell in East Anglia by 40 per cent.

As Table 1 suggests, there is a relationship between the magnitude of real price falls and their duration. Table 3 gives the results of a regression of the average annual rate of house price falls on their magnitude, and shows the two to be closely related. If p is the proportionate price fall, so prices fall from 1 to 1 − p over t years, it follows that r = ln(1 − p)/t is the average rate of decline. Table 3 gives the results of a regression of r on p. For every 10 per cent extra decline in real prices, the annual rate of decline rises by 1.5 percentage points.

3    The Irish housing bubble, causes and consequences.

The evidence of nearly 40 cycles in house prices for 17 OECD economies since 1970 shows that real house prices typically give up about 70 per cent of their rise in the subsequent fall, and that these falls occur slowly.

Before looking at what these numbers may imply for Ireland, it is necessary to dispose of the idea that Irish house prices merely reflect strong fundamentals: rising income and increased household formation due to the age structure of the population, declining household size, rising employment, and immigration.

This argument is hard to sustain. If the rise in house prices were due to increased income and more people needing somewhere to live, we would have observed rents rising alongside house prices. Figure 4 shows how house prices have risen far faster than either rents or income. In fact, while rents doubled relative to income between 1995 and 2000, the ratio has remained unchanged since. The failure of rents to rise, along with the number of recently built units that have been bought but are lying empty (Fitz Gerald, 2005), suggests that the Irish housing market has left the dull world of fundamental values far behind it.

A back of envelope calculation of the fundamental price of housing is the following. Abstracting from maintenance costs (which typically run around one month’s rent) suppose that housing generates an annual rent of n. This is a fraction ν of disposable income y which is expected to grow through time at rate g. The present value of this infinite income stream is then
p= νy/(r−g)
where r is the discount rate. As Figures 1 and 2 and Table 1 show, housing is not a risk-free asset, and this discount rate needs to exceed the risk free rate by an amount reflecting the fundamental risk of the asset. For housing, fundamental rise is large: housing is the largest item by far in most people’s asset portfolio and price changes are strongly correlated with income growth. To be conservative, however, we can assign a value of r of 8 per cent, equal to the long run real return on equities.
The ratio of fundamental price to rent is 1/(r − g). To explain why Irish house prices have doubled relative to rent since 2000 we need to ask if there is any reason to suppose that new information has arrived causing long run estimates of (r − g) to be rationally halved. Ireland’s stagnant exports, diminishing competitiveness, and the increasing structural problems of sectors such as IT and pharmaceuticals, would suggest that estimates of long run income growth for the Irish economy g should have fallen in this period. While it may be the case that increased international demand for quality assets may be driving down equilibrium returns (Caballero, 2006), there is no reason to believe that long run expected returns on risky assets r
have halved in the past 7 years.

As White (2006) has observed, there is considerable variation in price-rent ratios within Dublin, with values in the range 80–100 at the top of the market. These values recall the peaks of the dotcom bubble and can be rationalized, with a dis- count rate r ≈ 0.08, only with real long run growth of income of 6 to 7 per cent, equivalent to a doubling of real income every 10–12 years. This is the rate achieved by Korea during its transition from effectively the stone age to an industrial economy but has not been remotely approached by any rich economy. Alternatively, assuming an equilibrium price-rent ratio in the region of 15, it suggests that large falls in prices, of the order of 85 per cent, might be needed for the top of the market to return to fundamental value.

While other parts of the market appear less over-valued, they are still expensive by international standards. The Global Property Guide website reports that the average Dublin apartment rents for around 4% of its purchase price. Only Madrid among major cities has a lower ratio. By comparison, London apartments return nearly 6%, and Amsterdam and Paris over 8%.

4    International Perspectives on the Irish Housing Bubble.

Were Ireland to experience the same housing dynamics as every other OECD economy, except Spain in the early 1990s, what sort of price changes might be expected? Recall that Table 2 predicts a 7 per cent fall for ever 10 per cent rise (relative to peak values) of real prices from their trough level, with a standard error of 10 per cent.

Since the mid 1990s, real house prices have risen from an index level of 100 to around 350, and increase in terms of peak value of 70%. If seventy per cent of this rise were to be subsequently lost, the predicted fall in real house prices would be 50 per cent with a standard error of 10 per cent. In other words, a 68 per cent confidence interval for price falls would be in the range of 40 to 60 per cent. There would be one chance in eight of a price fall of only 30 to 40 per cent, just as there a predicted one chance in eight of a fall of 60 to 70 per cent.

Similarly, Table 2 predicts, given an approximately 70 per cent rise in the price income ratio, that the price income ratio will fall by around 60 per cent, with a standard error of around 12.5 per cent.

A fall in real prices of 50 per cent from Table 3, implies a predicted annual rate of decline of around 9 per cent, with a standard error of approximately 1.5 per cent. This translates into a decline of around 8 years, of the same order of magnitude as that experienced in the Netherlands in the 1980s or Britain in the 1950s. Assuming an inflation rate of 4 per cent, this implies an annual fall in selling prices of 5 per cent.

These estimates may be unduly optimistic. In all the housing cycles on which the regression was based, housing stock was, for practical purposes, fixed. In Ireland, by contrast, the number of housing units is growing at around 5 per cent per year, which would suggest the potential for larger falls than those experienced in other OECD housing slowdowns.

The prediction that Ireland may experience house price falls in the range of 50 per cent, is a good way from the OECD estimate (Rae and van den Noord, 2006) that Irish houses are overvalued by only around 20 per cent. However, the OECD methodology, and that of similar studies, is problematic. Such studies run a regression of house prices on interest rates, disposable income, employment and other fundamental variables. The regression residuals are then equated with the degree of over- or under-valuation in the market.

To see the difficulty with this approach, suppose that Irish house prices had increased twice as fast as they did, so the regression residuals would double in value. Instead of saying that house prices are over-valued by one hundred and twenty per cent, the residual approach would say that they are overvalued by only forty per cent.

House price falls have three effects. First, households feel less wealthy and consume less. Evidence from the United States points to a final long-run marginal propensity to consume from housing wealth of around 10 per cent: a $100,000 rise in property values, increases household consumption eventually by a total of $10,000 (Carroll, Otsuka and Slacalek, 2006). Secondly, banks face more bad loans, and become more cautious in their lending, leading to further falls in credit- worthiness through the standard financial accelerator. Finally, the value of Tobin’s q for residential investment falls, reducing house building. Most countries devote about 5 per cent of national income to building houses and in a typical housing bust, this falls to around 4 per cent of national income.

In most cases then, housing busts are uncomfortable, but not macroeconomically disastrous events. How about Ireland? There is some evidence that the wealth effect on consumption might not be as strong as in the United States: there has been no fall in personal saving in Ireland during the housing bubble, and households have not consumed home equity through second mortgages. Similarly, the larger banks which dominate lending are well capitalized and the banking system has, until recently at least, avoided the worst excesses of the sub-prime mortgage market, although it is likely that many interest-only and 100 per cent mortgages could go sour, especially given the ease with which delinquent borrowers can relocate to England.

It is the scale of the Irish house building industry that makes a fall in house prices potentially troubling. While most economies derive only 5 per cent of their income directly from residential construction, in Ireland house building accounts for around 15 per cent of national income, with another 3 per cent coming from selling houses.

Effectively, the recent growth of the Irish economy looks similar to the unstable case of an old-fashioned multiplier-accelerator model. The employment growth in the Celtic Tiger period of the 1990s led to increased demand for housing, reflected in rising real house prices and rent to income ratios. This stimulated house building, which generated more employment, leading to more demand for housing, and so on. Effectively, the Irish economy has come to be driven by building houses for all the people whose jobs have come, directly or indirectly, from building houses.

It is hard to envisage how a fall in house building from 18 per cent to 5 per cent of national income might be achieved without considerable macroeconomic dislocation. Building booms, moreover, tend to end suddenly: the example of Arizona in the summer of 2006 shows how a housing market can move in the space of a few months from buyers queuing overnight to buy, to empty tracts of new houses being priced below construction cost and still failing sell.

5 Conclusions.

This paper has taken an international perspective on the Irish housing boom. We have shown that there is a close relationship historically across very different economies and housing markets between the size of increases in real house prices, and subsequent declines. If this relationship were to hold for Ireland, the expected fall in average real house prices is in the range 40 to 60 per cent, over a period of around 8 years. Such a fall would return the ratio of house prices to rents to its level at the start of the decade. Given the unusual reliance of the Irish economy on building houses, the effects of any such fall on national income may be somewhat larger than that experienced at the end of other housing bubbles.

Policy implications are straightforward. Booms and busts are a normal part of property markets. The government did not cause the current boom, and is power- less to do anything about a subsequent bust.

Blanchard (2006) has observed that Euro-area economies appear at risk of ro- tating recessions: increased domestic demand drives up real wages and erodes competitiveness, but the impossibility of devaluing means that prolonged rises in unemployment become the only means to reduce real wages. Notable current ex- amples are Italy and Portugal. There may be some risk that the sharp fall in Irish competitiveness since 2000, which has been disguised and, to some extent, caused by the construction boom, may require a lengthy period of high unemployment to reverse.


Bikchandani, Sushil, David Hirshleifer and Ivo Welch. 1992. “A Theory of Fads, Custom, and Cultural Change as Informational Cascades.” Journal of Political Economy 100:992–1026.
Blanchard, Olivier. 2006. The Difficult Case of Portugal. Working paper Department of Economics, MIT.
Bulow, Jeremy and Paul Klemperer. 1994. “Rational Frenzies and Crashes.” Jour- nal of Political Economy 102:1–23.
Caballero, Ricardo. 2006. On the Macroeconomics of Asset Shortages. Working Paper 12753 NBER.
Caplin, Andrew and John Leahy. 1994. “Business as Usual, Market Crashes, and Wisdom after the Fact.” American Economic Revieww 84:548–565.
Carroll, Christopher D., Misuzu Otsuka and Jirka Slacalek. 2006. How Large Is the Housing Wealth Effect? A New Approach. Working Paper 12746 NBER.
Fitz Gerald, John. 2005. “The Irish Housing Stock: Growth in the Number of Vacant Dwellings.” Quarterly Economic Commentary pp. 42–63. Spring.
Rae, David and Paul van den Noord. 2006. Ireland’s Housing Boom: What Has Driven It and Have Prices Overshot? Working Paper 492 OECD Economic Department.
Shiller, Robert J. 2006.    “Long-Term Perspectives on the Current Boom in Home Prices.” The Economists Voice 3(4).    Available at
White, Rossa. 2006.    Dublin House Prices Heading for 100 times Rent    Earned.    Technical    report    Davy    Stockbrokers.    Available at

The great property debate
Sunday, April 15, 2007

With wildly varying predictions about the future of the housing market, The Sunday Business Post asks two experts if there will be a crash.

Yes: Housing market is sailing into a perfect storm
By Morgan Kelly

Now that ‘for sale’ signs have become permanent fixtures on the landscape, and even the dimmest cheerleaders for the property sector have given up pretending that there is going to be a soft landing, it is worth asking how far house prices are likely to fall, and what effect this will have on the Irish economy.

It is hard to be optimistic. Based on the experience of other economies that have had similar bubbles, we can expect the real price of houses to fall by around half over the next eight or nine years, and possibly by a good deal more.

This fall in house prices will cause a sudden collapse in house-building activity, which now accounts directly for an astonishing 15 per cent of our national income.

First we need to dispose of the transparent myth that the boom in Irish house prices simply reflects the strong fundamentals in the market. To see that this is false, we need only look at what has happened to rents. If fundamental demand for housing were strong, we should have seen rents rise along with house prices.

In fact, while real houseprices have doubled since 2000, rents have remained more or less static. You can rent a million-euro house in Dublin for well under €2,000 a month.

Were you foolish enough to buy it, the interest alone on the mortgage would cost more than €4,000. The average rent-to-price ratio in Dublin has fallen to about 4 per cent- a low return on what people are starting to discover to be an asset with considerable fundamental risk and barely above 1 per cent at the top of the market.

This recalls price-earnings ratios at the peak of the dotcom bubble. And rents are likely to fall as vendors realise they are unlikely to sell any time soon and start to let properties to pay some of the mortgage.

By how much can we expect house prices to fall? Looking at 40 housing booms and busts since 1970, I found a remarkably consistent pattern across very different economies (the report, On the Likely Extent of Falls in Irish House Prices, can be seen on my website in UCD).

Adjusting for inflation, housing markets typically give up 70 per cent of what they gained in a boom during the subsequent bust.

For Ireland, where real house prices in the mid-1990s were only 30 per cent of what they are now, this would imply a fall in the range of 40 to 60 per cent.

This is a prediction for average prices: typically properties at the bottom and, especially, the top of the market fare much worse than those in the middle.

Falls of this magnitude are far from unprecedented internationally: both the Netherlands in the 1980s and Finland in the early 1990s saw real house prices fall by half. Unlike stock price crashes, housing busts are extremely prolonged: more like the flooding of New Orleans than a tsunami.

Just as Republican officials kept denying there was anything wrong until the water was up to their necks, we can start looking forward to estate agents telling us that the worst is over; a necessary correction to an overheated market has taken place; there has never been a better time to buy; and so on, until most of them go out of business.

Busts of the magnitude that we are beginning to experience typically last eight to ten years. Assuming our inflation rate goes back to about 2 per cent, a halving of real house prices would entail annual falls in the selling price of houses of about 6 per cent, lasting for about nine years. Aside from the anguish that will be endured by those who have been conned into mortgaging their lives away to buy houses at grotesquely inflated prices, the macroeconomic reason to be terrified of a housing crash is its effect on the building industry.

Most economies, including Ireland until a few years ago, get only about 5 per cent of their income from building houses: less than households spend on recreation.

In Ireland now, house building accounts for almost one sixth of national income. And that is not counting the jobs processing new mortgages, insurance and title transfers; retailing furniture and carpets; advertising houses; or the indirect effects of these incomes on the rest of the economy.

When house building returns to its equilibrium level of 4 to 5 per cent of income, the effect on employment and government finances can only be catastrophic.

Building contractions are sudden: Arizona’s building boom looks eerily similar to ours - between May and November last year, housing starts fell from 8,000 per month to 3,000. Given the recent 25 per cent fall in planning applications, we can expect large falls in employment in the building sector, once current projects are completed.

Contrary to popular belief, more than 80 per cent of building workers are Irish: they are not going to get on a plane to Gdanskand disappear from the unemployment statistics.

Because the Irish economy has come to be based on building houses for all the people that have got jobs building houses means that our estimate of a 50 per cent fall in house prices may be unduly optimistic.

Other economies that experienced large housing bubbles had stocks of houses that were more or less fixed. By contrast, 15 per cent of our housing units are empty, bought by speculators to realise capital gains, while the supply of housing is growing at about 5 per cent a year.

The supply of houses on sale is likely to explode, as speculators scramble to unload the 210,000 empty units they are holding, along with the 80,000 or so new houses that will be built this year.

As this enormous supply collides with falling demand caused by expectations of further price falls, and falling employment in building, Ireland may be heading for a fall in house price that is without international precedent.

Along with our sharp fall in competitiveness and the structural problems of the IT and pharmaceutical sectors, the likelihood of further rises in interest rates, and the possibility of a hard landing for the US economy, the Irish economy is sailing blithely into something that is starting to look like a perfect storm.

Morgan Kelly is an economics professor at UCD.

No: Expectations of a soft landing are realistic
By Pat McArdle

House prices have been rising for longer than most of us can remember.

Since buying a house is usually the biggest financial decision of one’s life, it is understandable that the fear of a collapse in prices is a very real one.

And the reality? In my opinion, we are well on the way to a soft landing, but you would expect me to say that wouldn’t you? Well let me outline my thinking and then draw your own conclusions.

House prices across the developed world have surged since the mid1990s - with the exception of Germany and Japan, which are both still suffering the after effects of spectacular bursts early in that decade.

There is no room for complacency - housing collapses do occur. In fact, someone has calculated that, of the 37 booms between 1970 and 1995, no fewer than 24 ended in downturns which wiped out between one-third and 100 per cent of previous real gains (ie, inflation-adjusted).

This foreign experience provides a handy starting point for some commentators. As booms are usually followed by busts, surely the same fate will befall us.

It is, however, the lazy man’s approach, invariably with no attempt being made to examine the peculiarities of the Irish situation or the possibility that we might have a soft landing in common with the other third of our neighbours.

We will call it the lazy foreign comparison approach. Needless to say, I have little time for it. Another approach could be termed the academic model.

This involves the use of large, frequently complex models such as those developed by the IMF, the OECD and the ESRI, to derive a ‘fundamental’ value for housing. Some such models presented in recent Central Bank Stability reports show that house prices are overvalued by anything from zero to 70 per cent.

In its latest Quarterly Economic Commentary, the ESRI opined that the figure was 15 per cent.

Last year, the OECD produced a model which concluded that prices were 20 per cent too high. It will be immediately obvious from the range of results that something is amiss with this approach.

Data inadequacies and imperfections render such exercises speculative at best.

These limitations and qualifications usually show up in the overall assessments that accompany these studies, but which get less publicity. For example, the OECD stated that ‘‘a soft landing appears the most likely prospect’’ in its synopsis of the study in question. Similarly, the Central Bank concluded that house prices were not out of line with fundamental factors.

The reality is that model-based approaches have yet to overcome data limitations and, indeed, may never do so. Consequently, the margin of error associated with anything they produce is quite large.

All this is not very helpful, but could be summarised by saying that the academic model approach points to some, perhaps modest, overvaluation in the Irish housing market. This is a conclusion which would strike many as reasonable. It does not necessarily mean that a fall in prices is imminent as such overvaluations can be eradicated over time as house prices rise by less than incomes.

The third, and most common, approach is the ‘‘next man at the bar counter’’ analysis. Proponents of this usually look at loan to income ratios and reminisce about the good old days when a mortgage of two and a half times income was the most one could aspire to.

With multiples of five or more times salary now common, it is surely only a matter of time before the roof caves in.

These simple comparisons are still surprisingly common. The first to use them, as far as I can recall, was the Economist Magazine, which concluded in 2002 that prices were overvalued by 42 per cent.

Banks use affordability as the key lending criterion. This captures not only the increase in incomes but also the improvement in affordability that results from interest rates that are still way below the double-digit levels that were common in the past. It also reflects the improvements that arise from the radical overhaul of the income tax system.

These days, a married couple, each on the average wage, can expect to take home almost 90 per cent of their gross earnings. In the late 1980s, the corresponding figure was about 73 per cent. Any assessment of housing which ignores these changes is not much use.

Irish house prices have been static for several months. The annual rate of increase may be 9 per cent, but the monthly rate of increase has averaged less than 0.1 per cent since last autumn. This may partly reflect speculation about stamp duty, but that is only one factor.

The decline in the rate of growth began as far back as last May.

The cause can be traced to affordability and, in particular, to the impact of rising mortgage rates, which squeezed the first-time buyer.

The third major influence was the remarkable response of the construction industry. Unlike Britain, where supply is a problem, Irish builders and developers raised housing output nearly fivefold since the early 1990s.This combination has brought supply and demand finally into balance, with the result that prices are no longer rising.

The three main risks to housing are interest rates, unemployment and oversupply. The first two are not serious risks, given that interest rates are still low and we have full employment.

As regards the third, it seems that housing output is contracting modestly - evidence of a continued flexible response by the construction sector, which realises that a housing slump is in nobody’s interest. So it is a case of ‘‘so far so good’’.

My view is that fundamental economic conditions are broadly unchanged over recent months.

However, what has changed is the reporting of events, with a focus on the downside that was not there previously.

At this stage, the biggest risk to housing may well be confidence. That apart, I believe that the demographic and other influences are such that we can reasonably look forward to a soft landing and, with it, more modest but reasonable levels of activity in the future.

Pat McArdle is chief economist at Ulster Bank.

April 17, 2007

Banking on very shaky foundations
Morgan Kelly
Fri 09 Sep 2007

Economics: [i]While there has been a lot of interest lately in the possible risk to banks from subprime loans, nobody seems terribly concerned by the large and rapidly-growing exposure of Irish banks to property speculators, writes[/i] [b]Morgan Kelly[/b].

Irish banks are now owed almost as much by builders and developers as they are by mortgage holders, and are now more exposed to commercial real estate than Japanese banks were when they crashed in 1989.

While mortgage lending has slowed since the middle of last year, lending to builders and developers continues to grow rapidly and now stands at almost €100 billion, an increase of €20 billion on last October.

To put this in perspective, €20 billion is twice the market value of Bank of Ireland shares; while €100 billion is the approximate value of all public deposits with retail banks. Effectively, the Irish banking system has taken all its shareholders' equity, with a substantial chunk of its depositors' cash on top, and handed it over to builders and property speculators.

In fact, if you leave out the quarter of mortgages that are for buy-to-let property, itself a small-time form of property speculation, lending to developers is now €20 billion more than lending to people to buy their own homes.

In 2000, lending to construction and real estate made up only 8 per cent of Irish bank lending, much like other European countries. Now it has risen to 28 per cent. By comparison, just before the Japanese bubble burst in late 1989, construction and property development had grown to a little over 25 per cent of bank lending.

Increased lending for construction and development is driven by banks' urgent need to meet earnings expectations and is unavoidably risky.

While most home owners will continue to pay mortgages, even with negative equity, international experience shows that developers will walk when markets turn down, leaving banks, and often governments, to pick up the pieces. Diversification for lenders is difficult, moreover: when one developer goes bust, they typically all go bust.

While lending to builders, at €25 billion, is a good deal smaller than the €75 billion lent to real estate speculators, many of the loans appear to be in difficulty already.

During the property boom of the last decade, a mutually profitable symbiosis emerged between banks and builders. Banks would provide lines of credit at a generous mark-up over wholesale interest rates for builders to buy and develop sites, and builders would pay off the loans once they sold the new property, which they were often able to do before a single brick had been laid.

The arrangement between banks and builders was fine so long as sales of new houses did not slow, leaving builders unable to repay loans. Since the start of this year, sales of new houses have not slowed, they have entirely collapsed.

A Dublin estate agent told me that whereas last year they sold more than 3,000 new units, this year they have sold fewer than 100. They are about to try to launch one of their new developments for the third time, the first two launches having netted exactly no buyers.

While the market for secondhand houses still limps along, people have stopped buying new houses because they are afraid that developers will eventually slash prices and leave them with negative equity. They are right.

My contact told me of one heavily marketed development where they have taken deposits on €750,000 apartments and are now anxious to get the buyers to sign contracts so they can cut the prices of the many remaining units to €600,000.

It is ironic that the Government's abolition of stamp duty for first-time buyers has allowed them to escape entirely from the new housing market.

What was intended as a dig-out for the building industry may turn out to be one of the last nails in its coffin.

Given that nobody wants new houses, it is natural to ask who is going to buy the 80,000 or so units that will be completed this year and the 60,000 on stream for next. The answer, though they may not know it yet, is the shareholders of Bank of Ireland, Anglo Irish and other builder-friendly banks.

While we can see banks starting to make a show of turning up the heat on smaller developers, they have lent too much to large builders to allow them to fail. It is one thing to chop a developer off at the ankles if he owes you €16 million; it is quite another to admit that a developer in south Dublin owes you €160 million, let alone to force him into bankruptcy.

Were any one of the several Dublin developers, who are reputedly unable to service any of their large borrowing, to be driven into bankruptcy, the ripple effect on Dublin house prices and the value of other loans would be unpleasant.

Along with the many loans to builders that are already in the non- performing category, the exposure to commercial real estate poses a grave threat to bank solvency, because of the large sums involved and the highly leveraged nature of the borrowing.

Commercial real estate borrowing during booms follows the same pattern everywhere. You put up 20 per cent of the price of an office block or warehouse and borrow the rest. As prices rise, you use the equity gained in the first property as collateral for an 80 per cent loan on a second property and so on, as long as prices keep rising.

In Dublin, the 5 per cent rental yield allowed banks to charge a 5 per cent interest on commercial real estate loans so investors could use rental income to cover interest payments while they sat back and enjoyed double-digit capital gains.

With lending rates based on five- year euro swaps now risen to over 6.5 per cent and rental yields fallen to 4 per cent, new investors cannot cover interest from rent and are entirely reliant on capital gains from rising prices. With commercial property prices slowing rapidly, and loans taken out a few years ago needing to be rolled over, there is a strong risk of a sudden exodus from the market and a collapse in prices.

The large exposure of Irish banks to property speculators does not mean large losses are inevitable. If a crash occurs, or even if already nervous overseas bond markets cut off liquidity to Irish banks (foreign banks have over €400 billion on deposit with Irish banks and hold another €200 billion of bonds), it will be very costly to fix, dwarfing the bailout of AIB in the 1980s.

A partial bail-out of Japanese banks cost their government 10 per cent of national income, while refloating Finnish banks cost its government nearly 15 per cent of national income. In Irish terms this would translate into a €15 to €20 billion bill for taxpayers.

You probably think that the fact that Irish banks have given speculators €100 billion to gamble with, safe in the knowledge that taxpayers will cover most losses, is a cause of concern to the Irish Central Bank, but you would be quite wrong.

At a recent Irish Economic Association discussion of house prices, the Central Bank official in charge of financial regulation (whose publications with the ultra-libertarian Cato Institute strongly oppose any form of bank regulation - a real case of an atheist being appointed an archbishop) stopped the proceedings to announce that the view of the Bank was that, as long as international markets were happy to buy debt issued by Irish banks, there could be no problem with their lending policies.

We can only hope that this insane logic is correct and that the refusal on ideological principle of bank regulators to regulate banks does not lead to the same debacle here that occurred with savings and loan institutions in Reagan-era America.
Head to Head
Monday, October 8, 2007

Are we heading for a property crash?  Morgan Kelly says we can expect prices to halve in real terms over the next few years while  Austin Hughes disagrees, saying we are seeing a healthy, short-term correction in property prices.

Yes - Morgan Kelly:

As the Bertie Bubble of 2000 to 2006 fades into the distance, the question is no longer whether the Irish property market will have a soft or hard landing, but what kind of hard landing it will have. Will prices fall gradually over a decade, or rapidly over two or three years? And as the building industry sinks, will it drag the banks under as well? Property bubbles are nothing unusual: sudden affluence invariably leads to a collective lapse of rationality where people start to believe the utterances of estate agents, developers and other spivs. House prices boom for a while and then, as common sense gradually filters back, fall back to their previous level.

In Ireland between 2000 and 2006, house prices doubled relative to income and rents. Based on what happened after other European booms we can expect prices here to halve in real terms over the next few years.

Ten per cent of housing units in Irish cities are vacant, and almost none of the 70,000 or so new units built this year have been sold: a Dublin estate agent told me that whereas last year they had sold over 3,000 new units, so far this year they have sold fewer than 100. With Dublin house prices down about 10 per cent already, there is a real risk that panic-selling by investors and builders will spark a price crash.

Eliminating stamp duty will not help: so long as there is a large stock of unsold houses, buyers will stay out of the market for fear of further price falls, and these expectations will be self-fulfilling.

Commercial property also looks shaky: investors are now borrowing at 7 per cent interest to buy offices and warehouses that yield rents of 4 per cent. With rising vacancy rates and increasing supply, we can expect sharp price falls.

On the face of it, a fall in house prices should not be a disaster. The value of mortgages to buy your own home is only 50 per cent of national income here, compared with 75 per cent in Britain and the US, and 125 per cent in Switzerland. Massive transfers of wealth from the young to the old in Ireland are a figment of journalistic fantasy.

(Admittedly, mortgages to buy investment apartments and join commercial property syndicates equal another quarter of national income, but the gambling losses of the rich and greedy should not be near anyone's conscience.) But a large minority of borrowers have crushing, unsustainable mortgages and large negative equity will force many borrowers into bankruptcy As competitiveness has fallen, the prosperity of the Irish economy has come to be based on selling houses to each other. Nearly 15 per cent of our national income comes directly from building houses, three times as much as other industrialised economies. Large falls in employment are inevitable as building slows to a saner level, and do not forget that only 15 per cent of building workers are foreign born.

With spending on house building 10 times as large as spending on roads, no conceivable increase in infrastructural spending can compensate for job losses in residential construction.

While housing starts have halved since last year, the surprising thing is that any new houses are being started at all given that few, if any, are going to sell. The reason is that banks are owed so much by large developers that they cannot allow them to fail, and are allowing them to go on borrowing as if nothing is wrong.

Irish banks are now more exposed to property speculators than Japanese banks were when they imploded in 1989. Banks have lent almost €100 billion to developers, compared with only €80 billion to people to buy their own houses.

With no new houses being sold, it is unclear how developers are coming up with annual interest payments of around €6 billion (or 4 per cent of national income). Were one large developer to be allowed to go bankrupt, the value of the land used as collateral by other developers would collapse in value, setting off a spiral of bankruptcies.

The Irish economy is now looking eerily like the Nordic economies in 1992. Norway, Finland and Sweden all had house price and building booms in the late 1980s that encouraged banks to lend heavily to developers. But as house prices fell, developers walked away from their loans and banks collapsed.

The Finnish collapse was particularly spectacular, with unemployment going from 3 per cent to 20 per cent, national income falling by 15 per cent, house prices and share values down 50 per cent, and land prices falling by over 75 per cent. Recapitalising its banks cost the Finnish government over 20 per cent of national income.

While our football and rugby teams have disappointed lately, our builders and bankers may yet do us proud and effortlessly clear the bar for catastrophic avarice and stupidity raised by the Finns nearly 20 years ago.[b] Morgan Kelly is professor of economics at University College Dublin[/b]

No - Austin Hughes:

We are now seeing a marked slowdown in the Irish housing market. For many, familiar only with the exceptional buoyancy of recent years, this is a strange and scary experience. However, it doesn't mean we face a collapse in house prices.

We live in a world where every reversal seems to threaten a major calamity. But not every shower brings with it a flood. Not every cough threatens a fatal ailment. Not every sporting defeat spells catastrophe for the nation. In spite of headlines and hysterics, life usually goes on. Although this is a testing time for the housing market, the risks of a collapse shouldn't be exaggerated.

The main reason why a house price collapse is unlikely is that the key driver of the current slowdown - a sequence of interest rate increases every two or three months since December 2005 - now appears to be at an end. Although the European Central Bank may continue to threaten further increases, falling US interest rates, record highs for the euro against a faltering dollar and weaker business sentiment in continental Europe combine forcefully to argue that the next substantive ECB policy change is more likely to be downwards rather than upwards. Before long, interest rate changes should support rather than soften Irish house prices.

Another reason why Irish house prices should not collapse is a surprisingly sharp and speedy response by builders to softer sales. A substantial drop in housing starts means that the bulk of the current correction in the housing market is likely to occur through weaker activity levels rather than markedly lower prices. If house building falls to around 65,000 units next year, it will keep Irish house prices roughly 10 per cent higher than would have been the case if building remained at last year's levels.

It is sometimes suggested that, even if building is curtailed, the market still faces a problem of too much supply. Without doubt, there are mismatches in terms of location and/or type of accommodation that make for excess supply in some areas. In the near term, this will keep prices soft. However, double-digit rent increases suggest that underlying demand for accommodation remains strong and supply is not excessive. Indeed, compared to most European countries, Ireland's housing stock is still low relative to our population.

While alarmist noises are often made about the number of "empty" houses, last month's IMF report on Ireland shows the proportion of unoccupied dwellings here is slightly below the EU average. A surge in spending power that made ownership of holiday homes and accommodation for children at college almost commonplace is one element in this rise in so-called "empty" homes.

The scale of house price increases Ireland has seen may make some readers nervous. However, the Irish economy has undergone a transformation that is extreme in many ways. If it seems crazy that new house prices are now nearly 50 times higher than they were in 1970, it is even more astonishing that the money value of activity in the Irish economy is more than 70 times greater.

Increased prosperity has naturally translated into more expensive property. A surge in population in the past decade associated with a virtual doubling of employment, a halving of borrowing costs and dramatic gains in after-tax incomes have contributed forcefully to higher house prices. The unique transformation experienced by the Irish economy also means that many simple cross-country comparisons of house price changes can be dangerously misleading.

The slowdown is sharper than I expected. Softer house prices owe a great deal to higher interest rates. However, the fiasco surrounding stamp duties and some doom-laden predictions have also had a significant impact. As a result, there is a strong case for confidence-enhancing measures in the upcoming budget, not to avoid a normal correction in the market, but to prevent unnecessarily nervous conditions persisting through early 2008.

On average, Irish house prices are now around 2 per cent below the levels of a year ago. This conceals a range of circumstances. It is sometimes suggested that a definition of a downturn is when someone else loses their job, whereas a depression is when you lose yours. In the case of the Irish housing market, the personal experience of some would-be sellers may now be approaching what they would describe as a "collapse", but across the market as a whole, the softening is more limited.

The broad slowdown we have seen is, in general, a healthy correction, and in the next few months, softer prices could well persist. However, with better news on borrowing costs, a sensible budget, lower levels of building and a resilient Irish economy, I would be confident that a house price collapse will be avoided. Indeed, a modestly improving trend in house prices in a more stable market should become evident during 2008.

Austin Hughes is chief economist with IIB Bank

No comments:

Post a Comment