In an episode of Dallas, where Ewing Oil was over-exposed in its debt-to-equity ratio, JR told the family not to worry. "Now, daddy, everyone knows the price of oil never goes down," he said. It did, and the company suffered.
The same certainty almost always portends similar crashes. Everyone knows the price of houses only goes up. But because of that certainty, rational exuberance takes over. Lenders are less concerned over borrowers repaying because they can readily foreclose to retrieve their debts. Hence, they go looking for less than credit-worthy borrowers or lend too much to otherwise credit-worthy borrowers.
For their part, borrowers have observed a long period of rising house prices and are ready to really stretch themselves. They figure they will have paid off the worst of the load in the next few years and that rising prices will have ensured they have sizeable equity in their homes. Many will repeat the process two or three times over a dozen years.
This sort of ponzi game can only persist if there is a genuine one-way bet. Even then, market participants will eventually anticipate it, repackage it and sell it forward until it no longer applies.
Governments, infected by ideologues calling for "smart growth" of cities and addicted to the revenue that rising house prices bring them, have limited land for housing, thereby conspiring in the creation of the apparent one-way bet. In half of the US, like all of Australia and Britain, governments ration housing land, artificially stimulating the price.
And, anticipating the gains to be made, lenders plumb the depths of potential borrowers to recruit new sources of revenue into their fold. Hence, in a case of masterly understatement, we have the "subprime" borrower.
But in US cities such as Detroit, St Louis, Cleveland and Atlanta, there are no regulations restraining the use of land for new housing. In those cities there is no automatic escalator ratcheting up prices by limiting supply. Poor analysis of the cause of house price increases by some lenders failed to distinguish those US markets where prices have been remorselessly increased, because supply has been restrained, from those where such restraints are not significant.
Higher interest rates meant softer house prices in those US markets where new houses can readily be built. A rise in costs led to some people walking away from homes that were worth less than their debt. Mortgage companies were forced to sell the houses, creating further market distress and compounding softening prices. This required lenders to restore their liquidity standards by a more aggressive pursuit of wayward debts, lending restraint and selling of other assets.
Some lenders claim they are not exposed to the subprime market, where the difficulties began. But, in their hearts, they know that's wrong -- interconnectedness is the basic characteristic of financial markets. Like any house of cards, once a tremor occurs, the debt-fuelled financial market structure falls.
In the new-house market, demand is depressed by the lending companies' need to restore liquidity, which means courting fewer loans (raising interest rates or requiring better collateral). Other sectors of demand will also be affected as home owners realise they don't have as much surplus equity as they thought.
Markets next to the sectors where prices are falling are the first to become infected. Prices fall in the housing market generally because this is most closely connected to the most vulnerable subprime part of the market. Those exposed also have to restore liquidity by selling other assets. Hence the sharemarket crash.
The root cause of the present crisis is loose money. The US has been reining in the growth of money supply over the past year or so and this policy correction has first hit the most exposed and vulnerable part of the lending market. It is now being transmitted to all parts of the market.
Australia still has some way to go in correcting excessive money supply growth. The Reserve Bank considers itself to have been skilfully ensuring a strong economy while keeping inflation down. But it has been fooled by inflation shifting into houses, where it is only partially recorded in the normal inflation measures. Money supply growth in Australia last year was 14 per cent. It was 10 per cent in 2005-06.
The US sharemarket collapse in 1929 and the associated failure of the Creditanstalt Bank in Vienna in 1931 demonstrate the interconnectedness of financial markets across all continents. Nobody is suggesting a repeat of the Great Depression as a result of the oversupply of credit and its direction into housing. But there is plenty more financial distress to come and an impact on real markets for all goods and services.
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