US Recession

It has been my view for some time that the US is about to enter a recession. A major cause of this is house prices, which are now falling. As house prices fall, house owners feel poorer, and so reduce their consumption. But that is only part of the story. In addition, some home owners will no longer be able to pay their mortgages, and will potentially loose their homes. This is likely to spill over to the economy more broadly: anyone who "owns" mortgages (financial institutions, hedge funds, etc) will be poorer as a result.

Here in Hong Kong, we are no strangers to falling home prices. Between 1997 and 2004, the price of residental real estate fell about 70%. But things could have been much worse. The maximum a bank will loan, based on the value of a property, is 70%. This ensures that owners have a significant cushion of wealth if prices should start to fall. Without this cushion, prices would have fallen further and faster, and major financial institutions in Hong Kong would have been likely to fail as owners defaulted on their loans.

In the US, financial instutitions have applied a much more lax standard. Home owners were able (at least until recently) to borrow up to 100% of the value of a property, and in some cases make monthly payments that were less than the interest on the mortgage, implying that the size of the loan outstanding actually grows over time, rather than shrinking! (See, for example, this story on Bloomberg http://www.bloomberg.com/apps/news?pid=20601087&sid=a8ilcv.eOxMc&refer=home). This practice is foolish at best, and suggests that prices may come down a long way before they stabilise. If it is very easy to buy a home due to lax credit requirements, the demand for homes will be relatively higher, pushing up prices in the first place. Then, when the correction comes and home prices start to fall, the number of people who loose their homes will be much larger, and so the supply of homes will increase much more than it otherwise would have, driving down prices further. In short, very easy credit implies very volatile prices. I won't be surprised if house prices in the US fall by 20-30% in the coming 2-3 years.