This time around, US housing is unlikely to threaten the entire global financial system. Having said that, housing will still be a major source of financial pain for consumers, businesses and markets in the months ahead.
Ready to drop
As the chart above shows, from an affordability perspective, today’s house prices are far higher than those of 15 years ago and must fall. The indicator we use for prices, which show price to income ratios for existing buyers, is higher than in 2007-8 which is scary.
The temptation is to see that as a harbinger for a deeper correction - say 25 per cent - that would scare current owners, halt new buying and selling, and curb spending across the board. My feeling however is that inflation will do much of the heavy lifting over the next few years. As prices and wages across the economy rise due to higher than usual inflation, the real fall in value may make up much of the difference and keep the need for this sort of big nominal slide in house prices more limited.
That’s the good news. The bad news is that the impact on consumer spending is likely to be substantial. There are two elements to housing that people underestimate - the first is the mortgage payments, which for new buyers will rise sharply. The second is how rich you feel as a result of the value of your home and, as a result, how much you spend. There’s not much feel-good factor in an environment of rising consumer prices and sluggish or negative house price growth.
Middle-class America will feel the squeeze
The profile and situation of borrowers is also different this time. In 2005-6, as much as 25 percent of all mortgages in the US were adjustable rates (ARM). This time that number is about three per cent. Average credit scores of housing borrowers are much better too - at FICO scores of around 700, most borrowers are in “prime” and “super prime” territory unlike the “sub-prime” crisis of 2008/2009.
That should make the financial system more robust. But it tells us something else about the nature of what is coming. The first-time buyers who get squeezed this time will not be the struggling working class, drawn into buying homes on already tight budgets. Rather it is middle America, with good jobs and shrinking disposable incomes that will take this round of pain. This will get worse as unemployment starts to rise as intended by the Federal Reserve.
Painful, but not systemic
There is one positive to take from this week’s chart. The debt payments being borne by households in general are far lower as a percentage of disposable income than they were going into the 2008 crash. Safeguards put in place by financial sector regulators globally have included much tougher controls on the volume of risk taken by banks who themselves are much better capitalized than what they were in the Global Financial Crisis.
Likewise, the shock of the sub-prime crisis in the US has played a role in keeping Americans more cautious about the risk they take on. In 2006, debt as a percentage of income was around 135 per cent. This time it is 30-40 points lower. Fundamentally, people are less stretched and should be better able to deal with what is coming.
This shakeout therefore will not be like the one we witnessed 15 years ago. The correction will hit consumer spending but not the system as a whole. That will be little comfort to those feeling squeezed by high inflation, higher mortgage payments and the feeling that they are far less secure now than they were a year ago. But it means what is at stake is the depth of the recession rather than the financial system itself.