December 22, 2005

Wonk alert - Excellent read from PIMCO bringing together many of the topics we've been discussing: BW2, MEW, Yield Curve, Fed, Rent PE, Housing Bubble


For the West Wing and obscure economic theory book crowd amongst Housing Panic readers, this is an excellent analysis from PIMCO's Paul McCulley on some of the topics this blog has been involved in during the past few weeks, namely the interconnected role of BW2, the trade imbalance, the yield curve, rent PE, the housing bubble, and mortgage equity withdrawal (MEW).

Try to get through it - in my opinion, besides the Economist's article on The Biggest Bubble Ever, this write up does an excellent job of tying it all together. Hat-tip to HP reader GD for the link

Here's a few selected highlights for the crib-notes crowd:

If Fed-engineered changes in nominal rates no longer reflect changes in long-term inflationary expectations, but rather changes in real rates, then logic suggests that long-dated income-producing assets – bonds, stocks and real estate – will become inherently more prone to bubble and burst.

I’m not persuaded that the Fed has reached that level of enlightenment yet, even as its contemporaries on foreign shores have moved decidedly in that direction. (look what's happening and being said in New Zealand by contrast, where rates are going up fast in order to get a hold of the bubble there)

And downward pressure on real long-term interest rates is the stuff of asset inflation, notably for long-duration assets and in particular, property.

Rightly or wrongly, most Americans look at MEW (Mortgage Equity Withdrawal) as the closest thing there is to a free lunch: home prices magically go up, generating unrealized capital gains, which can be magically monetized, if not realized, by borrowing against them.

It’s not really free, of course, as homeowners must pay interest on the debt that extracts the equity. They are also exposing themselves to intensified risk of declining home prices, just like people who put increased margin debt on their stock portfolios. But it’s fun while house prices are rapidly appreciating, enabling consumers to increase their spending faster than their paychecks

But ultimately, there is a limit to how high the price-to-rent ratio can go, because as the ratio increases, fewer prospective home buyers have sufficient income to support the debt necessary to pay asking prices, particularly when mortgage interest rates rise

That’s called declining affordability, and it will ultimately bring any bubble in house prices to an end, undermining the MEW game

But once the momentum breaks – and again, Morgan, declining affordability is the fundamental break – reflexive demand becomes reflexive supply, as former speculative buyers become eager sellers. That’s what we expect in the year ahead

When the American property market comes off the boil, maybe turning tepid, the world will feel the impact, not just American homeowners



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Nathan said...

That was an interesting read. Thanks for passing it along Keith.

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