The Unburst Property Bubble

Brett Arends is in London, and, like most visitors, is shocked at the prices for everything from taxis to houses.

If London real estate is buoyed by the uniqueness of the town’s economy, there is a disturbing degree to which the reverse is also true. This is a ridiculously expensive city to visit. I seem to hemorrhage money with every step I take. I was wondering, as I got out of a taxi the other night and severed the requisite two limbs to pay the fare, how I ever afforded to live here all those years.

The answer is, I couldn’t—even though I earned a perfectly good salary. What made a difference was the money I made on my apartment, which doubled in value between 1997 and 2003. Two years after I sold it, in 2005, it had nearly doubled again. Remove this alchemy from the equation of ordinary Londoners, and the bars and restaurants and theaters would be a lot emptier.

It’s not clear to me how living in an appreciating apartment makes it easier to spend money on bars and restaurants and theaters. In the UK, which was never big on home equity lines of credit, Arends could live off his house-price appreciation in essentially one of three ways. Either he could do periodic cash-out refinancings, or else he could take out an occasional second mortgage, or else he could simply rack up revolving credit and personal loans, safe in the knowledge that he could pay off all that debt when he sold his house and moved back to the US.

All of which helps explain the enormous rise in personal debt in the UK: essentially a very large segment of the homeowning population embarked on a mass conversion of home equity to personal debt over the course of the past decade. Since debt is more liquid than home equity, and since liquidity is a key ingredient of bubbles, house prices started soaring unsustainably.

On the other hand, the UK avoided two aspects of the US bubble: the originate-to-distribute business model, which destroyed underwriting standards; and the soaring ratio between the cost of buying and the cost of renting, which is a huge incentive to default when your home equity drops below zero. What’s more, a lot of the housing bubble in central London, as Arends notes, is a function of properties “bought up by tycoons from Russia, the Middle East and elsewhere”. Those tycoons tend to pay cash, and a bubble without debt is relatively harmless.

Arends asks in his piece whether the crisis is really over, or whether there are other bubbles — like London property — which have yet to really burst. It’s a germane question, and I suspect that his worries are well founded, and that there’s a lot more crisis yet to come. My feeling is that there probably is. On the other hand, the next stage of the crisis might well be slow and protracted, as in Japan, rather than chaotic and devastating, as in 2008. The main difference, I think, lies in default rates. If international capital markets are rocked by another big wave of defaults (Greece, or Spain, or California, or commercial real-estate, say), then we could easily slide back into chaos. On the other hand, if all we see is a long and slow decline in property values in countries where homeowners are still able to pay their mortgages, the next stage of the crisis might take a lot longer to resolve.