07/06/2011: Residential property prices

An impressively decent dataset from CSO on residential property prices has been released for the second monthly installment, so here are the charts and some high level analysis.

• Overall Residential Property Price Index (RPPI) for April was 78.2 or 0.8 points below March levels. Hence, mom the index has fallen 1.013% and is now 1 point below its 3mo MA. Year on year the index has fallen 12.233% and relative to peak of 130.5 reached in September 2007 it is now down 40.077%.
• Overall RPPI has recorded its 8th month of consecutive declines having risen statistically and economically insignificant 0.11%mom in August 2010. Year on year, April marked 38th consecutive month of declines.
  
• April index for houses fell 0.9 points to 81.3, down 1.095% mom, or 1 point below 3mo MA. Year on year index has fallen 12.013%. The peak for this sub-index was reached in September 2007 at 132.0.
• April index for apartments fell to 60.4, down 0.6 points - a mom decline of 0.984% and a yoy decline of 15.288%. April reading was 1.233 points below 3mo MA. This sub-index peaked at 123.9 in February 2007.
• Dublin properties sub-index has fallen 0.5 points in April to 70.5, a decline of 0.704%mom or 12.963% yoy. The sub-index now stands 0.77 points below 3mo MA and 47.584% below the peak of 134.5 in February 2007

Charts to illustrate:
To summarize - the deflation of house prices continues, although the monthly rate of decline has now fallen below both 6mo and 12mo average. This, however, might be due to seasonality, since April marks a relatively moderate month in terms of price movements in every year since 2008. house prices have now fallen 38.41% since their peak, while apartments prices have declined 51.25% from their peak.

It is worth noting - not as a criticism of the CSO, since it cannot do anything about the data - that the index is computed based on mortgages drawdowns, hence excluding any share of transactions that might take place on the 'gray market' (tax evading payments, swaps etc), as well as cash-only purchases and mortgages issued by lenders other than the 8 largest lending institutions from which the data is available.

Another issue, again - little that CSO can do for this - relates to hedonic adjustments undertaken in index computation. Hedonic characteristics used by CSO exclude a number of relevant parameters, such as number of bathrooms and the site size, as well as existence of garage and/or off-street parking. This, alongside with the tendency - due to planning permissions restrictions - to under-report actual floor area and number of bedrooms - means that the hedonic model might be relatively weak.

Finally, CSO employes a Laspeyers-type indexation method, which is "calculated by updating the previous month’s weights by the estimated monthly changes in their average prices". However, like all types of indices, Laspeyers indices suffer from some specific drawbacks. In particular, these indices are weaker in periods of adjustment in the markets. Here's a quick non-technical discussion:

Laspeyers index is designed to answer the question: "How much is the sales price today for the house that is of the same quality as in the base year (2005)?" Quality is compared using the hedonic model mentioned above, based on specific size of the house (floor area), its amenities (number of bedrooms, house type) and location (note - we do not know the granularity of such 'location' adjustment, which can be critical. For example, I live in Dublin 4, but not the "fashionable" part of it. This means that if location code used is D4 for my house, it will receive signficantly higher locational weight relative to true value of my location than a house in a "fashionable" D4 locale.

One key objection to Laspeyers index is that it is computed while assuming that the base year (2005) house remains unchanged over time. Hence, quality is assumed to be constant for referencing, implying the index over-states inflation and under-states deflation.

In addition, index does not capture the effects of substitution in housing. In other words, Laspeyers index does not reflect conversions of house features to substitute away from more expensive options, etc, or purchases shifting in favour of smaller properties.

Index also assumes that geographical distribution of house sales does not change over time - a feature that introduces significant biases into the index when locational markets are not uniform (when there are significant differences within the markets).

Finally, the index overstates price appreciation at the peak of the bubble, since at that point, less desirable properties were disproportionately represented in the market as buyers chased any home available for sale. This is known on the basis of the US data where at the top of the markets 'gentrification' of lower quality locations in many states has led to Laspeyers indices understating price inflation.

For thes reasons, Laspeyers indices are known as 'constant quality' indices.

Chain-linked indexation, employed by CSO, helps addressing some of these issues, but it does not eliminate them. Of course, that too has its drawbacks, namely the more substantial data requirement, plus the lack of index additivity (you can see this indirectly in the first chart above by the gravitational pull of the houses index on overall index.

Economics 29/7/10: PTSB house prices

PTSB/ESRI house price index is in for Q2 2010. The core result: house prices were down, again, by 1.7% qoq in Q2 2010 - a lower rate of change on Q1 2010 contraction of 4.8% qoq. Thus, prices are now off-peak by 35% to an average of €201,364.

Dublin prices are down 3.5% qoq in Q2 2010 and are off 44% relative to peak. This gap between nation average and Dublin, assuming (as seems to be reasonable) that capital prices appreciation prior to the current crisis were significantly affected by underlying demand, should be erased over the next 12 months plus. Which means we can expect at some point that Dublin will lead the recovery across the country, while other regions continue to contract toward the 45-50% nationwide average off-peak pricing.

NCB stockbrokers gave a good comparison to fundamentals-determined prices. Per their analysis,

• Rental yield model implies house prices equilibrium at between €118,000 and €157,000, or a mid-range house price of €137,500;
• Earnings multiples model implies €170,000;
• Present value model (although not detailed as to the assumptions built in) implies the range of €158,000 to €236,000 for an mid-range of €197,000

You can see where these valuations are heading, don't you? Take a full range of estimates mid-range point of €177,000 - that would be a decline of 43% off the peak prices. Take the simple average price of all mid-range points to get 46% decline.

Now, recall - these are equilibrium prices. In normal price adjustments, there is a relatively pronounced undershooting in prices - in other words, we can expect prices to fall below equilibrium levels before reverting toward longer term values over time.

The depth of this undershooting and its duration depend on some external factors, such as the ease of getting mortgages approvals, mortgage conditions etc - none of which are currently helping the housing markets. So there is a very strong possibility for prices to hit the floor at around -55-60% off the peak.

Lastly, there is a question to be asked as to the validity of PTSB's data - the country largest mortgages holder might no longer be the country largest mortgages issuer. And the sample size globally has shrunk substantially. In other words, if a desperate homeowner in the distant province sells a house for, say, €120,000 while a dozen of his neighbors are not braving the market, does this really tell us anything about the market clearing price? Not really. Imagine what the said homeowner would have got for his dwelling if 12 more identical dwellings in the neighborhood had a 'For Sale' sign.

So a grain of salt is due - the size of an orange...

Economics 15/06/2010: Negative equity 3

Here is the third and last post in the series on negative equity based on my TCD speech (see here).

Rising negative equity has implications for financial stability:

Domestic mortgage lending by the major banks represents over x5 times their core Tier 1 capital in the UK and roughly 10 times in Ireland. Even post disposal of its assets (assuming rosy valuations), AIB’s multiple will be over x11 of its risk-weighted assets. BofI – x7-8. And these are the better ones of the Irish banking lot. In addition, around 40% of all outstanding UK mortgage debt has been used to back securities.

Large losses on these mortgage loans and associated securities can erode banks’ capital positions, affecting both lenders’ willingness and ability to lend and, in extreme cases, their solvency.

Both of the above effects can have implications for aggregate demand and the supply capacity of the economy, highlighting the interdependency of financial stability and monetary policy. Again, in the case of Ireland, the two effects are reinforced by the large exposure of the Exchequer to banks balancesheets and to the property markets.

The defining feature of the materialised losses, and their associated economic effects, is the value of debt at risk (loss given default) and the coincidence of that with the probability of default.

Rising negative equity has implications for loans default probabilities:

In economic literature, negative equity is a necessary condition for default to occur since borrowers with positive equity can sell their house and use part of the proceeds to pay off their mortgage. Transaction costs (high in Ireland) and transaction lags (also extremely long in Ireland) act to further increase this effect. For example, a household with positive equity of ca 10% will still trigger a partial default on the mortgage if it takes a year to close the sale (8% funding opportunity cost per annum) and if closing costs add up to 2% of the sale price.

However, negative equity is not a sufficient condition for default to occur, as discussed in “Negative Equity and Foreclosure: Theory and Evidence” by C. Foote, K. Gerardi and P. Willen (June 05, 2008, FRB Boston Policy Discussion Paper No 08-03). Similarly, in the UK, May and Tudela (2005) find no evidence that negative equity increased the likelihood of a household experiencing mortgage payments problems between 1994 and 2002, although their sample does extend over a lengthy period of robust economic growth and rising incomes. The latter two aspects of the sample are not present in today’s Ireland.

But, as Heldebrandt, Kawar and Waldron (2009) highlight, “if a household is experiencing difficulties meeting their mortgage payments, negative equity can increase the probability of default by reducing the household’s ability to make payments by preventing equity withdrawals.” Benito (2007) found that households are more likely to withdraw equity from their homes if they have experienced a financial shock. Negative equity can affect a household’s ability to do that because of credit constraints.

Furthermore, negative equity can increase the probability of default by reducing household’s willingness to make mortgage payments, since defaulting can reduce the debt burden of the household. In Ireland, despite our anachronistic bankruptcy laws, this option is still available for anyone willing to emigrate. You might as well call this www.book-your-one-way-ticket.ie effect, as households leaving Ireland fleeing bankruptcy will have:

1. a very strong incentive to emigrate; and
2. a very strong incentive never to return for the fear of debt jail.

Negative equity may significantly increase the probability of default of buy-to-let mortgages over and above that of owner-occupiers as costs of defaulting on a buy-to-let mortgage may be lower because defaulting does not lead to loss of residence. In addition, buy-to-let mortgages are, at least in some cases, registered via businesses, implying no recourse on family homes and wealth.

Overall, available economic evidence does suggest that negative equity plays a significant role in mortgage defaults:

• Coles (1992) presents results from a 1991 survey of lenders in which a high LTV ratio was frequently noted as an important characteristic of borrowers falling behind in meeting their mortgage payments.
• Brookes, Dicks & Pradhan (1994) and Whitley, Windram & Cox (2004) find that a reduction in the aggregate housing equity in the UK was associated with an increase in arrears.

Overall, Heldebrandt, Kawar and Waldron (2009) conclude that “evidence suggests that the level of household defaults, and the impact of negative equity on financial stability, is likely to depend on conditions in the broader macroeconomic environment”. And Ireland is at a clear disadvantage since the combined macroeconomic shocks (decline in GDP/GNP, rising unemployment and contraction in private sector credit) are much more severe here.

Rising negative equity has implications for the size of the expected banks losses:

When bank borrowers face negative equity, as probability of default and the value-at-risk in default rise, banks have an incentive to stave off the actual mortgage default. To do this, banks engage in:

• Renegotiations of covenants (loans extension, provision of a grace period, interest only repayments etc)
• In extreme cases – joint equity ownership in asset (though banks will usually engage in this type of transactions under regulatory duress)
  

All of these measures aim to put the borrower into a position to eventually repay the loan in full.

However, in cases where default in unavoidable, the loss to be realised by the bank on any given loan depends on the recovery that can be achieved if the borrower defaults. Negative equity, or positive equity that does not exceed the sum of the cost of carrying the loan during the sale, plus the cost of sale, will imply a net loss on the default. From the bank point of view, the problem is not in the actual level of individual defaults, but in the combined level (aggregate) of negative equity net of costs and recovery values.

Such net losses impact not only the actual mortgage book, but also securitised pools that can be held off balance sheet, as current negative equity puts at risk future revenue against which the book is securitised. The end result on mortgage backed securities side is to reduce the value of MBS asset and, as Heldebrandt, Kawar and Waldron (2009) point out this can induce a second order effect of changing risk perceptions and investors’ sentiment “regardless of the actual performance of any given portfolio of loans”.

Both types of losses lead the banks to record write downs on their mortgage books and securities held. If these are large enough, banks’ capital ratios will be reduced.

In the case of Ireland the problem is compounded as the banks are actively delaying recognition of losses on negative equity. These delays mean that banks are likely to pay elevated costs of external funding over longer period of time. In addition, these delays lead to losses compression – the situation where banks recognize significantly larger volumes of impaired assets later in the crisis cycle. Bunching together losses creates a much more dramatic investors’ loss of confidence in the bank.

In addition, negative equity-driven impairments, plus delayed recognition of such impairments lead to suboptimally high demand for capital from the banks. If this coincides with the period of severe credit crunch, monetary policy aimed at increasing economy-wide liquidity flows can become ineffective, as banks park added liquidity on their balance sheets, creating a liquidity trap. This is evident throughout the crisis, but by all possible monetary policy metrics, it is much more prevalent in Ireland, where even today credit available to the private sector continues to contract. Irish banks are hoarding liquidity and are raising lending margins to offset expected, but undisclosed writedowns. This problem is compounded by Nama which induces greater uncertainty onto banks balance sheets through its hardly transparent or timely operations.

Negative equity and generational asset gap:

In Ireland, the problem of negative equity is further compounded by the generational spread of negative equity to predominantly younger, more productive and more mobile (absent negative equity) households. These households today face higher probability of unemployment (thanks to our unions-instituted and supported ‘last in – first out’ labour market policies). They also much deeper extent of the negative equity because of higher cost of financing their original mortgages and entering the housing market.

The generational effects of negative equity are compounded by geographic distribution of the phenomena – with younger households being more likely to reside in the areas of excess supply of new housing, with poor access to alternate jobs, should they experience unemployment.

Finally, it is the younger households that are subject to twin effects of higher probability (and deeper extent) of negative equity and depleted savings (due to high cost of entry into the housing market). This implies that it is the very same households which have the greatest incentive to engage in precautionary savings motive.


So traditionally, economies grow by:

• encouraging the young to acquire new assets (invest and save); and
• encouraging the old to consume (divest out of savings).

With negative equity, Nama and pressured banks margins, Ireland is:

• forcing the better (more productive today and in the future) young to emigrate;
• keeping the remaining young deep in the negative equity (neither capable of investing in the future, nor of moving to find a lost job today);
• underwriting - at the expense of younger, tax paying generations - continued excessive provision of pensions to retired public sector workers;
  
• forcing younger families to cut deeper and deeper into their children education budgets and own training and education funds in order to assure they continue paying on the asset that will never have net positive return on investment; and
• incentivising the old to remain in their highly priced (if only rapidly losing value) homes backed by slacked consumption due to inability to monetize their pensions savings.

In what economics book is this scenario better than any moral hazard problem that can be incurred in the short run by reforming our bankruptcy system to an American-styled 'restart' button?

Economics 15/06/2010: Negative equity 2

This is the second post of three consecutive posts on the effects of negative equity in Ireland.

Negative equity can lead to a reduction in consumer spending, collateral & credit

This can take place via four main pathways:

1. Housing equity can be used as collateral to obtain a secured loan on more favourable terms than a loan which is unsecured. This channel for lower cost financing is cancelled out by the negative equity.
2. Falling collateral values may also affect the cost of servicing existing mortgages if borrowers have to refinance at higher interest rates when their existing deals expire (eg when exiting temporarily fixed-rate or tracker mortgages). That would reduce income available for consumption, which may further reduce demand.
3. Households on adjustable rate mortgages are facing additional pressure of higher banks margins. Since vintages of many ARMs are coincident with 2005-2007 period, negative equity has direct and significant impact on them. Nama exacerbates this impact by forcing banks to up their margins on performing loans, pushing more and more households into not just negative equity, but virtual insolvency.
4. Fourth, falling values of housing equity also reduce the resources that homeowners have available to draw on to sustain their spending in the event of an unexpected loss of income (eg due to redundancy, illness or a birth of a child). By reducing the value of housing equity, falling house prices may lead some homeowners to seek to rebuild their balances of precautionary saving at the expense of consumer spending and investment.
   

Note that precautionary savings are held in highly liquid demand deposits – a fact that I will use below. In general, households with high amounts of housing equity may not respond much to falling house prices, because their demand for precautionary savings balances may already be satisfied through their positive net worth balances on the house. Households with low or negative equity have an asymmetrically stronger incentive to save in a form of short-term deposits.

Rising negative equity can also result in a reduced supply of credit to the economy as a whole:

Negative equity can raise the loss that lenders would incur in the event of default (loss given default) and the probability of a loss. That can make banks less willing or able to supply credit to households and firms.

Per Benford and Nier (2007) Basel II regulations, which require banks to hold more capital against existing loans when their anticipated loss given default rises, can reinforce that.

If credit is more costly or difficult to obtain, households and firms are likely to borrow less, leading to lower demand through lower consumer spending and investment. This, in turn, can lead to reduced business investment.

Expectation hypothesis suggests that negative equity effects on willingness to borrow and lend can extend beyond those immediately impacted as other households anticipate their own asset value decline toward negative equity.

Blanchflower and Oswald (1998) paper showed that a reduction in credit availability may also have some effect on the supply capacity of the economy by reducing working capital for smaller businesses and the capital available for small business start-ups. In addition, a recent (June 2009) paper “Reduced entrepreneurship: Household wealth and entrepreneurship: is there a link?” by Silvia Magri, Banca d’Italia, published by the Bank of Italy (Working paper Number 719 - June 2009) shows that negative house equity can result in reduced entrepreneurship, as many new businesses are launched on the back of borrowing secured against primary residencies or other real estate assets.

Rising negative equity can also result in a reduced household mobility:

Negative equity can affect household mobility by discouraging or restricting households from moving house. Two fathers of behavioural economics, Tversky and Kahneman (1991) argued that households may be reluctant to move because they would not wish to realise a loss on their house. Notice, that our so-called ‘smart’ politicians often claim that negative equity is never a problem unless someone wants to move. Actually, it is a problem even if someone does not want to move, but has to move because of their changed employment or family circumstances.

Tatch (2009) shows that a household in negative equity would be unable to move if they were unable to repay their existing mortgage and meet any down payment requirements for a new mortgage on a different house. This is even more pronounced in Ireland due to the nature of Irish bankruptcy laws.

Hanley (1998) shows that the effect of negative equity on mobility were quantitatively significant during the early 1990s in the UK. The paper estimates that of those in negative equity in the early 1990s, twice as many would have moved had they not been in negative equity. The paper argues that reduced household mobility leads to a reduction in the supply capacity of the economy by increasing structural unemployment and reducing productivity.

Reduced household mobility implies a reduction in the number of households moving home. This can have adverse implications for tax receipts, spending on housing market services and certain types of durable goods as highlighted in Benito and Wood (2005). So as negative equity increases, tax revenues and economic activity in the housing sector and associated white goods sectors falls.

15/06/2010: Negative equity 1

Yesterday, I gave a speech at the Infinity Conference in TCD on the issue of negative equity (see newspaper report here). The following three posts (for the reasons of readers' sanity) reproduce the full speech.

What effects can negative equity have in the case of Ireland?

I did a troll of the literature on negative equity and below I summarize the main findings, relating some to the case of Ireland.

Broadly-speaking there are three dimensions through which negative equity can have an effect on Irish economy:

1. Macroeconomic channels via negative equity impact on aggregate supply and demand;
2. Monetary channels which lead to negative equity impacting adversely banks balance sheets and increasing the cost of default and probability of default for mortgage holders; and
3. Growth channels, which relate to the adverse effects of current negative equity on future demand and investment, and directly on growth.

Here are more detailed explanations of these channels.

Why the problem of negative equity is likely to be greater in Ireland than in the UK

A forthcoming paper “House Price Shocks and Household Indebtedness in the United Kingdom” by Richard F. Disney (University of Nottingham), Sarah Bridges (University of Nottingham) and John Gathergood (affiliation unknown), to be published in Economica, Vol. 77, Issue 307, pp. 472-496, July 2010, used UK household panel data to explore the link between changes in house prices and household indebtedness. The study showed that borrowing-constrained by a lack of housing equity households make greater use of higher cost, higher risk unsecured debt (e.g. credit cards or personal loans). Crucially, when house prices revert to growth, “such households are more likely to refinance and to increase their indebtedness relative to unconstrained households”.

These effects – present in the case of the UK – are likely to be more pronounced in the case of Ireland, because Irish households which find themselves in negative equity today experience much severe deterioration in their net worth base due to the following factors:

• Majority of Irish households have been forced to front-load property taxes into their purchase costs and often mortgages. Thus average LTVs are more likely to be higher here in Ireland, for more recent mortgages vintages, than they were in the UK.
• Ireland has experienced a much more severe contraction in house values than the UK to date.
• Because of significantly higher entry-level taxes, younger buyers in Ireland had to be subsidized more heavily by their parents than their UK counterparts, implying that once true levels of indebtedness are factored in, real mortgages and debts held against a given property of more recent purchase vintage might be higher than those recorded on the official mortgage books.
  

In many cases – we do not know how many, but anecdotal evidence suggests quite a few – credit unions and building societies, as well as non-mortgage banks were engaged as sources of top up loans to younger buyers, implying that once again the true extent of house purchase-related debt in Ireland, for younger households, might be higher than official records on mortgages suggest.

Another recent study, titled “The Economics and Estimation of Negative Equity” by Tomas Hellebrandt, Sandhya Kawar and Matt Waldron (all Bank of England) published in Bank of England Quarterly Bulletin 2009 Q2 looked at the effects and extent of negative equity between Autumn of 2007 and the Spring of 2009. Over that period of time, nominal house prices fell by around 20% in the UK, suggesting that negative equity impacted around 7%-11% of UK owner-occupier mortgage holders by the Spring of 2009.

By now, in Ireland:

• house prices fell down ca50% already (accounting for the swings in terms of premium to discount on asking prices – by closer to 55%),
• vintage of many purchases was much closer to the peak valuations, so
  

for Ireland, estimated negative equity impact is now around 35-40% of the mortgage holders.

Extent of negative equity here is compounded by:

1. High entry costs into the homeownership (100+% mortgages due to stamp duty costs and poor quality of real estate stock);
2. Lax lending – cross-lending by banks and credit unions and building societies;
3. Hidden nature of some of borrowing – parents’ top ups etc;
4. Coincident borrowing – with younger households being more likely to engage in borrowing for a mortgage, while borrowing for car purchase etc.
   

BofI, which holds ca 25% of all mortgages in the country (about 190,000) has reported that of these, more than 20% were already in negative equity (over 40,000) around the beginning of 2010.

The aforementioned Bank of England paper provides a good starting point for outlining the set of adverse impacts that negative equity can have on the Irish economy.

Negative equity can have implications for monetary policy:

A rising incidence of negative equity is often associated with weak aggregate demand as households in negative equity are more likely to cut their expenditures across two channels:

• due to reduced marginal propensity to consume out of wealth; and
• due to increased marginal propensity to save.

The direction of causation is not always obvious, implying a possibility of feedback loops – as households experience (or even anticipate) negative equity, they start reducing their borrowing against depreciating assets, the effect of which is amplified by the banks reduced willingness to lend against such assets. In addition, households rationally interpret these declines in today’s wealth as declines in future wealth, implying greater exposure to pensions under-provision in the future, plus greater exposure to the risk of sudden collapse in earnings (due to, say, unemployment or long term illness). As the result, these households tend to reduce their consumption today and in the future.

The reduced consumption leads to a loss of revenue to the exchequer and thus to additional pressures on future public pensions and benefits provision. This, in turn, leads households to further tighten their belts and attempt to compensate for the risk of reduced future benefits by lowering consumption exposures today.

Negative equity tends to become more prevalent when house prices fall, which usually reflects weak demand for housing, since housing supply is fixed in the short term. In the case of Ireland, this is compounded by the fact that we have severe oversupply of properties in the market. Demand effect, therefore, reinforces supply effect. Once again, in Ireland there is one more additional channel of induced market uncertainty due to Nama operations.

Weak housing demand often coincides with weak consumer demand in general, due to

1. reduced availability of credit to consumers and potential home buyers; and
2. precautionary savings as households respond to decline in their nominal wealth.

If negative equity leads to a further contraction in the availability of credit to both households and firms, as in Ireland – exacerbated in the case of Ireland by Nama – second order effects reinforce first order effects.

Lastly, as negative equity in Ireland is coincident with construction sector bust, we have twin effects of decreased households’ mobility and increased unemployment. This once more reinforces the uncertainty levels in the markets for housing, implying that risk-adjusted negative equity becomes even more pronounced here.

Economics 25/05/2010: Daft rental report

Update below: stabilization or not?

Daft rental report is out today. Some interesting reading of the numbers. As predicted by me on the foot of January data - when the prevailing media song was about 'stabilizing' rental markets - rents are continuing their Southward trajectory.

Relative to peak rent:
So no relief in sight. Remember, in this country we call things 'stabilizing' when the rate of fall slows down... Pardon my foreign language skills, but I'd say things are stabilizing when we reach the bottom. In other words, when the numbers above stop increasing in absolute value.

Let me reproduce for you the seasonality chart I did back on the foot of January data:
You can see what I meant by January rally back then, and you can see that things have fizzled out since then. When one realizes that since 2008 we virtually had no new units coming into the rental market, this figure looks even more depressing. We are experiencing a real decline in demand as jobless families are dropping out not out of the property market, but out of the rental market! Emigration is, no doubt, also playing its part. All of which means that those first time buyers... well, are rapidly becoming first time lodgers in their moms homes.

What about the dynamics going forward?

Well, neither levels of rents, nor rates of change in rents are showing any stabilization. Both series are trending in the negative territory, suggesting that pressure on rents might remain, adjusting for seasonality, for some time. That said, positive monthly territory for now remain in sight, both in moving average terms and in rate of change terms. So expect shallow moves, with a risk to some downside.

Update: Since earlier today, there have been some debates going on as to whether Daft data shows any stabilization in rents. As I asserted earlier, relative to peak, monthly march downward continues (see table above) uninterrupted (once seasonality is factored in for January) and in absolute terms for all 4 months. But what about year on year changes? Table below shows the results:
So per annual changes, 2 conclusions are warranted:

• While the rate of decline has moderated across 2010 relative to 2009, the declines continued in double digits in February, March and April. Only in March and April have the declines been lower than a year ago.
• Probability wise, this was to be expected given seasonal variations, with likelihood of more positive moves in March and April being twice higher than in February.

On the net, I do not see any stabilization so far. Oh, and just in case you wondered - Daft data also shows uptick in properties available for rent... Hmmm...

Economics 29/04/2010: House prices peak to peak cycle

Back in October last year I did an estimate, based on the IMF model, of the peak-to-peak duration of the current housing slump. Now's time to do some updating on this matter.

Assumptions:

• Peak to trough correction in real prices of -40-43%;
• Growth rates - resuming in 2011: 2011-2013 +3.6% - in excess of the long-term growth rate estimate for Ireland in the current GFSR (2.6%), slowing to 3% in 2014-2016, then to 2.7% in 2017-2019 and 2.6% thereafter.

Using peak of Q2 2007 to assumed trough in Q3 2010, we have the full cycle duration of between 95 and 87 quarters, taking us back to 2007 peak by either 2029 or 2031.

If bottom hits at -48%, we get return to 2007 peak by 2034, with 107 quarters from peak to peak cycle.

Now, think Nama will run out in 2015? or 2020?

If Nama sets shut-off date in 2015, it is likely to get between 61 and 70 cents on the euro for each value underlying the loan. Assuming loans LTV of 70% and default rate of 30% on loans transferred to Nama (extremely conservative assumptions, but these allow a cushion on some interest collected), the value of Nama realized book will be 26 cents on the euro and 30 cents on the euro, or less than 50% of the post-discounted price paid!

If Nama shuts down in 2020, the above two figures will be 30 cents and 34 cents on the euro paid or just around 50% of the post-discounted price paid!

Now, that's what I would call overpaying for the loans.

Economics 20/04/2010: IMF report on global financial stability

IMF's GFSR report for Q1 2010 is out today, and makes a fantastic, albeit technical reading of the global financial system health. Ireland features prominently.

First, Ireland, alongside with Austria, the Netherlands and Belgium are the four leading countries responsible for contagion of markets shocks to the rest of the Euro area. Own fundamentals drove, per IMF team, Irish sovereign bond spreads more than those for any other country in the common currency area, dispelling the Government-propagated myth that our crisis was caused by the US and the global financial markets collapse. Chart below - from the report - illustrates:
Between October 2008 and March 2009, Ireland's contribution to cross-Euro contagion was 12.3% of the total Euro area distress probability - second highest after Austria (16.7%). For the period of October 2009 - February 2010, the picture changed. Greece came in first in terms of distress contagion risk - at 21.4%, Portugal second with 18.0%. Ireland's role declined to 8.1% - placing us 6th in the list of the worst contagion risk countries. A positive achievement, beyond any doubt. But again, IMF attributes the entire probability of the risk of contagion from Ireland to the Euro zone down to domestic fundamentals, not external crisis conditions.

This progression has not been all that rosy for the sovereign bonds:
Notice that Ireland's term structure of CDS rates has barely changed in Q4 2009-Q1 2010. Why is that so? Despite the Budget 2010 being unveiled in between, the markets still perceive the probability of Ireland defaulting on sovereign debt in 5 years times relative to 1 year from now as pretty much unchanged. This would suggest that the markets do not buy into the Government promise to deliver a significantly (dramatically and radically) improved debt and deficit positions by 2015! In other words, the Budget 2010 has not swayed the markets away from their previous position, leaving Ireland CDS's term structure curve much less improved than that of the other PIIGS.

Here is another nice piece of evidence. Guess who's been hoovering up ECB lending?
And if you want to see just why Irish banks will be raising mortgage rates regardless of what ECB is doing, look no further than this:
The chart above, of course, covers 2008 - the year when Anglo posted spectacular results and AIB raised dividend. Imagine what this would look like if we are to update the figure to today. Also notice that in terms of return on equity, Irish banks were doing just fine with low margins back in 2008 and before. The reason for this is that our lending model allowed for that anomaly: banks were literally sucking out tens of billions of Euro area cheap interbank loans and hosing down a tiny economy with cash. As long as the boom went on, it didn't matter whether the bankers actually had any idea why and to whom they were lending. Now, the tide has gone out, and guess who's been swimming naked?

Interesting note on the equity markets. looking at historic P/E ratios, the IMF staff concludes that back in February 2010 "For advanced economies, equity valuations are within historical norms". Except for Ireland, which deserves its own note: "Forward-looking price-to-earnings ratios of Ireland appear elevated due largely to sharp downward revisions in earnings projections."

So, read this carefully: Irish stocks were overvalued - based on forecast forward P/Es - back in the time of the paper preparation. Using z-scores (deviation of the latest measure from either the historical average or the forward forecast based on IMF model) for Irish equities are: +2.1 for shorter horizon (a simplified 96% chance of a downward correction) and +0.9 for longer term forecasts (roughly 63% chance of downward adjustment). In other words, the market is overpriced both in the short term and in the long run. Worse than that, we have the highest short and long term horizon over pricing in the world!

In housing markets, our price/rent ratio z-score is +1.1 (74% probability of deterioration), which means we are somewhat close to the bottoming out but are not quite there. How big is the 'somewhat' the IMF wont tell, but it looks like we are still 1.1 standard deviations above the equilibrium price. Price to income ratio - the affordability metric is at +0.8 stdevs, so prices might still have to fall further to catch up with fallen incomes (57% probability).

Economics 21/03/2010: Reckless expectations, not competition

This is a lengthy post - to reflect the importance of the issue at hand. And it is based largely on data from Professor Brian Lucey, with my added analysis.

The proposition that this post is proving is the following one:

Far from being harmed by competition from foreign lenders, Irish banking sector has suffered from its own disease of reckless lending. In fact, competition in Irish banking remains remarkably close (although below) European average and is acting as a stabilizing force in the markets relative to other factors.


I always found the argument that ‘too much competition in banking was the driver of excessive lending’ to be an economically illiterate one. Even though this view has been professed by some of my most esteemed colleagues in economics.

In theory, competition acts to lower margins in the sector, and since it takes time to build up competitive pressure, the sectors that are facing competition are characterized by stable, established players. In other words, in most cases, sectors with a lot of competition are older, mature ones. This fact is even more pronounced if entry into the sector is associated with significant capital cost requirements. Banking – in particular run of the mill, non-innovative traditional type – is the case in point everywhere in the world.

As competition drives margins down, making quick buck becomes impossible. You can’t hope to write a few high margin, high risk loans and reap huge returns. So firms in highly competitive sectors compete against each other on the basis of longer term strategies that are more stable and prudent. Deploying virtually commoditized services or products to larger numbers of population. Reputation and ever-increasing efficiencies in operations become the driving factors of every surviving firm’s success. And these promote longer term stability of the sector.

Coase’s famous proposition about transaction costs provides a basis for such a corollary.

This means that in the case of Irish banking during the last decade, if competition was indeed driving down the margins in lending (as our stockbrokers, the Government and policy analysts ardently argue today), then the following should have happened.

1. Banks should have become more prudent over time in lending and risk pricing,
2. There should have been broader diversification of the banks lending portfolia, with the bulk of new loans concentrating in the areas relating directly to depositor base – corporate and household lending, and a hefty fringe of higher-margin inter-mediation lending to financial institutions, and
3. Banks would be seeking to ‘bundle’ more services to differentiate from competitors and enhance margins.
   

In Ireland, of course, during the alleged period of ‘harmful competition’ exactly the opposite took place. Let me use Prof Brian Lucey’s data (with added analysis from myself) to show you the facts.

Firstly, Irish banks became less prudent in lending – as exemplified by falling loans approvals criteria, and by rising LTVs:

1. Lending to private sector as % of GDP was ca 50% in 1995, reaching 100% in 1998 and rising to 300% in 2009
2. Vast increases in lending to developers: in 1997 there were €10bn lent out to developers against €20bn in mortgages; in 2008 these figures were €110bn and €140bn respectively
3. Over the time when lending to private sector rose 600%, mortgages lending rose 550%, our GDP rose by 75%
   

Secondly, banks reduced their assets and liabilities diversification (charts 1-3 below) setting themselves up for a massive rise in asymmetric risk exposures.

On the funding side, out went customers deposits, in came banks deposits, foreign deposits and bonds and Irish bonds.
Capital ratios fell out of the way.

And so there has been a change in the world of Irish banking that no other competitive and mature sector of any economy has ever seen. Why? Was it because foreign banks started pushing the timid boys of BofI and AIB and Anglo and INBS out into reckless competitive lending?

You’ve gotta be mad to believe this sop. In reality, the Irish banks’ assets tell the story.

Business loans collapsed, personal loans (the stuff that allegedly, according to the likes of the Irish Times have fuelled our cars and clothing shopping binge during the Celtic Tiger years) actually declined in importance as well. Financial intermediation – the higher margin, higher risk thingy that so severely impacted the US banks – was down as well. No, competition was not driving Irish banks into the hands of higher margin lending. It was driving them into the hands of our property developers. We didn’t have a derivatives and speculative financial investment crisis here – the one that was allegedly caused by the foreign banks coming in and forcing our good boys to cut margins on run-of-the-mill ordinary lending. No, we had an old fashioned disaster of construction and property lending.

And this lending could not have been driven by foreign banks. It came from the total expansion of credit in the economy, presided over by our Central Bank and Financial Regulator, our Government and ECB.

Just how dramatic this change was? Take a look at the ratio of private sector credit to national income in the chart below.
Even a child could have seen the bust coming. The reason that our Financial Regulator and Central Bank failed to see this, despite publishing all this data in the first place, is that they were simply not looking. The former probably obsessed with the pension perks, the latter – well, may be because all the fine art in the Central Bank’s own collection was just too much of a distraction. Who knows? But judging by the above chart lack of significant correction during the crisis – we know who will pay for this in the end. Us, the taxpayers.
As chart above shows, the fundamentals for the boom – in lending and in construction – were never there, folks. And the banks missed that completely. As did our regulators and our policymakers. Brian Lucey of TCD School of Business provides evidence on what was really going on in the Irish banks (again, note that some of the analysis below is mine).
Chart above, based on the Central Bank Credit Survey, basically shows the impact three major forces: expectations of increased competition by the banks, improved banks outlook on the Irish economy three months ahead, and LTVs expectations had in Irish banks willingness to increase lending. Scores above 3 represent tightening of credit conditions (as in banks expecting to cut lending to households), while scores below 3 show forces driving looser credit to households.

If the proposition that foreign banks competition pressures drove Irish banks into looser credit supply were to be correct, one would expect the blue line above to reach far deeper into ‘below 3’ scores than the other two lines. Alas, it did not dip. In fact, competition from other banks was recognized by Irish Bankers themselves to be the least improtant factor contributing to credit supply expansion. Instead, their over-optimism about economic prospects (red line) and their willingess to give away cash at massively inlfated LTVs (the orange line – also a proxy for Bankers’ optimism regarding future direction of house prices) were the two main drivers of credit boom.

Where’s the evidence on ‘harmful competition’ that so many Central Bank leaders, the stockbrokers and Government spokespersons have decried in recent past?

The delirium of our bankers was actually so out of any proportion that, as the surveys data shows, even amidst the implosion of the housing markets since early 2008 they were still saying “hang on....we expect that changes in LTV and economic prosoects will cause us to loosen in the next 3 months". In other words, they were chasing the deflating bubble, not the imaginary foreign banks competitiors.

Let’s take another look at Brian Lucey’s data. Take the scores for Ireland in the above surveys and take their ratios to the Euro area average scores. If the ratio is in excess of 1, then the said factor has contributed to greater tightening in credit supply in Ireland than in the Euro area. If it is less than 1, then the said factor has contributed more to loosening in lending in Ireland than in the Euro area.
So, really, folks, competition in Ireland was actually more of a stabilizing force, than de-stabilizing one. LTV’s optimism and lack of realism in economic forecasts were the two main driving forces of the boom.

Lastly, ECB Herfindahl Index (ratio of Ireland to “big5” EU states) provides exactly the same conclusions:
Again, what above shows is that on virtually every occasion, Irish reading for Herfindahl Index (measuring degree of concentration in banking sector) is in excess of the average Index reading for top 5 EU countries. In other words, there was no such thing as ‘too much competition’ going on in Irish banking sector. If anything, there was somwhat too little of it, compared to Germany, France, Italy, UK and the Netherlands.

And now, for the test of all of this. The chart below regresses each survey factor on the private sector credit index. The negatively sloped line – for LTV and economic prospect factors combined - shows that when this factor scoring in the survey increased, lending became tighter. Positively sloped line – for competition – shows that when competition pressures rose (factor reading declined), lending actually got tighter. And the statistical significance of the LTV and expectations factors is more than double that of competition...
Let’s just stop talking nonesense about too much competition in Irish banking sector drove unsustainable lending. More likely – an anticiaption by our bankers that no matter what they do, they will never be allowed to fail by the state, plus an absolutely rediculous expectations about opur economy drove our banks to the brink.

Economics 26/01/2010: House affordability in Ireland

Demographia International issued Housing Affordability Survey: 2010 (based on Q3 2009 data) (hat tip to Ronan Lyons).

Couple of interesting points highlighted below:

1. Irish dynamics are improving, but not fast enough; and
2. International evidence suggests that land (site) value taxation might be a better way of cooling the overheating markets than draconian planning and regulatory restrictions on land use.
   

The ratings are based on a house price relative to a median multiple of income, with table below showing the relative categories.The authors use gross median income, which, of course implies that taxes are not considered to be an impediment to affordability. Now, Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States are the markets considered, and in general Ireland stands out as the higher tax economy here.

The ratings are based on major urban centres' data for 272 markets surveyed across the countries listed above.

For the entire sample, the study found that in 2009 there were 103 affordable markets, 98 in the United States and 5 in Canada. None in Ireland.

Note that of 5 regional markets surveyed for Ireland, 3 were found to be moderately unaffordable and 2 were seriously unaffordable.

In other words, we are still way off from actually reaching affordability that would be consistent with our house price declines and income uncertainty (ca x2.5-2.75 multiple). Or, put differently, we are far away from getting support for this property market.

But what about regional variation?
Now, I am not going to pass a judgment as to whether Limerick is more desirable than Cork or Galway... One has to enjoy though a comparative: Limerick is ranked next to Portland (Oregon). I had a laugh. Galway is between Sacramento (California) and Austin (Texas). Cork is ranked next to Atlantic City (NJ) - somewhat reasonably, but more expensive than Quebec in Canada. Waterford is, apparently, comparable to Philadelphia and Tucson Arizona. Hmmm...


An interesting chart: relationship between housing affordability and land regulation. Notice the reds - these correspond with more prescriptive nature of land regulation - regulation based on more planning, stricter planning and more state/local authorities' controls. Predictably - greater controls, higher prices, lower affordability.
Unfortunately, I cannot tell out of this chart or the discussion in the report as to what exactly comprises prescriptive model of regulation. Only a glimpse:

"Severely Unaffordable Markets: There were 62 severely unaffordable markets this year, down from 64 in 2008. The least affordable markets were concentrated in Australia (22) the United Kingdom (19) and the United States (11). Nine of the 11 US severely unaffordable markets were in California. There were 5 severely unaffordable markets in New Zealand and 5 in Canada (Table ES-3). However, many of these severely unaffordable markets have experienced steep price declines in the last year. Among the major markets, Vancouver is the least affordable, with a Median Multiple of 9.3, followed by Sydney (9.1), Melbourne (8.0), Adelaide (7.4), London (7.1), New York (7.0) and San Francisco (7.0). As in the past, all of these markets were characterized by more prescriptive land use regulation (such as “compact city,” “urban consolidation,” “growth management” or “smart growth” policies), which materially increase the price of land, which makes housing unaffordable."

This is interesting, for it really does suggest that some other means - other than direct regulation/rationing of land - must be used to cool the markets at the times of excess demand. Not a restriction on supply, but, perhaps, a reduced incentive to speculatively invest in land? Indeed - bring on land (or site) value tax...