Churchouse Letter
August 2012           by Peter Churchouse

Housing Policy—the Root of Many Modern System Failures

Real Estate-related stocks make up a surprisingly small proportion of total global stock market capitalization

Inside This Issue:
Subsidized housing policies in the West constituted a fundamental root cause of the financial crisis — is Asia following the same path?
An Olympic London — a trip to the capital provides an opportunity to re-examine the London Property Market.
A trip to Oregon with Newport Asia LLC: a reminder of back to basics value investing and patience.
Portwood Portfolio: upsizing our tech position and US Inflation, buying some downside protection, and a look at our Fixed Income Portfolio.

First year economics students are taught that all forms of economic activity involve three basic inputs – land, labour and capital. The amount of each varies greatly of course across economic endeavors of all kinds. That garage tech startup involves a land (a garage), capital (a computer at the very least) and labour (the geeks) – in this example intellectual property is the core ingredient in the mix. Farming in environments like Myanmar, for example uses lots of land and labour but precious little capital. Industries such as banking use lots of expensive property, lots of technology and a lot of expensive labour. Many industries in developing economies can offer access to cheap land and labour for activities that may not need a great deal of expensive capital.

Real Estate Sector is Under Represented in Global Equity Markets.

Given that pretty much most of the world’s population lives in houses of one kind or other, and the majority of the world’s workers work in factories, offices, shops, hotels, schools, the “land” based component of the world’s economy is strangely under-represented in the capital markets. Total market capitalization of the world’s major stock markets totals more than US$45 trillion (World Bank: 2011). Add up the total market capitalization of all the listed property companies in the world, including REITs, developers and including agricultural entities, the total is less than US$2.5trillion, a very small proportion of the total. For an industry that is so capital intensive – it takes a lot of cash to construct building’s – it is perhaps surprising that capital markets have not been tapped more to fund the world’s housing and commercial property markets.

Property Sector is Better Represented in Asian Markets Than Elsewhere.

A great amount of property around the world is privately developed and certainly privately held. Only a small part of the office stock of the world’s major capitals is owned by listed real estate companies or REITs. For most countries the great majority of housing stock is built by private companies and private individuals, not listed companies. That is slightly different in Asia where a much greater amount of private housing is built by listed companies. In Singapore and Hong Kong the vast majority of private housing is developed by listed companies, and that is rapidly becoming the case in China also. India, despite some 10 or more years of liberalization has a surprisingly small listed developer sector. Similarly in other large population markets such as Indonesia, Philippines, Thailand, Malaysia, the numbers of listed housing property development companies is small as is their share of total housing production.

In certain areas of Asia, the vast majority of residential real estate is developed by listed companies.

For most western countries private home ownership is in the vicinity of 55% - 70%. Of the balance some is public or alternative subsidized housing, but even the private sector component is not widely held in publicly listed vehicles. Most Asian countries are moving towards a similar pattern of home ownership, often highly encouraged by public policy. And herein lie potential systemic problems.

Housing as a Basic Human Right.

Everyone on this planet needs housing just as we need food, and shelter has been declared a basic human right in a variety of globally sanctioned forums.

“Everyone has the right to a standard of living adequate for the health and well-being of himself and his family, including, clothing and shelter….”
 - Article 25 of the Universal Declaration of Human Rights.

Very few of us would argue against such a proposition. More recent gatherings of worthies have re-affirmed and enhanced this basic premise through the Habitat Agenda and the Vancouver Declaration on Human Settlements.

“Homeownership lies at the heart of the American Dream. It is a key to upward mobility for low – and middle – income Americans. It is an anchor for families and a source of stability for communities. It serves as the foundation of many people’s financial security. And it is a source of pride for people who have worked hard to provide for their families.”
 - President George Bush, June 2001.

“My primary preoccupation was to give every citizen a stake in the country and its future. I wanted a home owning society.”
 - Lee Kwan Yew, Prime Minister of Singapore.

Housing or shelter as a basic human right, versus homeownership as a socio-political ‘right’.

It is not the issue of housing as a basic human right that is the problem but the widespread transformation of this basic right into a political tool centred on devices to encourage and subsidize home ownership. This a big leap from the concept of the right to adequate shelter.

In fact for some countries the basic right to shelter seems to have migrated to a right to public assistance for home ownership.

Housing is expensive. This is an almost universal phenomenon. When did you ever hear anyone NOT complain that housing costs are too high. It is the nature of the beast, and particularly in large urban areas where there are many competing uses for land and the desire to live in reasonable proximity to workplace creates demand pressures on a location basis.

In any society there will almost always be a strata of society for whom even the lowest cost accommodation in the private markets is unaffordable. This clearly speaks to the need to provide some form of assistance to house such people, but this is a very different proposition from subsidizing people to own a home.

Most countries around the world provide some form of subsidies for encouraging home ownership, way beyond simply providing shelter for the poor or needy via government supported housing for rent. There are many justifications given by governments for provisions of subsidies to own housing. Some are more social, some are economic, but underneath it all, the skeptic in me thinks that political motivations carry more weight in the minds of politicians than all the social hyperbole and labored economic theory.

Promotion of Subsidized Home Ownership Seems More a Vote Gathering Strategy Than Sound Economic Policy.

To be on the political hustings promoting policies to make home ownership easy, at the expense of the taxpayer generally, is a big vote winner.

As the run-up to the housing bubble and subsequent crash in the US showed, pro-homeownership politics is difficult to oppose or even assume a measured and sensible opposition to.

“From a sociological point of view, home ownership is believed to promote community-based values, nurture respect for law and order, and provide a stake in the stability and prosperity of the system. From an economic point of view, the hopefully steady appreciation of home values, the main asset held by a household, can provide the basis for a continuous increase in consumption, the driving force of the US economy.”
 - Ashok Bardham. “Housing and the Financial Crisis in the US: Cause or Symptom?” September 2009.

The first part of Bardham’s contention here is hard to prove or quantify, but some research does tend to confirm these assertions. (We will come back to these later). It is the second part that draws attention in the context of financial markets. Two aspects deserve attention.

First the “steady appreciation” thesis has two components, steady and appreciation. The first alludes to a belief that house prices will continually go up. That is a statement that springs more from hope or wishful thinking than from fact. Prices of ALL assets can go up as well as down, real estate included. Our readers will have noted our earlier work demonstrating that over the long term real estate prices have typically gone up and have beaten inflation, but there can be significant periods of down drafts. Asian markets in particular have been very prone to such ups and downs in property markets.

Then there is the notion of “steady” increases, but steady against what? Inflation? Or in absolute nominal terms, real terms? Over the decade leading up to 2007 house prices in a great many western countries ran up at a rate that could hardly be described as “steady”, with increases often multiples of inflation, or multiples of GDP growth.

Second is the assertion/hope that increases in house prices will underwrite a “continuous increase in consumption”. Isn’t that where a good part of the current crisis emanated from? – households in the US indulging in ever increasing rounds of re-financing of their properties to buy holidays, computers and TV’s and the like. That is borrowing for consumption, spending on consumer goods beyond one’s underlying means.

This is the outcome that successive US governments actively encouraged via housing ownership and financial policies. In effect, government policies in housing intended to underwrite the great consumer society via ever increasing levels of leverage at the consumer level, which ultimately was laid off to institutions all around the world by all those clever credit derivatives.

The question of “cause or symptom” – this is a nice literary device, but it should seem abundantly clear to anyone that housing policies that encouraged home ownership for people who could not fundamentally afford to own, and the encouragement of ever increasing debt on housing to fund consumption are root causes, but not the only ones, of the current financial crisis that engulfs the world.

Promotion of home ownership by governments around the world were traditionally predicated mainly on issues of social and community values, sense of belonging, creation of vested interests in community stability and so on. For the most part the economic/financial dimension to housing policy in most nations has been restricted to issues of tailoring and structuring mortgage finance and some discussion of the long term wealth and financial security aspects of home ownership for families. Mention of broader economic and financial implications of home ownership have come about much more recently in the policy meanderings around the world.

IMF Indicates Property Busts Hit Consumer and Business Confidence Way More Than Stock Market Crashes.

For example more recently discussion has opened up on the role of housing and home ownership on the broader health of local economies. Major corrections in house prices often seem correlated with downturns in domestic consumption, consumer confidence and general business activity. Cause or effect? Studies by the IMF suggest that the impact of falling house prices on an underlying economy is considerably greater than severe falls in equity markets. Certainly in Asia over the years, we have seen very sharp falls in domestic consumption, retail sales and general business activity during sharp falls in property prices. But I cannot claim to know definitively whether the economic contraction is caused by the bust in the property market or vice versa.

Having lived in Asia for many years, we can question the IMF findings on this subject from our own, albeit anecdotal experience. A crash in Hong Kong or Singapore’s stock market certainly does seem to be accompanied by a general pull back from the consumption trough by the local population. Perhaps this is to some extent due to the fact that ownership of stocks and trading of stocks is a very much more widespread activity than perhaps it is in most western societies. As an analyst who has been around the traps quite a long time I am forever getting asked by taxi drivers, hotel doormen, shop and stall keepers my views on the market, this stock or that stock, the outlook for the local property market.

Current Crisis Will Force a Deeper Look at Wider Ramifications of Subsidized Home Ownership Policies.

The whole policy discussion surrounding policies promoting home ownership is likely to broaden out substantially as a result of the global financial crisis that had its roots at least initially in the collapse of the US mortgage financing structure. Fig. 1 demonstrates just how severe the subsequent downturns were in various countries. Policy makers, politicians and academics have tended to focus only on the good outcomes of widespread promotion of home ownership around the world, without much focus on the potential risks of such policies. Those risks have been laid bare in no uncertain terms in the past five years. And there are a range of subjects and angles that will be more closely examined:

Political and academic discourse regarding the promotion of homeownership has centered more on benefits rather than risks.

  • The very underpinning of social policy engineering that holds that everyone has the right to be subsidized to own their own home even if the ability to afford is questionable.
  • The fact that so many people have been hurt by climbing on to the housing bandwagon, at the behest of their elected representatives, and then to be forced into the streets under foreclosure, may make politicians stop and think whether this is such a great vote-buying strategy as has been implied hitherto.
  • Policy has encouraged banks and others in the loan business to sharply cut lending standards in order to achieve housing ownership goals, and the taxpayer is paying the costs of that.
  • The world of finance is much more international than it has been in the past with flows of capital from many different parts of the world ending up funding housing loans in many other parts of the world, providing much greater access to liquidity than was the case historically when only local domestic savings/bank deposits could be drawn on to fund housing markets. Deregulation of financial markets has been a major factor in housing finance in the past 15 years.
  • Recent recessionary conditions may in fact prove negative to home ownership insofar as high unemployment and falling wealth may well increase wealth gaps and discourage home ownership, with a shift back to rental rather than ownership. The outcome of flawed home ownership polices may be to increase pressure on governments to provide more low income subsidized rental housing, placing furtherstrains on stretched government finances.
  • Unintended consequences: Bringing a wider range of lower income families into the home ownership net may in fact increase insecurity and risk for such households in a time of economic slowdown or shock. Provision of government subsidized rental accommodation would likely produce less risk to financially vulnerable families.
  • Demographics are changing with many societies, even in Asia, facing ageing populations which will change the dynamics of demand and supply of housing. In Asia, families in many countries face high costs of education, health care, inadequate retirement income support schemes, poor social welfare safety nets, and as such, these factors may well impact the choice or ability for homeownership

Very few commentators have really questioned the underpinnings of promoting homeownership as a broad social objective. Morris Davis in an article published in Policy Analysis, May 2012, does so on a variety of grounds, with reference to the US home ownership subsidization situation. His arguments make the following points:

  • Over the past 40 years, home ownership rates have not moved appreciably, despite powerful home ownership policy initiatives (see Fig 2 below). Ownership rates have fluctuated from around 64.2% to a high of 67.4% in 2000, falling to a touch below 67% now. So policies seem to have been ineffective in raising home ownership levels in the US.

The U.S. rate of home ownership is roughly flat over 40 years despite aggressive policies.

American politicians and its central bankers and regulators have a lot to answer for. But hey seem to continue to exhibit all the characteristics of “Willful Blindness” so well described in Margaret Heffernan’s excellent book of the same name.

  • The mortgage interest payment tax deduction Davis demonstrates “is a subsidy for homeownership enjoyed by relatively high income earners who, in the absence of a subsidy, should not have trouble buying a house.” Lower income owners enjoy relatively lower benefits from mortgage interest tax deductions. So tax deductions are helping higher income earners much more than lower income homeowners.
  • There is considerable argument that Fannie and Freddie (the GSE’s) have encouraged home ownership via lower mortgage interest rates, which the literature argues to be between about 7bp and 25bp compared to a 30 year fixed rate mortgage in the absence of the GSE’s. The fact of the matter is that long term structural changes in the trends of interest rates have been far more important than this small spread between the two rates.
  • Cost to the U.S. taxpayer of homeownership subsidy policies—approximately US$2.5 trillion

  • Moreover, the fact that homeownership rates have been largely constant over a period of the last 30 years when mortgage rates have fallen from around 10% to around 4% suggests that homeownership is NOT correlated to mortgage rates in any event.
  • The argument made by politicians that promoting home ownership creates valuable construction jobs has to be a fallacy. Construction of ANY housing whether rental housing or ownership housing will produce construction and other related jobs.
  • On the supposed intangible, “soft” impacts of homeownership – that home ownership creates stable, responsible communities - Davis makes the point – “ other intangible benefits are likely to be correlated with home ownership and not caused by homeownership” . “ …we expect that homeowners will tend to move less frequently than renters, which will make mostly-owned-home neighbourhoods appear more stable than mostly-renter neighbourhoods.” “ Home ownership will therefore be correlated with neighbourhood stability but might not necessarily cause it”. That old chestnut – correlation does not mean causality!
  • Finally, Davis argues that the cost to the US taxpayer of the two core housing ownership policies – subsidization of mortgages through tax breaks, and the subsidization of Fannie and Freddie’s activities amount to around US$2.5 trillion on a present value basis.

Policy Makers Around the World Will Likely Continue with Policies to Subsidize Homeownership in Various Ways – Asia Included.

However, despite the painful consequences of these policies, when all is said and done, we will still probably find that western countries will continue to find justifications for subsidizing home ownership. But we should hope that the systems change to prevent the worst excesses of subsidization that have brought collapse and dire consequences to whole financial systems...

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