Housing Prices - Further to Fall?

A couple weeks ago, The Economist ran a story on housing prices which stated that a number of developed countries (the United States was a notable exception) faced significant decline in prices in order to realign them with long run historical averages.  It included a table summarizing their results (at the bottom, click for a larger image).  The long run historical average used tp determine the implied declines was the price-to-rent ratios, which differ from country to country.  While there is certainly an argument that the long-run average should persist, I believe that there is a much more thought-provoking argument that there may be a structural break in the price-to-rent ratio.

The fact that the long run average price-to-rent ratio differs from country to country forms the basis for my argument.  A number of factors could influence this ratio across countries, such as differences in the difficulty/ease of obtaining financing, differences in marginal utility of owning a house versus renting, differences in available investment opportunities (China?), etcetera.  Each of these factors is in turn influenced by a number of other factors, ranging from the social to the political, with the result being a host of factors influencing the price-to-rent ratio.  The Economist does not give the long run average price-to-rent ratio in each country, but I suspect that it could be quite wide ranging (otherwise they would not differentiate between countries).  Assuming changes in geography dictate a considerable range in price-to-rent ratios, I am positing that the factors which influence this ratio may undergo permanent change over the short term, thereby introducing a structural break to the price-to-rent ratio.  The long term is generally defined as at least 25 years.  Consider the changes in the social, economic and political landscape which have occurred over the last 25 years in some of these countries.  Quantifying some of the relevant measures and crunching the numbers would prove enormously time consuming, but I suspect would add significant value, as The Economist is calling for a significant fall in Hong Kong, Australia, Spain, and France, among other markets.  Let us not forget one of (my) primary takeaways from in Rienhart and Rogoff's "This Time is Different": property market busts are often precursors of financial crises.

Greece Sliding Towards Oblivion

Given the time-honoured trend of bailouts and deals being made during the two day respite from the whims of the markets (also known as the weekend) I was quite surprised that no meaningful news regarding the progress of the Greek bailout was released on Sunday night.  Late last week Greek PM Papandreou formally requested aid and the EU and IMF representatives finally arrived in Athens after being held up by the European resulting from the volcanic eruption in Iceland.  I consider this (lack of news) to be very bad news, and it appears the market agrees with me.  Greek bond yields have exploded (see images below) over the last few trading days, with the 2-year now yielding north of 15 percent! Despite the pledge of 45 billion euros in EU-IMF loans at 5 percent or less, the markets seem concerned that the cash will not be forthcoming quickly enough to prevent a Greek default when their 8.5 billion euro redemption comes due 19 May.  Of particular concern is the provision that the EU portion of the funding must be unanimously approved EU member states, effectively granting each state a veto.  Angela Merkel, in particular has been forced to play hardball in the face of sharp domestic opposition to the bailout, as her party is facing elections in Germany's most populous state on 9 May.  At a recent rally, she was quoted as saying she "want[s] to see the program" before any proposed funds are released.  It is likely that she is simply playing the populist card and looking to score some easy political points with a harsh sound byte and who can blame her?  When as many as 80% of your constituents are against anything, you must at the very least pay lip service to their concerns.  It is reasonable to expect that Germany will not approve the aid package until after this crucial election, leaving very little time for the implementation of the program.

Timing issues and political maneuvering aside, what exactly Mrs. Merkel meant by her comment confuses me, as Greece has already offered a detailed deficit-reduction program to the EU.  Market participants seemingly had a similar reaction.  Then, throwing salt in the wound, S&P downgraded Greece from BBB- to BB+ and Portugal from A+ to A-, both with outlook negative (indicating the possibility of further downgrades in the 12-18 month space).  Not surprisingly PIIGS bond and CDS spreads, especially those of Greece and Portugal, blew out on this combination of news.  With time being of the essence, it appears that the Greek goose is all but cooked.  Restructuring strikes me as the only possibility short of a totally open-ended promise of funding from the EU/IMF - politically a near-impossibility.  If you haven't had the (dis)pleasure of seeing graphically the widening in peripheral bond and CDS spreads, please see the charts below.  Now the discussion over the broader impacts of a Greek default and how to best mitigate them begins...

The Missing Link in Financial Reform

Paul Krugman of the NY Times weighed in yesterday on the need for more meaningful reform of ratings agencies.  This is an area of regulatory reform which has fallen by the wayside, to the detriment of the future stability of the financial system.  The case against the current setup for ratings agencies is quite simple.  Currently, the issuers of debt pay the ratings agencies for their services, and issuers have a choice of which ratings agencies, resulting in agencies having the incentive to 'inflate' the ratings to some extent - as issuers will naturally pay the agency most likely to provide them with the highest rating. 

In the run-up to the crisis, investment banks would shop their structured products to a variety of ratings agencies and pay whichever firm was willing to rubber stamp said products with the highest ratings.  A number of emails have recently made news for highlighting the misconduct at the ratings agencies which resulted from the pressure to give the ratings that the bankers were seeking.  Large scale investors which were either too lazy or lacked the institutional capacity to do their own homework on such structured securities relied heavily on rating agencies to do their due diligence for them, leading to catastrophic losses when the securities experienced heavy losses.  Evidence of the distortions created by these incentives is offered by the fact that over an 18-month period of the crisis, Moody's and S&P downgraded more securities than they had in their respective 90 years of preceding history.  When these securities were downgraded, institutional investors with investment profiles which included minimum ratings thresholds (Ie. most pension plans are only allowed to invest in AAA securities) were forced to sell their securities  into suddenly illiquid markets, thereby compounding their losses, as well as those of others who were marking their assets to market (until the FASB suspended such practices).

Krugman is not convinced that the proposed reforms do not effectively deal with the skewed incentives of ratings agencies it appears that he is right.  Krugman supports the proposition that issuers continue to pay the ratings agencies, but a third party, such as the SEC chooses which agency rates which debt.  This seems reasonable, although I am skeptical of the SEC's ability to fight their way out of a wet paper bag, let alone invent a reasonable process for assigning rating responsibilities.  A similar structure with a more competent 'middle man' strikes me as a reasonable solution to one of the most overlooked shortcomings of our current system.