June 2, 2008
When financial booms are followed by busts, there are usually distinct developments.
The other day, a stockbroker told me that, in the last month, it is as if ‘‘someone has pushed the accelerator button on the downturn’’. He was trying to sum up the feeling in the financial community as the economic data – which the ‘‘economic fundamentalists’’ who cheerleaded the boom were telling us was robust – turned out to be marshmallow soft.
Across the board, from tax revenue to unemployment and company insolvencies, the evidence of an accelerated slump is everywhere. Bank lending has dried up and house prices are in freefall, as confirmed by figures last Friday showing a sharp 1.1 per cent monthly drop in April.
There are no buyers. This negativity has been accompanied by the rumour mill of imminent bankruptcies. The same lad was at the Heineken Cup final in Cardiff last weekend and told me that the conversations among the attendant brokers and bankers centred on speculation about who was next.
The gossip, innuendo and tittle-tattle about which ‘big player’ is about to go under is only human nature. It is the mirror image of what was happening in the boom, when the gossip centred on who was making what, how ‘mega-deals’ were being put together and how such and such was ‘worth’ this or that amount.
Put simply, mass greed has been replaced by mass fear. Everyone is terrified of the financial equivalent of the KGB knocking on their door in the middle of the night. Meeting your bank, which only last year was an exercise in ego-massage and financial back-slapping, is now about as enticing as a chat with Josef Stalin.
Given the rapid change in sentiment, it is probably worth looking at other financial rollercoasters to assess what we are likely to face for the next few years. Looking at a number of experiences in other countries, we find financial booms that are followed by busts always lead to three distinct developments.
The first is financial scandals, where sharp practice in the boom gets exposed. Whether it is a couple’s life savings expropriated by some snake oil salesman or the high-level malfeasance of Enron, the details are usually the same. JP Morgan himself described the herd mania with the brilliant observation that ‘‘nothing undermines your financial judgment like your neighbour getting rich’’.
Typically, the blindness of the frenzy leads people to believe almost anything, so long as it promises to make them rich. Therefore we can expect a deluge of financial scandals to be exposed in Ireland over the coming years. If the people you gave your money to over the past few years are now refusing to return your calls, get on to your solicitor.
The only problem is that it is quite likely that your solicitor got you into the deal in the first place. Therefore, expect a number of high-profile – as well as numerous low-profile – cases of financial skulduggery, where cash has gone missing, investments have gone pear-shaped and promises have been broken. This is guaranteed.
As well as affecting the individuals involved, theses episodes will further undermine the credibility and integrity of the financial system.
The second development is that house and land prices will fall way below where they should. Asset prices have a tendency to both overshoot and undershoot. In good times, prices go way out of whack with any economic rationale, because the herd makes the fatal mistake of thinking that this time it’s different. People just get carried away on the promise of quick riches.
This occurred in Ireland in the past seven years, when house prices reached silly levels. Similarly, now that prices are falling, they will drop way below the level that is justified by economic logic or what is termed fair value. We have a long way to go.
A simple way of calculating the value of a house is to examine rent. The value of a house as an investment should be some multiple of the annual profit or rent you can generate from that asset. In the US, for example, the long-term value of the house has been 12 to 14 times rent. So if the rent were $10,000 per year, the house would be worth between $120,000 and $140,000.
At the peak of the housing boom, this multiple had risen to 22 times in certain expensive areas, so the house generating $10,000 rent was selling for $220,000. Let’s call this valuation method the rental value of a house, or RVH for short.
Granted, the Irish RVH could be higher than the American for historical reasons, so let’s call it 18 times – although this is more to make us feel better about our financial situation than any hard analysis.
To get a handle on how far Irish house price might fall, I asked the very helpful people at daft.ie to assemble a similar valuation for Ireland, taking in Dublin, the major cities and the countryside where thousands of people have bought holiday homes – many now trying to sell them.
The table gives the price of a house, the rent it is fetching at the moment and the multiple of that rent to the price of the house. So what is the Irish RVH telling us?
As you can see, even today after a 25 per cent fall in house prices, Irish property is madly overvalued and is likely to fall dramatically over the next few years.
For example, your average three-bedroom house in Donegal is trading on an RVH of 48 times. This implies that even if this property fell by 50 per cent from here, you’d still be better off renting. A three-bedroom house in Kildare trading at an RVH of 23 times is a much safer bet, albeit still significantly overvalued. Clearly houses in Connemara and west Cork make no sense at all.
As for Dublin, large houses are the most overvalued and, while apartment prices have fallen dramatically, the overall picture is that prices would have to fall by at least another 40 per cent to be fair value.
The problem in downturns is that prices undershoot fair value and will have to become very cheap before people realise there is a bargain and begin to snap up properties. Taking the experience of other countries and the RVH index into account, we are in for major downward movements in house prices for some time.
As a result, the third observed development of boom-bust cycle is ongoing banking problems, where the banks begin the downturn by hiding bad debts and only eventually confess – when they have to. This takes time and explains why Japan only had its first real banking crisis six years after the property market began to turn down.
The lessons from the rest of the world and from our own RVH is that, without a massive increase in rents, which are determined by wages – or immigration, which is determined by job opportunities – Ireland is in for a long, difficult transition.