The housing cycle has played a central part in the economic cycle culminating in the Global Financial Crisis (GFC) of 2008. In the US and across most markets, the boom preceding the GFC featured elements common to past booms, namely sharp rises in house prices, some significant increases in housing activity and some deterioration in lending quality.
In the case of the US, the price cycle has been significant in historical terms: prices rose 60 per cent (or by an average 4.8 per cent per annum) in real terms between 1996 and their peak in the September quarter 2006; this makes it a more significant rise than experienced in past cycles, and relative to the long term trend growth in prices for the US of about 1.6 per cent (Figure 1). For the US, the recession has featured some extremely sharp price falls, with the OFHEO and Case-Shiller measures of house prices showing prices falling 9 per cent and 30 per cent respectively between the September 2006 peak and the December quarter 2008 (Table 1). In Australia's case, from 1996-2007, prices rose 87 per cent in real terms: this also represents a more significant rise than that experienced in past cycles (Figure 2) and is an acceleration from the trend rise apparent since 1975 (2.9 per cent) and indeed since the 1950s (Figure 2). (1) In part because of the magnitude of the rise, some forecasters (such as Keen 2009a, who predicted a 40 per cent fall) (2) have been punting that prices in Australia might fall by similar magnitudes to the US. Does this follow?
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The first point to note is that when making comparisons, it is more relevant to compare coastal Australia with coastal California than with inland US cities which dominate the average for the US. California prices have shown more significant rises (+155 per cent) and falls (-30 per cent) than Australia in this cycle and also in preceding cycles (Figure 3 and Table 1).
The second point to note is that the US housing finance system is fundamentally different from that operating in Australia or in Europe. The differences are highlighted in Table 2. The Australian system is the product of a history of minimal government intervention: what limited intervention there was, was phased out in the early 1990s when the NSW State Government-owned equivalent of Fannie-Mae collapsed with significant losses. (3) By contrast, the US system is the product of a history of heavy and on-going intervention, (4) the key feature being the subsidised securitised mortgage market. The central question for debate is the degree to which the US housing finance system contributed to the excesses in the boom, and to the sharpness of the subsequent fall in prices. US Federal Reserve Governor Ben Bernanke has conceded that the incentives in the US system are prone to promoting the extremes observed in the US housing market and that fundamental reform is required (Bernanke 2009). According to Bernanke, the key weakness is the lack of sufficient incentive for mortgage originators to assess risk adequately, related to the ease with which they have been able to pass the risk in securitised mortgages to unwary investors. This weakness accentuated the natural tendency for risk to be under-estimated by all parties in periods of boom.
The difference in risk-taking will be reflected in the volume of mortgage defaults it produces and these have been significantly higher in the US. This is crucial for the price story for forced sales that follow default, and foreclosure of mortgages produces a large discount to house prices (Campbell et al. 2009) and would explain the precipitate decline experienced in US house prices in 2007-2008. On the buyer side of the equation, banks typically tighten up on their lending when the market weakens which has a pro-cyclical effect on prices. The severe damage to the US banking system has overlaid this, causing a drying up of funds available to borrowers and further adding to the short-term downward pressure on prices. …