Jun302014
The deflating Chinese real estate bubble could destabilize the world economy
The Chinese inflated a real estate bubble more than ten times larger than the United States. Bursting this bubble could destabilize the world economy.
I recently asked what would happen if the Chinese housing bubble burst. The implications for Coastal California’s real estate market is enormous as a crash in Chinese real estate would not just remove a component of local demand, it could turn Chinese buyers into desperate sellers. My sanguine attitude about the ability of lenders to maintain pricing through inventory restriction would change if desperate Chinese sellers began putting must-sell inventory on the market.
The problems in China go beyond our little niche in the real estate world. A deflating housing bubble in China could destabilize their entire financial system and disrupt the world economy.
Some in China want to see the return of market forces and a movement away from central economic planning.
Let housing prices in China be determined by market forces
If the government weighs in to reverse the downward trend in real estate prices, the market might not plunge temporarily, but it is sure to lead the market down a more dangerous path, force the property bubble to burst and jeopardize the country’s economy. …
Chinese investors, who have invested their funds in the housing market during the last decade when the market was booming, are eager to lock their gains by cashing in their chips.
The investors’ withdrawal from the market is set to trigger a decline in prices which could hardly be reversed despite the government’s interference. Knowing that market forces will lead to the most effective use of economic resources, the 18th National People’s Congress decided that the government should refrain from interfering with the market, which means that the government should try not to control housing prices.
The business circle that has prompted the decline of real estate prices may be hindered for a moment by the government’s meddling but it will have its own way in the long run.
The reason the Chinese government will likely continue to prop up its real estate market is because the bubble is so large, that allowing prices to find a natural equilibrium will lead to a 90% to 95% reduction in home prices — and that’s not an exaggeration.
We built $500,000 houses for a local population making about $40,000 a year in Riverside County, CA. Prices cut in half there despite aggressive government stimulus before an equilibrium was restored. In China, they built $500,000 houses in areas where the local population lives in shanties on $3,180 a year, so take our bubble and multiply the problem by 12. A 90% reduction in prices is necessary just to bring priced down to where they were as inflated as our bubble was during 2006. Cut that in half again, and a 95% decline in Chinese house prices is a very realistic scenario.
There is more evidence of the 10-fold imbalance. The United States averaged a home vacancy rate of about 1.6% since the mid 1950s. During the housing bubble, due to property speculation, investors began trading empty stucco boxes, and the US home vacancy rate increased to 2.7%, a dangerously high level indicative of a housing bubble.
If 2.7% vacancy is dangerous, what do we make of China’s vacancy rate of 20%?
More Than 1 in 5 Homes in Chinese Cities Are Empty, Survey Says
By Esther Fung, June 11, 2014 7:01 a.m. ET
SHANGHAI—More than one in five homes in China’s urban areas is vacant, and a current housing-price correction is putting additional pressure on the owners of such empty properties, according to a nationwide survey by researchers from China’s Southwestern University of Finance and Economics.
The vacancy rate of sold residential homes in urban areas reached 22.4% in 2013, or 49 million homes, up from 20.6% in 2011, according to the Survey and Research Center for China Household Finance, which conducted the analysis.
Again, China’s problems are 10 times larger than ours were at the peak of our disastrous housing bubble.
So why does this matter?
Dear Investors: China’s Problems Are Your Problems
By A. Gary Shilling, 31 May 26, 2014 6:03 PM EDT
… a financial crisis in China could well be the trigger that persuades investors to pull in their horns.
China is the world’s second-largest economy, even if it remains an economic pygmy, with $6,091 in per-person gross domestic product in 2012, compared with the U.S.’s $51,749. Its global importance was magnified when North America and Europe shifted their manufacturing to the Middle Kingdom. That shift made China the primary importer of raw materials and exporter of manufactured goods. …
China’s size and impact on the global economy mean that China’s problems … are now the world’s problems….
Disruptions on the flow of capital and goods and services will have global implications.
Chinese leaders want to shift from export-driven to domestic-led growth. But in promoting a consumer-led economy, China is way behind the goal post. The latest data from 2012 show that consumer spending only accounted for about 36 percent of GDP, far behind the developed countries. …
The government knows that to increase consumer spending it must increase incomes and reduce savings. Chinese households don’t have much of a safety net to fall back on, so they save almost 30 percent of their income to cover health care, retirement and education.
One of the common myths surrounding China is that they save prodigiously, and the banks aren’t nearly as leveraged Western banks were at the onset of the financial crisis. But what if the capital on Chinese bank’s balance sheets is an illusion?
The problem with Chinese bank’s collateral backing its loans is complex and requires some background explanation.
Global agenda: Rehypothecation
Frankly, I don’t expect many readers to be familiar with the term above, let alone to know what it means. So let’s begin by turning to the fount of all knowledge in our age – Wikipedia.
Here we learn that “hypothecation is the practice where [usually through a letter of hypothecation] a borrower pledges collateral to secure a debt or a borrower, as a condition precedent to a loan, or has a third party [usually an affiliate] pledge collateral for the borrower. The borrower retains ownership of the collateral, but the creditor has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer’s house becomes collateral until the mortgage loan is paid off.”
Hypothecation is the standard practice in the real estate industry. A borrower pledges the collateral to get a loan — but they can only pledge it one time to get one loan. The same collateral cannot be pledged multiple times to get multiple loans because if the borrower defaulted, multiple banks could not foreclose and resell the property to regain their capital.
We now advance to “rehypothecation” and, reverting to Wikipedia, we learn that “rehypothecation is a professional financial market practice, where the counterparty reuses a security pledged as a collateral for its own use. It is how the hypothecation mechanism fundamentally works in the security market, replacing the overhead of liens through actual title transfer against cash with the promise of an opposite transaction in the future [repo].
Counterparties receiving the security can use it freely.”
Rehypothocation is using the same collateral to get multiple loans. It allows both borrowers and lenders to become much, much more leveraged because the 1-to-1 ratio of collateral to loan is broken.
For most readers, that is impenetrable jargon. But the distinction is now clear – hypothecation is something everyone does, rehypothecation is something that only financial market professionals practice. Let us, therefore, stick with hypothecation and see what we can do with it.
You want to buy an apartment, house, building or property.
You don’t have money, so you go to the banks – “cos that’s where the money is,” as bank-robber Willy Sutton explained, when asked why he kept robbing banks – and they lend you money. But they want collateral, so they take a lien on the asset you are buying with their money, effectively making it their asset, until you have repaid the loan.
Now, suppose you tried to be clever and, having borrowed the money from Bank A and pledged the asset to them, you then went to Bank B and tried to borrow money from it, offering your asset as collateral. In Israel, as in all counties where the financial system, real-estate sector and government bureaucracies function properly (that’s not the same as efficiently…), Bank B would check and discover that the said asset was already pledged to Bank A. It would then refuse to lend you money, unless you put up another asset – and maybe it would throw you out in any event. If somehow the second loan was made (maybe you bribed the relevant manager) and the fraud was only discovered ex post, Bank B would probably initiate legal proceedings against you.
One of the main reasons we record all real estate transactions in the public record is to prevent rehypothocation. Many people attempted rehypothocation Ponzi schemes during the bubble, and some managed to get the loans by timing the loans to close on the same day at multiple banks so it wouldn’t show up in a title search. It’s fraud, pure and simple.
Now, we’ll play a different thought experiment. Supposing you had an asset, a real, hard asset – such as a consignment of thousands of tons of iron or copper, or even thousands of kilograms of gold. You had documentation proving that your asset was being stored in a secure warehouse facility – and on this basis, Bank A gave you a loan, against which the asset was duly pledged. But in the imaginary country we are talking about, you could go to Bank B and do the same thing, i.e. rehypothecate your asset, getting two loans both underwritten by the same lien.
You could, in fact, go to Banks C, D and E and do the same thing. In theory, if the lenders played along with you, for whatever reason (most likely, the one cited above), you could rehypothecate the same asset infinitely.
Each time a loan is rehypothocated, the amount any one bank can recover is reduced. The amount of outstanding debt the exceeds collateral value introduced potential deflation pressure in the system if any of the banks needs to foreclose. Further, a chain reaction of defaults, foreclosure, and subsequent resale could cause asset values to crash like they did with the US housing market.
Now, imagine that this imaginary country where multiple rehypothecation was possible really existed and it was called China.
OMG! Think of the scale of the debt not backed by any real assets in China! I question whether their central bank could print enough money to paper over this problem.
It imported huge quantities of raw materials and built endless housing projects, while its currency offered a one-way rise to slow, unspectacular returns that, if you used massive leveraging, became enormous. Imagine that eventually, this monstrous distortion of physical markets was uncovered – 100,000 tons of iron, 20,000 tons of copper, etc. were found to be “missing,” just in China’s third-largest port and the investigation is spreading.
In fact, they never existed, the import documentation was fictitious – but the loans given against them were real.
However, the money from the loans is gone, because the housing market has crashed, the currency has changed direction, the whole “sure thing” has fallen apart.
Now wake up. This nightmare is really happening in China and the scale of the fraud being unearthed – and hence of the banks’ losses – keeps growing.
We thought the 2008 crash was bad. What happens when the massive financial Ponzi scheme in China blows up?
The moral hazard of central banking
Central banks like our own federal reserve exist to promote moral hazard. Central banks seek to make recessions less painful by making money cheap and plentiful. If they print enough money, and steal from anyone with stored wealth, they can buoy nominal prices of most asset classes and make recessions less economically painful for those who deserve to feel the most pain — stupid speculators.
With each round of economic intervention, the people who are bailed out learn that the consequences for their wild and irresponsible risk taking isn’t as bad as they thought. In fact, after a few cycles, it becomes widely known that any irresponsible risk taking will be bailed out by the central bank. People respond to incentives, and if people realize they have huge potential rewards for wild risk taking and limited potential for downside risk, people take ever wilder and more irresponsible risks. That is the essence of moral hazard, and every policy of central banks nurture moral hazard into larger and larger financial catastrophes.
Most people don’t understand the economic cycle. After the deep double-dip recessions of 1979 and 1980, people really believed the federal reserve conquered inflation and made our economy immune to recessions. We all existed in a state of delusion and false security. Hyman Minsky noted that long periods of economic stability become characterized by increasing levels of Ponzi finance that introduces instability to the system and promotes the misallocation of resources. The purpose of a recession is to wipe out Ponzi schemes and correct these poor resource allocations. This restores the economy to health and promotes efficient use of resources in those areas where they provide the most benefit.
Central banks in their policies to lessen the impact of recessions prevents this natural cleansing from taking place. The Ponzi schemes of the bubble survive, people don’t learn their lessons about the dangers of Ponzi schemes, and the inefficient use of resources and outright theft of money continues.
Many people envision the Great Reset, the ultimate culmination of Hyman Minsky’s vision. So far central banks around the world have lowered rates and printed more money to prevent this reset from happening, particularly in China. Right now, the moral hazard in China is so extreme that nobody believes the central bank will allow the Great Reset to occur — even the central bankers believe it; however, when you consider the size of the enormous bubble in real estate in China, it’s hard to believe the central bank can print enough money to save it.
If China prints enough money to paper over its bubble, it will flood the world with its currency, and its value will crash. Ultimately, the value of any currency cannot exceed the value of a countries assets and the value of goods and services produced. If China’s real estate is 90% to 95% overvalued as I demonstrated above, the actual value of property based on the income of Chinese workers will force the Great Reset to occur — and it’s not like China can raise everyone’s income by 2000% to support real estate because such high wages would ruin its export base and further destabilize the economy.
The Chinese economy is a time bomb waiting to explode. I fear for the future.
[listing mls=”OC14135713″]
Let it blow. Deflation = good for the middle class.
It’s good for the middle class that doesn’t have debt, but those with a lot of debt will hate deflation because they have to repay those debts with more valuable currency.
No they don’t have to pay them because they are discharged in bankruptcy.
The availability of credit in this country is obscene and it appears the lessons about debt from the hundreds of past generations has been forgotten. When people surviving on government assistance are able to get 18 different credit cards I would say we have a problem.
if the currency cannot be debased, the world of money and economy turns around completely.
Housing — the economy’s needy friend
Redfin Chief Economist Nela Richardson described it best saying: “In the past, housing has always saved the economy. In the last several economic downturns, the housing market was the first to recover, leading the rest of the economy out of recession. The housing market was the reliable buddy who would bail you out of jail or drive you home at the end of a wild night. But now, the housing market is the needy one in this relationship. The housing market needs the economy to pick up before it can recover.”
And in order for the housing market to get the boost it needs, there are two areas it has to get past.
The first is a lack of inventory, particularly in major metro markets. Second is the current state of the labor markets, Richardson explained.
“Income growth has been weak overall and even though job creation has picked up recently, the type of the jobs created tends to be in low-paying sectors and roles that don’t lend themselves to supporting the purchase of a home,” she explained.
But there is hope for the rest of the year. “We remain confident that the first-quarter drop in activity will reverse, and we are seeing some positive signs in the current quarter, but economic growth likely will be playing catch-up for the rest of the year,” said Fannie Mae Chief Economist Doug Duncan.
I’m starting to feel like I did in 2007. Something is just not right. Unrealistic valuations are going to crash. The final straw was this past weekend at an open house. A realtor was bragging about the wealthy Chinese buying all of California.
I’m exiting all my final positions on interest rates. When interest rates rise the tech bubble is going to burst, the Chinese bubble will burst… and all hell is going to break loose. It’s time to get out of equities and get in cash.
It won’t have a huge impact on Irvine premium real estate and other premium areas. The drop won’t be enough to justify exiting especially at the legacy low interest rates. Fringe areas especially in Northern CA will be hammered as tech deflates to realistic valuations.
Timing it is the hardest part. I know this is going to happen but will it be in 3 months or 24???
I don’t remember you ever making a bearish statement. Interesting.
That is certainly the sign of a top in activity. It’s akin to shoe-shine boys offering stock tips as a sign of a stock market top.
That’s because I became bullish before you. I had fun as mav and then saw that interest rates and the banking cartel had it all under control. It was time to get off the bearish bandwagon. I timed it right and did well. Now the tide is about to go out again leaving the naked swimmers. Admittedly timing is outrageously difficult…. But I would bet on under 9 months for the calamity to begin.
Irvine SFRs might get hit with a 10% decline but that may be after another 10-15% run up. Irvine crap condos could get hit with a 10-20% decline.
Were you the mav that used to post on Lansner’s blog? We had some good debates back in the day. I remember you imploring me to read Mish’s blog to get the full story. mav was on one of the most bearish posters from that time.
Yep, those were the days.. Good times
Based on the debates we had on the IHB and here, I am shocked to find you used to be bearish and that you are again.
It definitely feels like 2006/2007 to me too. We visited Capella at Orchard Hills yesterday:
http://www.villagesofirvine.com/Villages-and-Neighborhoods/Orchard-Hills/Residence/Capella/Residence-2
Three plans ranging from 2,906-3,203 sq ft. The models have tiny lots and so does nearly every lot in the site plan. The prices are in the $1.3m range!
Federal reserve economists are the worst economic forecasters
On Wall Street, there’s an adage, “Don’t confuse brains with a bull market.”
Fed chief Janet Yellen should have that crocheted and framed and hang it in her office.
On Wednesday, the final first-quarter GDP was announced at a staggering -2.9 percent annualized.
Yellen’s Fed had as recently as Dec. 18, 2013 — a mere two weeks before the first quarter began — forecast 2014 to be a strong year of positive 2.8 percent to 3.2 percent GDP growth, with no negative quarters.
This also marks four years, or 16 quarters, since the last time the Fed was correct on an economic forecast.
So how can these people ever devise a solid economic or monetary policy if they are so off with their projections?
This Fed thought we would have a GDP growth of 3 percent just before Christmas, and got -3 percent soon after Flag Day.
That’s a 6 percent whiff.
If you do some back-of-the-envelope calculations, that 6 percent miss could translate into a $1 trillion shortfall annualized. That’s how big a miss it is.
So, on Thursday — just one day after the worst negative GDP contraction in five years — out comes St. Louis Fed CEO James “I haven’t been right with a forecast in years” Bullard, stating that the markets “don’t appreciate how close the Fed is to its goals.”
Sure, the Dow Jones has been hanging in there, bouncing around new highs, but that’s not because of robust economic growth; in fact, it’s because of the opposite.
Low- to no-growth environments mean interest rates remain low in the bond market, and therefore most investors recognize that stocks are cheaper on a relative basis to bonds and their puny yields.
It’s just Darwinist-style investing: Money goes where it’s treated best, and 2.5 percent yields for 10 years or 0.15 percent in a savings account is just not as appealing as stocks.
Besides, as confusing as that may seem to the Fed, just because the Dow rallies or sells off or corrects or starts a new bull market, those are essentially non-economic events by themselves, in terms of employment or inflation.
Real estate prices won’t go down*
*Unless:
1) China implodes
2) Stock market corrects
3) Fed loses control of interest rates
4) Inventory and sales continue in opposite directions
5) Any combination of the above
6) Etc.
The China implosion and the fed losing control of interest rates are the most worrisome.
A China implosion would put must-sell housing inventory on the market. We must get must-sell inventory on the market for house prices to really drop.
If the federal reserve loses control of interest rates, nobody will be able to afford current pricing, and prices will have to drop.
“If the federal reserve loses control of interest rates, nobody will be able to afford current pricing, and prices will have to drop.”
Why is that worrisome? That would be great!
You’re right; it isn’t worrisome to me, and it isn’t worrisome to renters looking to buy later, but at this point, another catastrophic decline in house prices would push us back into another deep recession, something that worries politicians, bankers, and the federal reserve.
I suggest speculators (oh wait, they call ’em investors in OC LOL) familiarize themselves with the word CONTAGION.
Oh stop all your worrying! If China doesn’t think it control the popping of their bubble, they will just bulldoze all those empty cities, throw debtors into prison and manipulate their currency even more. What I’m trying to say is they have a lot more options than our country does because their gov’t isn’t afraid to break human, legal, and economic principles.
And for all the realtards in CA bragging about all the Chinese buyers out there. That’s like saying working in a coal mine is wonderful because of all the beautiful birds singing.
The local homebuilders will be hugely impacted by a collapse in Chinese demand. A real estate market consultant recently noted anecdotally that 80% of the buyers of new homes are Asian. Perhaps many of these are Asian-American, but a significant portion may be Chinese nationals. If that’s the case, a sudden and dramatic decline in new home sales may happen if the Chinese bubble implodes.
If you tour any new Irvine development (Great Park, Orchard Hills, etc.), nearly every family you see is Asian and speaking something other than English.
Actually my point was the exact opposite. The reason so many Chinese are buying over here is because they KNOW the bubble is going to pop back home. Actually it already is popping. And al the money in China is trying to harbor it elsewhere before the Chinese gov’t declares it illegal.
This is what’s going on in the San Gabriel Valley in the last few years. They’re moving a lot of money into real estate and quite frankly I think much of it for laundering purposes or just to get it out of China since RE traditionally has been the piggy bank. If China falls, it will be interesting because you will have two Chinese capital running in opposite direction. One still trying to get out of China while the other try to get it out from overseas to pay for investment losses. Based on trend from the last few years. I still think there’s still more money going out than in but future down turn in the economy will dampen asset prices. Unless…there is a shift from paper to tangible asset.
Exactly. We seem to be confusing the PRC with a western democratic and capitalist society, with decades of contract business case law and courts They don’t face the same obstacles. They used a brutal 5 and 10 year plan to get into this mess. They’ll probably use another brutal 5 and 10 year plan to get out of it, and to hell with currency markets. Also, unlike the US and Europe, some (not all) of these bankers and fraudsters involved are going to be apprehended, publicly tried and executed in typical Chinese example-making fashion. Given that life is so goddamned nasty, brutish and short in China, the grand deception had to have been worth it, even for a just a few years.
Is it interesting to anyone else how outside of this Israeli article and Zero Hedge blog, nobody in Europe or the US media are picking up on this China re-hypothecation scandal?
Even if China can manage to quell civil unrest and force a solution on its own population, it will still have a broad impact on the world economy, and if they aren’t able to deal with the problem, it could get even worse.
I wouldn’t be surprised if this does start to gain the attention of the MSM. It’s a complicated and esoteric issue few understand. It reminds me of the derivative and credit default issue back in 2007 and 2008. Once the MSM understood it, they began to cover it.
So the lesson here is that the moment an individual in China claims they have good collateral, you will want to…….?
ZeroHedge: As homeownership rates tumble, perhaps it is not just the stagnation of income or piling up of ‘other debts’ disabling any organic buying frenzy; perhaps, as Bloomberg breaks down, it is the realization that real-estate is nothing less than another boom-bust roller-coaster ride. ??
When so much wealth is tied up in one asset, the risk — or stability — of a local market can mean a lot to a homeowner and Bloomberg has quantified the ‘riskiest’ (and most stable) home markets in America…
Bloomberg: The Riskiest Housing Markets in the U.S.
5. Los Angeles
Risk of loss: 29.1%
3. Riverside, California
Risk of loss: 30.8%
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2014/06/20140630_Risk.jpg
housing can never go down. the government’s got this.
/sarc
Many people won’t invest in the stock market due to its volatility. It wouldn’t surprise me to see many people be afraid to participate in the housing market for the same reason.
I would agree with the study based on the raw data. I count 8 rolling 5-year periods out of 28 that were negative for OC (28.5%). The years 2009, 2010, 2011, 2012, 2013 can’t be measured yet because 5 years haven’t elapsed, but I would predict that at least the first four of those will be positive as well.
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