Apocalypse soon

The leverage pyramid supporting world property prices is unravelling, but it's not too late to sell
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The troubles at Fannie Mae and Freddie Mac, the US semi-government lenders that hold or guarantee US$5.4 trillion of mortgages, have exposed the innermost sanctum of the credit-cum-property world of the past decade. They have lent their semi-government credit ratings to dubious financial products that purport to decrease financial risks by reshuffling the deck. While government money will bail them out, they will cease to be the sugar daddies for Wall Street. The leverage bubble has nowhere to hide; it will explode.



Rising leverage was the tide that carried all asset prices upwards. In Hong Kong, London, Mumbai or New York, rising property prices became the reason for prosperity, and this prosperity was the rationale for the rising prices. As one Hong Kong tycoon told me, wealth begets wealth; people who make money in the stock market buy property, people who make money in the property market buy stocks, and the happy story goes on and on. Yet, the free lunch was an illusion. Its engine was the debt pyramid game.



The bricks for the pyramid were new financial products that purported to decrease risk for owning assets and, hence, required less capital for their purchase. The rising price trend validated the power of the financial innovations for several years. In fact, the rising trend was due to the belief in the new products that created a demand boom for risk assets with debt financing. Like any bubble before, this one fell under its own weight. As a bubble grows, it needs proportionally more money to stay afloat. At some point, there isn't enough to keep it rising. The ensuing rush for the exit reverses the momentum. The way down is usually much steeper than the way up.



Rising oil prices are an accelerator for the downturn. Money is reallocated from most bubble cities to oil exporters. The money reduction sucks the air out of the bubble. To fight the receding tide, central banks are printing money to slow the descent. But more money leads to higher oil prices, sterilising the central banks' efforts. Further, high oil prices depress economies and decrease investor confidence. The central banks are fighting a losing battle against falling asset prices and are fuelling stagflation. The inflation will take years to cure. The central banks are digging their own graves.



Investors should sell any asset that has benefited from rising leverage. Property is entering a bear market everywhere except among oil-exporting countries. All else being equal, while inflation is good for property, the current price is already too inflated to be supported by inflation. While the consumer price index rises, property prices fall. At some point, the ratio of the two returns to the historical norm and the bubble is fully deflated. On that basis, property prices may fall by one-third globally, and by half in many "hot" cities.



Hong Kong's property market is triply vulnerable. First, the city's economy depends on its stock market. That is falling. Local speculators made billions from mainland IPOs and they splashed out on luxury properties. The wealth spillover from the stock market boom was the driving force for the property market.



Expanding financial sector employment was another spillover. As investment banks expanded their payrolls on the dream of endless hot Chinese IPOs, many bankers got their big bonuses. But the hot IPOs of yesteryear are now underwater. Loss-bitten investors are not re-entering the market. Those bankers lucky enough to keep their jobs have no expectations of a bonus. This is definitely not the time to splash millions on a luxury property that is actually a modest-sized concrete box.



Second, the US Federal Reserve is likely to raise interest rates after the November election. US inflation is becoming entrenched. The Fed is caught between financial and price stability. Every time it tries to sound tough on inflation, another financial explosion forces it to loosen the money supply again, sparking more commodity speculation.



Next year, the explosions may cease and the Fed may be able to switch to fighting inflation: it may raise interest rates to 5 per cent in the second half of the year. As adjustable-rate mortgages dominate Hong Kong's property financing, the massive rise could hit investors or speculators hard. The default rate could spike.



Third, China's economic cycle is turning down but inflation is staying up. In particular, Guangdong faces a serious downturn. Its export economy is being hit hard on rising costs and falling demand. What is happening to Macau's casino business shows how a lack of money in Guangdong could affect its neighbours. At the same time, inflation means that Guangdong will charge Hong Kong more for its goods and services. Hong Kong will get less money from, but pay more to, its neighbour.



The triple squeeze may imply one of the worst years, next year, for Hong Kong property. During the current bubble, the mass market hasn't inflated dramatically. The pain from the massive price decline between 1997 and 2003, plus sluggish income, has prevented mass hysteria in the property market this time. Those with money to spare ramped up the "luxury" market. Citing negative real interest rates, too many people - mostly financial professionals who may lose their jobs soon - have maximised leverage for property purchases in the past two years. The prices at many well-known developments have tripled since 2003.



Hong Kong's luxury property price may fall by 50 per cent from its peak. It is not too late to sell. An offer may be significantly lower than you expect. But you should take it. The big fall is yet to come.



Andy Xie is an independent economist