NOTE: An edited version of this piece was published in the Shenzhen Daily on April 15.
Several years ago in the U.S. there were advertisements running all over the media for mortgages, second mortgages, home equity loans, and other housing related financing schemes. Some ads offered to loan 110%-125% of the home’s value. Others offered to make mortgages with no down payment required. Interest rates were historically low.

Encouraged by government policies, loans were made to people who couldn’t afford them. Loans were made to people without requiring a verification of their incomes. Repayments were kept as low as possible by requiring only interest to be repaid, thinking the rising market value of homes would build equity. With all the money these policies attracted into housing, the value of homes rose far above historic rates.

The bankers and mortgage brokers who made the loads sold them to money center banks who bundled them and resold them to investors, insurance companies, and other banks. The rating agencies gave the bundles top scores, indicating they were suitable for investment.

Fannie Mae and Freddie Mac, government agencies, bought loans from originators, and the originators used the proceeds to make new loans. Commercial property was on a path similar to that of housing.

There were at least five national TV shows about house flipping, where investors were shown buying a home, fixing it up, and re-selling it quickly for a large profit. The good times rolled so long as real estate was involved. Irrational exuberance was the rule, not the exception.

Meanwhile the stock market was booming with the dot.com bubble. Stock investors put some of their gains into housing. Everyone was getting rich.

Then, in 2001, the dot.com stock bubble began to deflate. People re-evaluated their finances and began to pull in their horns a bit. The house of cards began to collapse. Interest rates edged up causing adjustable rate mortgages to become unaffordable to marginal owners. The rise in home values ended, and began heading down. The mortgage bundles began to unravel as borrowers defaulted. Banks, insurance companies, and investors who owned these instruments found out they would default.

Similar scenarios were being replayed all over the world. The world’s economy began to slow. The worst financial crisis since the 1930s began. We are still feeling its effects today.

While not a perfect parallel, China is experiencing its own real estate bubble. Housing prices have gone up more or less constantly for many years. Some years the gains in value have been at unsustainable levels of 10-20%.

As the Chinese economy booms, many are getting joining the ranks of the affluent. They have high incomes well beyond what they need to live. Many spend their money on luxury goods like expensive automobiles and designer clothing. Others invest in housing.

Since the march of home values has been more or less straight up, housing has proved to be a historically intelligent investment. It was reported that house prices tripled between 2005-2009.

Starting in 2010, the Chinese government began enacting policies to curb the growth in real estate values. Chinese mortgage policies are considerably stricter than western standards. Still, in 2010 they were tightened further by requiring a 40% down payment on second homes. Many places including Beijing enacted restrictions on who could own a home, and how many homes a person could own. Interest rate were increased several times. New taxes on real estate transactions were introduced.

By the summer of 2011, the rapid rate of housing inflation began to slow, even stop. It looked like the government had successfully stopped the bubble from growing. But no, the housing market began to show signs of coming back to life in 2012. Recently the government passed a 20% tax of capital gains from the sale of a second homes. Whether that will slow things is doubtful.

There are two ways the inflation in housing can be slowed or stopped. The first if for the government to remove itself from the housing market. Eventually the laws of economics will cause the value of real estate to rise too high, and it will collapse of its own weight. Of course, this would hurt many people in a number of ways. Understandably the government doesn’t want to stand by as people lose their savings and investments.

The second way housing prices can be influenced is by making alternate investments available. The crux of problem is Chinese have very limited choices where to invest. As families accumulate wealth, they discover there is little they can do with it other than buy houses. The money accumulates like steam in a pressure cooker. It must have somewhere to go. The government has attempted to keep the lid on the pot, but eventually the steam will find ways to escape.

Banks pay interest on deposits that barely keeps up with inflation, so keeping it in deposits is not a good alternative to the 10% gain possible in housing.

The stock market is not trusted because Chinese accounting and transparency standards make evaluating shares difficult. Recently the American company, Caterpillar, took a $580 million USD write off from an investment in Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd. of China when accounting fraud was discovered. If a large multi-national company like Caterpillar with legions of experts and accountants can be cheated, what chance does a small investor have in the capital markets? People instinctively realize this.

The best way for the government to curb housing speculation is to do what it can to make investments other than real estate available. If people are allowed to feel comfortable investing in stocks, mutual funds, foreign exchange, overseas markets, tangibles, etc. It would remove much hot money from the housing market and slow the irrational increase in values.

 

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