Of Banks And Politicians

To show you that I'm not politically motivated, I will now pick on the current Norwegian government led by Labor (Arbeiderpartiet). Oh, looking at the news it's impossible to miss the fact that the general election is approaching!

At least since 2011 the Prime Minister, Jens Stoltenberg, and the Finance Minister Sigbjørn Johnsen, have not been hiding (here and here) the fact they are very concerned about a possibility for a housing bubble. And even now they don't deny it, even though they might try to downplay it somewhat (you don't win an election by telling people living in a bubble that they are living in a bubble?). Anyway, the government has been working hard to make mortgages less profitable for banks, and legislation to achieve this is already on its way. Basically they are telling the banks that "if it's a bubble, you need to save yourselves, the government can't foot the bill". Well, how does an investor like a bank respond to increased risk? They ask more compensation for bearing the risk, in this case through higher interest rates on the mortgages.

How does the government respond in an election year when many banks tell their clients that they will take mortgage rates up 0,3 %-points initially (and that more may follow) and that it is due to demands from the government? The government gets furious! And the Finance Minister says banks are doing so good that there's no need to increase the mortage rates.

Do not expect any responsible behavior from the politicians before autumn 2013! And like in this case, if they have behaved responsibly earlier, expect them to deny it at least three times.

By the way, this news spells a lot of "bad blood" between the banks that compete for mortgage customers in Norway. Skandiabanken, which is a subsidiary bank of a Swedish insurance company, is reporting that during the last two weeks they have received a huge flow of mortgage clients from the banks (for example the giants DnB and Nordea) who warned about increases in their mortgage rates by 0,3-0,35 %-points. Skandiabanken tells that they are not thinking about increasing the rates, hinting that the doors are open for new customers.

This might get dirty?

Erna Solberg Lives In a Bubble?

 This interview is already 10 months old, but I stumbled upon it now and can't believe what I read:

Norway isn’t in the grip of a housing bubble and a shortage of supply in the property market will prevent prices from falling, said Erna Solberg, the leader of the Conservative Party and the front-runner to take over as prime minister in next year’s election. 

“I argue against a housing bubble because a housing bubble is an influx of prices without demand; in Norway it’s demand that’s the biggest reason,” Solberg, 51, said yesterday in an interview in Oslo. “I don’t think house prices will fall.”

When it comes to economic bubbles, if this is the level of understanding of a possible future prime minister, what can you expect from the people in general? (I know, many of you might say that you should expect more...)

How could you ever have a housing bubble without demand? Wasn't it too strong demand that took Norwegian housing prices to a bubble heights in the 80s? Wasn't it too strong demand that took the "dotcom" share prices to ridiculous levels in the late 90s?

Speculative demand is "the usual suspect" behind economic bubbles, and I'm quite confident that when the day comes that Norwegian house prices will lose 20-40 % of their value, people will point fingers at speculative demand fed by a common and - on the surface - a coherent story adopted by majority of Norwegians: "House prices will not decline because there is a shortage of supply".

There might be a shortage of supply, but the only thing that it has to do with a housing bubble is that it is the single biggest reason why the prices have reached a "bubbling" level. "Shortage of supply" means that demand has been and is right now bigger than supply. When people assume that this will not change in the near future, they assume that this situation needs to be corrected by increasing the supply, i.e. building more, and that it will take years. They make an assumption that demand will not get lower, which would of course be the other way to solve the problem of shortage of supply.

So people keep on lifting demand by buying "second houses" (to let) because it is clear to them that the prices will not get lower any time soon, and that buying now and selling when the prices flatten out is a smart move. Eventually supply picks up (you can witness this for example in Fornebu/Snarøya in Oslo) and more houses are built just so that more people could buy a second house, until there is an oversupply of houses for rental (and remember, it's smart to buy, not rent...). Suddenly, demand is the side of the equation that moves unexpectedly lower, because it doesn't any more make sense to buy the second house. It actually makes more and more sense to sell it instead, and so the supply increases while the demand decreases.

As you see, the process above is fully possible without any steep increase in interest rates or unemployment. That's why it is impossible to predict when it is going to take place. Perhaps just expectations of higher interest rates and higher unemployment is more than enough to bring down an overheated market?

The Problem With Basing Worst-Case Scenario On a Past Extreme

I will start with a quote from one of my favorite authors: Nassim Nicholas Taleb. In his new book, Antifragile, Taleb writes

[R]isk-management professionals look to the past for information on the so-called worst-case scenario to estimate future risks – this method is called “stress testing.” They take the worst historical recession, the worst war, the worst historical move in interest rates or the worst point in unemployment as an exact estimate for the worst future outcome.

But they never notice the following inconsistency: This so-called worst-case event, when it happened, exceeded the worst case at the time. I have called this mental defect the Lucretius problem, after the Latin poetic philosopher who wrote that the fool believes that the tallest mountain in the world will be equal to the tallest one he has observed.

You might ask what does this have to do with house prices in Norway? It's hard to blame anyone limiting their imagination to past extremes, when real house prices, ratio of house price to rent and ratio of household debt to income keep on breaking past records with nearly every month that passes. For more on these statistics, see a great paper, "Housing Bubbles and Homeownership Returns", from Marius Jurgilas and Kevin J. Lansing (2012) of Bank of Norway / San Francisco Fed. It's essential reading for anyone interested in the current situation. And by the way - and this applies especially to the "post-Reinhart-Rogoff era" - if an economics writer concludes that "Time will tell whether things turn out differently for the Norwegian housing market", you can fairly safely assume he/she suggests it's a bubble. They can't say it clearer than that if they don't want to risk public humiliation in the case the prices keep on soaring for five more years.

Now back to the title of this post. What I refer to with the "past extreme" is the banks' losses on mortgages in the last house price crash of the late 1980's. Despite a 40-50 % price decline, the credit losses for banks were minimal. You can call it "high Nordic morale" or "bad legislation favoring creditors", but people here will try to meet their loan commitments as long as they can afford to buy some food (or perhaps they would even steal food rather than miss a payment to the bank?).

The fact above has been widely applied as a kind of worst-case scenario, leading to a conclusion that the banking system is robust despite all-time-high household debt levels. Where does a conclusion that the banking system is robust and that mortgages have never created significant credit losses lead us? It leads to

1. low risk-weighting (loss expectations) for mortgages,
2. banks lending more and more (and more) to these "AAA-rated" households (banks make their profits mainly through lending, after all), and
3. finally to testing if the previous worst-case was really the worst possible (even if it was, see the problem I brought up in a previous post).

I applaud the latest move from Norwegian government to raise the mortgage risk weights to 35 % as an essential action to curb lending, but I remain very skeptical when it comes to the relevant question: Is it already too late in order to avoid a bubble? As far as I know, the authorities around the world have always been several steps behind in these situations. To me it makes sense that since it's so hard to tell a bubble (otherwise we wouldn't have them), at the time the authorities are confident enough to take tough actions the bubble is already too apparent, and so the actions from authorities serve rather as a pin to burst the bubble. In trying to be counter-cyclical, the authorities many times end up being pro-cyclical. But perhaps this time is different?

The Bubble Is Finally Confirmed?

Petter Northug Jr, the cross-country skiing hero of Norway, has finally shed some light on his plans for life after skiing career:

"It's likely I'm going to study. Most probably something related to real estate, since I think it's fun."

I think the irony lies in the fact that when he is done with the studies, the market might very well offer low prices again, which translates to good investment opportunities - but it's not fun anymore. Good times are fun. Bubbles are fun.

There are some rumors that Northug is investing in Florida real estate with a group of Norwegian investors. At least it's a lot better idea than investing in Oslo real estate, which I hope he has avoided. But even with Florida, I suspect that spotting the bottom of the market is not as easy as it currently seems. A good idea for the long run, surely, but it seems people are expecting quick wins. Charlie Munger of Berkshire Hathaway has said about investing:

"It's not supposed to be easy. Anyone who finds it easy is stupid."

 Fun and easy. As long as it lasts.

Slow, Second-Level Thinking

Many of you have probably, if not read, at least heard of the bestseller "Thinking, Fast and Slow" by Daniel Kahneman. For the purposes of this blog post, I just mention that "slow thinking" is something that is called for when making certain decisions where "fast thinking" is vulnerable to different kinds of biases - in other words, it's needed so that we don't get fooled by ourselves. It is thinking that requires sometimes considerable effort. That's the slow-thinking part of my title today.

What is a lot more relevant to this post, and comes from a book that should in my opinion be read by every person who wants to make investments, is "second-level thinking". It is something that Howard Marks, a renowned investor, calls for in his book "The Most Important Thing: Uncommon Sense for the Thoughtful Investor" (not as catchy a title?). This excerpt from the book explains the concept:

First-level thinking says, "It's a good company, let's buy the stock". Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell."

By the way, Daniel Kahneman is also one of the gurus in the field of "behavioral economics", which

[studies] the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation.

Very well. Now that we're in the world of slow, second-level thinking, let's examine how the situation in the Norwegian housing market looks like:

• The vast majority of people agree that real estate is a safe investment
• The vast majority of people also expect the house prices to continue their climb in the coming years
• There are very good explanations for the rise in house prices, presented daily by experts in newspapers, telling that there is no bubble and we shouldn't worry
• Mortgage rates are at historic lows and expected to remain low for years to come
• You'd struggle to find an economist in Norway who would publicly admit that there could be a bubble - the "no bubble" consensus among professionals seems to be very strong
• Norway is a rich country, so we can't be the next Ireland or Spain - oil has brought us well-being for decades to come

First-level thinker looks at the bullet points above and says: "It's a safe investment, there is no bubble, so let's take out the cheap loan and buy our dream house.".

Second-level thinker looks at the evidence and says: "Everybody thinks it's a safe investment, everybody says there is no bubble, so everybody takes out the loan and buys the dream house, and not just that, but also a second house to make some easy money. If no one thinks of the price, if no one fears a bubble, and the mortgage rates are at historic lows, then there must be a bubble."

The First Concrete Sign Of The Trouble Ahead?

First, I want to sincerely thank those of you who have given me feedback in recent weeks. Being realistic (some call it pessimism) is a heavy duty, and you need a break now and then. I'm happy to say that I'm back in business and full of realism ;-) Since my last post, there has been some interesting developments on many of the points I have brought up, and I can't wait to write about it. But I want to start with what I view as possibly one of the first real signs of the trouble ahead. As always, if you don't agree (or have something to add), feel free to share your views in the comments.

On February 16th, the "FT.com of Norway", DN.no, wrote about a downward pressure on rental prices in Oslo (Google Translate helps if your Norwegian is not yet strong enough). In brief: Nikolaos Farmakis, who has been interviewed for the article, works for a well-established rental broker Utleiemegleren. He tells about a case where he expects to be forced to lower the rental price by 20% for an apartment situated in one of the most popular neighbourhoods in Oslo when the apartment comes back to the market in April. This anecdote is supported by a study by Opinion Perduco showing that rental prices flattened out during Q4/2012 and that more prices are lowered than increased when looking at the price adjustments taking place on the leading rental website Finn.no. Farmakis also talks about the unrealistic rental price expectations of private, non-professional investors who are new to the market, causing some heated discussions between the broker and the house owner, and ending up in a disappointment for the investor.

To me it seems that there might be a worrying development underlying this downward pressure in rental prices.

If you combine a) the current, almost incredibly strong trust in increasing house prices among Norwegians with b) the easy access to credit and c) the fairly low return (although I'm very satisfied with the 3,7% I currently get) on savings accounts, you could expect that many households with extra savings (a rarity in these times) would be willing to become rentiers? This article is a prime example of what I'm talking about. Professional, experienced investors must have noticed that the return on rental investment is currently very low (DN.no recently wrote about how it makes more and more economic sense to rent instead of buying a home, and the article above has a calculation that shows you get more on savings account "risk-free" than you get by renting out an apartment), so I assume the main motivator for these investments must be the "total return", i.e. rent + expected increase in value over time. Some of these amateur rentiers might be counting on finding - a couple of years down the road - the famous "Greater Fool" who will offer them more than they paid, or then they just sincerely think that the prices will always appreciate.

There are at least two direct consequences for this kind of speculation that are already in effect:

1. These "second house" investors have increased demand for - and thus prices of - apartments on the already hot market.
2. They also reduce the supply of houses/apartments to own, and this increases prices when practically everybody wants to own, not rent.

What these two articles and the study might very well show is that we may already face the further consequences:

1. Speculation leads to oversupply of rental apartments while there has not been corresponding increase in demand for rentals.
2. This leads first to downward pressure in rental prices and, through lowered return for rentier, it eventually increases the supply of dwellings for sale when it makes less and less sense to rent out instead of selling and cashing in the value increase of previous years.
3. The supply of dwellings for sale increases while lower rents cause more people to rent instead of buying, leading to cooling house prices.

Makes sense? To me this kind of mismatch between rental prices and house prices is a classic sign that something is wrong in the market.