With inflation on the rise and the era of ultra-low interest rates over, financial markets will face a huge stress test in 2023. While banking systems are more robust than they were in 2008, a real-estate slump could severely affect heavily leveraged private-equity firms, producing a systemic crisis.
CAMBRIDGE – The fact that the world did not experience a systemic financial crisis in 2022 is a minor miracle, given the surge in inflation and interest rates, not to mention a massive increase in geopolitical risk. But with public and private debt having risen to record levels during the now-bygone era of ultra-low interest rates, and recession risks high, the global financial system faces a huge stress test. A crisis in an advanced economy – for example, Japan or Italy – would be difficult to contain.
True, tighter regulation has reduced risks to the core banking sectors, but that has only led to risks shifting elsewhere in the financial system. Rising interest rates, for example, have put huge pressure on private-equity firms that borrowed heavily to buy up property. Now, with housing and commercial real estate on the cusp of a sharp, sustained drop, some of those firms will most likely go bust.
In that case, the core banks that provided much of the funding for private equity real-estate purchases could be on the hook. That has not happened yet, partly because lightly regulated firms are under less pressure to mark their books to market. But suppose interest rates remain stubbornly high even during a recession (a distinct possibility as we exit the ultra-low-rate era). In that case, widespread payment delinquencies could make it hard to maintain appearances.
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Writing for PS since 2002
233 Commentaries
Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. He is co-author of This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, 2011) and author of The Curse of Cash (Princeton University Press, 2016).
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Unlike the GFC of 2008-09, this time's US housing crisis, if any, will probably be caused by the county's institutional investors (iis).
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In the past decade, many of the US's iis, like the big companies Opendoor and Zillow, have entered the country's residential housing market, and as a result they have completely changed the investment rules of the market there.
Through the iis' iBuyer program, a house-seller in the US received a bid from an iBuyer Company in cash outright, and the bid-price was usually higher than the prevailing market price by a non-trivial amount.
As a result, the US's housing market prices had in the past years been bid up to quite a high level, and this rising trend had further been invigorated by the Fed's recent 4th round of pandemic QE.
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Up until the first quarter of 2022, the share of the iis in many of the US's cities already exceeded 15%, with their share in Texas as high as 28%.
If the trend persisted, many of the houses in the country's smaller cities would mostly have been bought out by the iis, which with their large market share could then have controlled the sources of housing supplies and arbitrarily raised the housing rents.
Given the US's long low-interest-rate environment and policy supports, the above situation had persisted for many years.
The rise in both home prices and rents in those areas chosen by the iis also attracted a lot of individual investors who jumped onto the same buying bandwagon, further pushing up the home prices and rents there.
As a result, investor home purchases spiked in 2021, with 1/4 of the homes having been bought by the iis.
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When in early 2022, the Fed started her rate-hiking and QT cycles, almost everything and everyone started to unwind, and many iis started to sell their inventories en masse, even when incurring a (big) loss when doing so.
Just like they were paying too-high prices when they were buying the houses in the past, they were then selling their houses at too-low prices relative to their values.
In the 3rd quarter of 2022, 15% – 20% of the houses were sold by the iis.
Individual investors also jumped onto the selling bandwagon.
Once again, the fallacy of composition came into play.
It's said that Redfin has already sold off all of her company's owned residential houses, while the other companies are still in the process of selling their inventories.
The coming US housing market won't improve before all those iis have finished their current selling spree.
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According to the country's "Home Builder Cancellation Rate," a very important housing market statistic seldom noticed by the person in the street, with the rise in the country's borrowing rate and the drop in house prices, more and more new-home buyers have chosen to cancel their buying contracts, signifying the buyers' declining confidence in the country's housing market, which will also adversely affect the confidence of the country's home builders.
Starting from May of 2022, this Rate had been rising persistently, up from a normal 10% to 25.6% in October last year, meaning that every one of four buying contracts had been cancelled.
In the US's Southwest, the rate jumped to as high as 45%; Texas's was 39%.
Twelve months ago, the rates in those two places were only 9% and 12% respectively.
Due to the inelastic nature of a country's housing supply, the price-falling pressure in the market there has been further aggravated.
The bear housing market of the US is yet to reach its true bottom.
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Whether the coming US housing market will cause a credit or liquidity event in the US in the near future remains to be seen.
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The sleeper story of the coming year will be Japan’s emergence as a major geopolitical actor. And, for the first time since the fall of the Shah in 1979, the future of the Islamic Republic will be in serious doubt.
With inflation on the rise and the era of ultra-low interest rates over, financial markets will face a huge stress test in 2023. While banking systems are more robust than they were in 2008, a real-estate slump could severely affect heavily leveraged private-equity firms, producing a systemic crisis.
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