Real Estate Bubble and Financial Crisis

Introduction

The most significant economic event in 1990s was the Financial Crisis in East Asian, which also affected the world economy in the next few decades. People probably question the specificity of the East Asian Crisis. Radelet and Sachs (1998.p.1) gave a response to this question: ‘The East Asian financial crisis is remarkable in several ways. The crisis has hit the most rapidly growing economies in the world. It has prompted the largest financial bailouts in history. It is the sharpest financial crisis to hit the developing world since the 1982 debt crisis. It is the least anticipated financial crisis in years.’

In my view, Asian financial crisis is triggered by real estate bubbles. This paper is organized around the topic ‘the collapse of real estate bubble causes Financial Crisis’ as below. Section 1 introduces what is real estate bubble; what are the factors inducing the occurrence of a real estate bubble; and by what measurements to identify this phenomenon. Then, Section 2 discusses the effects of real estate bubble in Financial Crisis reflect in different approaches: theoretical economic approach statistical data and historical facts. In conclusion, besides summarize the main idea of the overall contents, the exposure of the limitation of the theoretical economic approach will be mentioned.

Real estate bubble

The real estate bubble, also known as property or housing bubble is considered as an economic bubble, which is also a cyclical phenomenon occurs in the local or worldwide real estate market. Its prime feature is that the valuation of housing is growing swiftly, however, once the people’s financial situation and economic indicators unable to sustain such upward trend of price that follows the collapse of housing pricing. That implies a negative equity in investment for the proprietors. (Investor Dictionary. Com)

There are several factors that induce the burst of the real estate bubble in Asia from 1997 to 1998. The following focuses on several main reasons:

An excessive support of bank lending

The developers are unable to cope with the investment of the real estate based on their own capital due to the function of this industry-‘capital-intensive’. Thus, bank lending becomes a major source of funds. Before the mid-90s, the Asian real estate is fairly booming. However, because of the lack of a formal system of banking supervision, banks competed for developers by lowering interest rate. (Koh, Mariano, Pavlov, Phang, Tan and Wachter, 2004)

Government’s improper macro-guidance and control

Government intervention influences the real estate bubble in two perspectives: On the one hand, the land market and economic system is not mature or perfect enough. On the other hand, it is the limitation of the land resources and the market mechanism. Therefore, inappropriate regulation contributes to the growing of the real estate bubble. (An International Comparison of the Real Estate Bubble, 2009)

Some other reasons

For example, ‘the relaxed financial environment’; ‘excess international capital flows’ (An International Comparison of the Real Estate Bubble, 2009); excessive amount of house ownership; speculate in purchasing; and ‘bad lending practice’ ( Merriam, 2009)

When economists acknowledge the reasons of bubble burst, they strive to distinguish the breading real estate bubble by the measurements of financial ratios and economic indicators. That aims to prevent the bubble burst.

Housing affordability index

‘Monthly housing affordability index’ (HAI) is a method to identify whether ‘housing is becoming more or less affordable for the typical household. The HAI incorporated changes in key variables affecting affordability: housing prices, interest rates, and income.’ The formula is:

HAI= (Median Family Income/Qualifying Income)*100%

HAI ratio denotes the level of affordability. When HAI ratio is high, more people are able to buy a house. (Dr. Econ, 2003) This index facilitates banks to adjust fiscal policy. Assumed that the HAI is high, banks probably adopt liberal policies to extend loans, such as decrease the lending rates.

Price to earnings ratio

The real estate price to earnings ratio (P/E ratio) is the basic measurement to evaluate the comparatively assessment of the equities. This ratio is determined by three factors: The price of purchasing a house; the price of renting a house; and the spending on renting a house. The formula is:

Real Estate P/E Ratio: House price/ (RentExpenses)

This ratio provides an intuitive analysis that how purchasing houses restricts other family’ expenses. (The Real Estate Bubble in the 2000’s-Housing Market Indicators, n.d.)

Give an example of Washington DC House P/E ratio, which provides an integrated thinking about how purchase interacts with rent. The graph below states a rapidly grow in the ratios, which implies that the speed of raising purchasing price is extremely faster than that of renting price. It seems that such increasing trend will lead to real estate bubble, if none approaches is using to control it. (Eric, 2006)

Some other financial ratios or economic indicators:

Such as ‘real estate price to rent ratio; gross rental yield; ownership ratio; housing debt to income ratio; housing debt to equity ratio; or deposit to income ratio’. (The Real Estate Bubble in the 2000’s-Housing Market Indicators, n.d.)

Real estate bubble cause Asian Financial Crisis

The growing booming economy of Southeast Asia is known as the ‘the tiger economies’ between the late 90s and early 20s. Counties in Southeast Asia such as Thailand, Malaysia, Singapore, Indonesia, South Korea and Hong Kong (China) were regarded as the states with the most remarkable economic growth worldwide. According to the Gross Domestic Product, it seems that economies of these states increased by 6% to 9% annually. However, good times do not last long, from June 1997 to January 1998, the burst of financial crisis this Asian miracle was dashed to the ground. In the end of 1997, collapses of the stock and currency markets in these state occurred frequently, then, at the beginning of 1998, the stock market lost more than 70% of their profits. (Hill, n.d.)

In the economy system, real estate, compare with other sectors, it is ‘the most highly leverage sector’ that cause a financial crisis of the utmost probability. The increasingly compound of issues or difficulties lead to the real estate deviates from the normal development. That not only generates a breeding ground of the real estate bubble, but also potential risks for financial crisis. Because of the rapidly decrease of real estate price, there was a disastrous loss of bank lending in some Asian countries, which also affects the current monetary assets. (Lanka Rating Agency Limited, n.d.)

There is a theoretical economic approach (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006) that analysis the correlation between the return of real estate and the fluctuation in the spreading of bank loans. If the numerical value of the correlation is below zero, which indicates a phenomenon of under pricing, which prick up the exacerbation of financial crisis. This assumption could be explained though a formula, that calculates the housing price for trade:

P=V () M (, s ()) +B

Here are the meanings that each symbol denotes: V denotes the basic valuation of a house; M denotes the valuation of bank lending for having a mortgage on a house and the par valuation of bank lending for having a mortgage on a house with certain deposit rate; denotes the intending fluctuating level of a house; s denotes spreading of the bank loan according to certain deposit rate.

Assumed that set an accurate price for mortgage, a house’s marketable valuation is equivalent to par valuation, in addition, price for trade is equivalent to the basic valuation of a house. Suppose that is an independent variable, while s is a dependent variable, thus:

= 0

is equivalent to zero, as the spreading of the bank loan modulates according to recoup the bank for the transformations in the value as a result of the ‘put option’ is included in the mortgage lending.

When is equivalent to zero, it means the transformations in the growing fluctuating level of a house ( is completely spread round. However, when is below zero, it means the intending fluctuating level of a house ( has an impact on the covariance of the house return with the market. When the house price changes in response to the spreading:

= 0 ; = 0 ; 0

Thus, if the growing fluctuating level of a house ( is completely spread round, then the correlation between the house price for trade and the spreading of bank loan is equivalent to zero. Furthermore, if this correlation influences the covariance between the house and the whole market is influences, it on the verge of zero.

From another point of view, assumed that the spreading of the bank loan transforms according to under price rather than the intending fluctuating level of a house (, the house price changes in response to the spreading is completely distinctive:

= 0; = 0; and 0

Therefore, correlation between the house price for trade and the spreading of bank loan is below zero, as following equations:

= )

) 0

These two distinctive house prices which are influenced by default spreading generate an appropriate effect of under price: ‘Under pricing of the default risk in non-recourse lending produces a negative correlation between asset returns and changes in the default spread. Correctly pricing the default risk in non-recourse lending produces no correlation between asset returns and changes in the default spread. Countries that experience under pricing, experience larger market crashes following negative demand shocks.’

On the base of this theoretical economic approach, we could analyze the practical cases, in 1997 Asian Financial crisis, to support the idea that the collapse of real estate bubble causes Financial Crisis

The financial crisis was began from Thailand and then extended over the whole Asian even the whole world. During that period, the characteristic of its economy is overheating with a deficit of 8% in 1997. The valuation of housing increased swiftly and collapsed swiftly. The main element that generated difficulties for financial institutions was the loans to real estate. (Hunter, Kaufman, and Krueger, 1999)

According to the data from the Investment Property Databank , (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006) the figure below is obtained.

Based on the theoretical economic approach, the numerical value of correlation below zero will lead to a result of under pricing. Such under price may cause a great amount loss of funds, which will finally deteriorate into a financial crisis. From the above figure, Thailand is the typical example that explains the real estate bubble causes financial crisis.

At the beginning of the 1990s, a massive amount of foreign funds continued to flow in the Asia market until the 1997 Asian Financial Crisis started. During that period, the lower deposit interest rate in the country encouraged people to seek investment channels with higher return. Meanwhile, foreign funds benefited the growing of the real estate industry. Additionally, because bank expanded the total amount of lending though decreasing the lending rate, under pricing became uncontrollable. (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006)

In the In 1996, Thailand loaned to the real estate sector US $160 billion, which accounted for 30% to 40% of the total lending. (Mera and Renaud, 2000) The figure below illustrates the amount of funds finance companies lend to industries related to the real estate and manufacturing from 1987 to 1996 in Thailand. It is obviously that the loans to real estate sector rapidly grew between 1989 and 1990, after that the percentage of real estate loan to the total loan maintained at a relative high level, which was between 20% and 30%.

(Source: Bank of Thailand)

Another support case is Malaysia. Between 1992 and 1996, over 70% of the bank lending was invested in real estate sector and stock market. (Mera and Renaud, 2000) The massive amount of funds injected into the real estate industries lead to a rapidly increase in GDP in that period. It is the fact that GDP increased by 40%, 62% 115% and 70% in Malaysia, Indonesia, Philippines and Thailand respectively, that was much greater than that in Germany (19%), United Kingdom(16%) and United States (21.5%). However, this accelerated the formation of the Asian real estate bubble. (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006)

It shown in the below figure that Malaysia, Philippine, and Singapore also generated an negative correlation before the occurrence of financial crisis

Conclusion

To summarize this paper, at the beginning a briefly introduction of the real state bubble is given. In this part it includes the definition, the reasons for breeding real state bubble, for example banks compete by lower lending interest rates to excessive support the real estate industry, and government’s improper macro-guidance and control. Follow that are the measurements of financial ratios and economic indicators, such as housing affordability index and price to earnings ratio, which benefit to identify the signal of bubble burst.

The most important part in the paper is to analyze the relationship between the real estate bubble and the financial crisis to produce a result that the real estate bubble is a factor that triggers the start of the Asian financial crisis. A theoretical economic approach is given with some statistical data, figure and real facts of Asian financial crisis.

However, there some limitations in this theoretical economic approach, that do not agree with the reality. In the above figure, Hongkong and Japan generate positive correlation, according to theory this do not according with under pricing lead to financial crisis.

The fact is that Japan is a typical example to illustrate that governmental action has negative impacts on the real estate industries. The Nikkei 225 index increased rapidly from 10000 to 38916 (peak value) between 1985 and 1989. Facing this, the manager of the Bank of Japan focused on dealing with the inflation rather than shrinking monetary policy, which reflected a decrease trend in housing price. The real estate bubble burst. (Frankel and Tschoegl, 1993) This is one of the limitations of the economic approach, which need further improve.