Article review of Living in Never-Never Land, from the Economist, Jan 9, 2003

This article discusses the continuation of consumer spending regardless of the falling stock markets. They offer as a primary reason for this the home refinancing that has been occurring because of low interest rates. Three countries, America, Britain and Australia, have been on quite a binge. In all three countries spending has been partly propped up by rising house prices, which have offset the effect of a decline in equity wealth. Indeed, housing has a bigger impact on spending, because more people own homes than own shares. It has also become easier to turn capital gains into cash by refinancing mortgages or taking out home equity loans.

Falling interest rates have allowed millions of home owners to take out equity and not increase their debt service payments. But how long can this continue? The article points out the concern of an impending increase in interest rates will cause housing prices to fall and leave many home owners with no equity at all. But more to the point, eventually consumer spending based on low home mortgage rates and refinancing is not a long term situation. Hence the title of the article, “living in never-never land.”

One interesting point is that even if house prices don’t fall, the one time cash influx of a refinancing will not be there again, at least for most people. So the shot in the arm that we have been getting in consumer spending may dry up even if the housing market doesn’t burst like a bubble.

My Take: I believe that the housing market will burst like a bubble. The amount of house payment you can afford is basically fixed. If interest rates rise, you will be able to borrow less money for the same payment and therefore people will be able to afford less house on the same salary. So prices will naturally decline. When they start to decline, there could be horrible spiral effect that causes them to keep declining as demand shrinks and it becomes a buyers market. Also, I should mention that those that got in on exceptionally low adjustable rate financing may be very unhappy as adjustments start to take hold.