August 2007

Back in London for the summer, I find myself amazed at the silence of the Property Peakees and their less affluent cousins, the Property Dispossessed.  The former have seen their paper property wealth rise, while the latter have been left off the housing ladder, and found it difficult to get the media or politicians to take any interest in their economic frustrations.  I reckon this may be now changing.

Various newspaper columnists, and other Britain-based commentators have begun to write about the huge inequality in wealth that has developed in the UK, and London in particular.  Many comment with surprise that the apparent victims, who include the poor and the middle class, have remained silent for so long.  Also, the political parties so far have stopped short of exploiting the inequality gap.  It is interesting to ponder why this silence has occurred, and what might change, causing those on the wrong side of the wealth gap to become more vocal.

I call the people who bought UK property in the past year or so, the "Property Peakees", and I think a rapid change of their circumstances may be about to happen.  Then suddenly, and with great force, we will see the inequality issue emerge, as the Peakees find themselves sliding into a very uncomfortable trap - the mortgage debt trap.  The financial pain of the Peakees could turn wealth inequality into a hugely important political issue within the UK.

Let's consider how the current circumstances arose:

+ The super-rich have been attracted to the UK.  Favorable tax laws mean that they can enjoy low taxes so long as they remain domiciled elsewhere.  (This doesn't work for Americans, who pay tax on a global basis.)

+ London has benefited from its less onerous financial regulation.  The over-reaction to the problems of Enron, meant that the US passed an unfortunate law, Sarbanes-Oxley, which made it very burdensome for companies to list their shares in the US.  Many of those companies seeking a public listing have turned to London, which has a less onerous regulatory regime.  This boom in equity issuance help to boost incomes in the City, and has also brought many new highly-paid CEOs to London.

+ Extremely aggressive money supply creation in the US followed on the heals of 9/11, and an expensive war in Iraq.  US trading partners reacted by also boosting their own money supply growth, so their currencies would not become overly-strong against the dollar.  For instance, M4 money supply in the UK grew at over 14% per annum in 2006.  The boom in global money growth, has fed a boom in asset prices.  Property was one of the first assets to boom, and it boomed for years.  But in the last year or so, various property markets have began to peak-out, as higher inflation (from all that excessive money growth) eventually forced up interest rates.

+ The asset prices boom, which also benefited stock markets around the world, allowed hedge funds and private equity funds to show years of outsized returns.  This brought in huge fees for those fortunate entrepreneurs that had started fund businesses.  And many of those successful fund managers were based in London, thanks to the low tax regime.

+ The concentration of wealth, and the boom in returns for the types of investments preferred by the super wealthy meant that there were massive sums of money chasing luxury items, including London properties, a must-have investment for many of the superwealthy.  Those who made big returns elsewhere (Russia, India, China, etc) were also attracted to London as a place to park and to protect their wealth, while having their families live in safety.

+ The reigning Labour government did little to discourage the influx of the wealthy, because they saw few immediate negative consequences of this trend.  And also, because barriers to this wealth might have brought down property prices in London, causing negative ripples throughout the economy.  The other parties, and the Conservatives in particular, remained silent about rising wealth inequality, because of their ideological support for free markets and wealth creation.  The middle classes also remained silent, because "trickle-down" in the property market meant that their properties were also rising in value, and on paper, the property-owning middle classes were also getting more wealthy as property prices rose.  For those willing to borrow against that wealth, Mortgage Equity Withdrawals meant more spending cash, and more money to invest in other properties.

+ Those without property, the First Time Buyers looking to enter the market, complained, but for a long time have found it difficult to find a voice.  There was no political discussion and hardly any media outlets for venting their frustration of being left behind.  They watched helplessly, as the wealth-generating property engine took off and lifted out of sight.  Others, who were more willing to shoulder the risk took on heroic amounts of debt to participate in the rising property bubble.  The natural home for those who felt dispossessed by the wealth gap was the Labour party, but that party has been co-opted by praise and political patronage from those who had benefited from Britain's miracle economy.  Of course, in hindsight, it was not a miracle at all, but a debt fueled bubble.

SO THIS is where things stand now, as the former Chancellor Gordon Brown, who was one of the principal architects of the so-called miracle, has taken over as the new prime minister. He is proud of the decade of strong growth, but few beneficiaries of that growth have been willing to look behind the curtain, and see how it has been engineered. The UK economy is in a debt-bloated bubble, which has well-suited the wealthy, and those many workers and professionals in the City and Estate Agencies that have benefited from the rapid growth in asset values (and debt) which have brought matters to their current over-stretched condition. But so-called miracle has not delivered much at all in the way of increases in the disposable incomes of the average voter. Such income gains as have been seen, have been mostly eaten up by higher taxes, something that Brown as Chancellor had proved expert at increasing with various clever stealth methods. Pensions in particular have been hard-hit by t
 axes he introduced. And many have turned to property as a place to park their pension money. They are hoping that a huge cyclical upswing, which has already lasted twelve years, will defy all previous cyclical indicators, and be maintained indefinitely. That's another heroic assumption, going along with all those who have taken on massive debts, that it is safe to borrow huge multiples to their incomes.

What is next?
Affordability is extremely stretched.  Traditionally, it was FTBers who kept the property game alive.  In the past, they would account for 25-30% of property purchases.  But as prices rose out of sight, with an approximate 10% rise in the past 12 months, after almost tripling in the decade before, most potential FTBers can simply not afford the prices anymore.  Their share of property purchases has now fallen below 10% of property sales.  Meantime, investors and the super-rich have stepped in and bought with enthusiasm.  And high-end properties favored by the super-rich have risen much more than middle tier and cheaper properties. Some observers estimate that top properties in areas like Kensington and Chelsea are up over 30% in a year.

Incomes have not kept pace.  Thanks to a rising tax burden, which supported Brown's massive expansion of public sector employment to keep his "miracle" alive, after-tax disposable incomes have been falling.  So there has been little scope for rent increases.  So as property prices rose, yields have fallen.  Typical property yields of a decade or so ago, were 8-10%.  And yields today, for many parts of London are well below 4%, while mortgage financing costs are now pushing up towards 6%.  Only strong buying by the yield-insensitive super-rich, and enthusiastic property investors have kept the bubble alive.

In the UK, property investors are called Buy-to-Let (BTL) investors.  These BTLers have been assisted by highly-aggressive lending by the banks, who now lend 85%, 90%, and even more to those who can show a reasonable income, or surplus cash flow from their existing property portfolios.  Within the UK, and in London in particular, there is great confidence that capital gains will continue, even if prices are showing a negative return on a yield-less-finance-cost basis.  But aggressive BTL buying will only persist as long as investors are willing go on paying rather hefty subsidies on top of the rents they receive to cover the high finance costs.  Today's (7/7/2007) announcement that the Bank of England is pushing up base rates to 5.75%, will mean even larger subsidies are required for recently-acquired properties.

People routinely point to the rising population of super-rich, and big bonuses amongst the Hedge Fund magnates, and assume these trends will continue.  They talk of a two-tier market, with the low end properties favored by some BTLers being vulnerable to pauses, while high end buying will continue.  However, the easy times for the super-rich in London may not go on forever, particularly if it becomes politically fashionable to squeeze the rich.

There is beginning to be some antagonism towards the wealthy.  Rising property prices are not an unalloyed blessing.  Other prices, for things like restaurant meals, and personal services have also risen in the wake of rising rental costs.  And for those who have not yet bought (because they were too young to "get on the property ladder" before it rose out of sight), and for those who sold out 2-3 years ago, when property was just beginning to stretch beyond historical levels of affordability, the high prices create stress, and delay important life-decisions, like "settling-down" and starting a family.  Many of these people now have a feeling of being dispossessed by the property boom.  And the dispossessed, as a percentage of the political electorate is rising in number, as older property-owning folk pass on, and are replaced by new voters as non-property owners reach voting age.  They are a force not-yet-exploited, but one that the political parties, are increasingly likely to turn to, to win votes in future elections.

In Britain, there has recently been a lively debate about the tax advantages afforded to private equity investors, who pay small long term capital gain taxes on gains. This seems like favoring the rich, who then wind up paying a lower percentage of taxes than their secretaries and their cleaners.  Rumblings about how the British approach to taxing those domiciled elsewhere continue to be heard from time-to-time, but as a Chancellor to PM Blair, Brown never pushed too hard to close these loopholes.  Might things look different to him now that he occupies number 10 Downing Street himself?

We are already getting some signs that New Labour under Brown may take up different causes than New Labour under Blair.  Once known as the stealth Chancellor, Mr. Brown is capable of becoming the Chameleon Prime Minister, turning against policies that he supported as Chancellor, on the basis that it is politically expedient to change his stripes.  A hint of this appeared on some internet sites.  A story was making the rounds of various property-related internet sites that Gordon Brown will cease allowing fully tax-deductibility of interest payments on buy-to-let properties.  This would make it less attractive to gear-up these properties, and give current owners a huge incentive to sell down to escape the harsher tax.  Whilst only a rumor, it does suggest that the new PM may want to tighten some of the tax incentives which have helped to grow property wealth.

Meantime, the lower and middle tier of the property market is beginning to look tapped out.  Hometrack announced in the past few days that the number of properties on offer in London has suddenly jumped by 10.9 percent in June, as compared with May.  That is the biggest single month rise since January 2005, when the big jump in supply triggered a pause of more than six months in the property market.  Another indicator that I particularly like is the price of traded Builder shares.  Normally, this will lead the market by perhaps six months.  In the USA, the builders gave a great early warning (almost a year ahead) that the US property market was peaking.  They may be doing something similar now in the UK.  The average builder stock peaked around the turn of the year, and is now down about 25-30%.

A similar drop was a good warning in the UK. T his suggests that UK prices may be peaking out this summer, even in London, where the market had been so hot through the spring.

If prices do fall by as little as 5-10%, then the Property "Peakees" who bought in the last year or so, will find themselves with a losing investment, which is costing them each month, substantially more than renting.  This could bring about an important change in sentiment towards buying, since it only makes sense to own and finance such expensive property when the market is rewarding the extra monthly cash cost with a stream of capital gains.

A wake-up call that property has become too risky, would soon put prices even lower, as alert investors and the over-geared suddenly rush for the exits.  Then the market might find itself in an even more dangerous phase.  If and when prices fall far enough that the Peakees find themselves with negative equity, then the real stress will begin.  At that point, many will be trapped with expensive debt, and no exit.  The banks will not allow them to sell the properties, unless they can cover the full mortgage amount.  Many will have stretched to buy, so they will not have the extra funds to cover the mortgage shortfall, and so they will be stuck continuing to make the debt repayments, unless they are willing to face bankruptcy.  Many could find themselves as virtual debt slaves while the market continues to slide. Some will sell, and also bank foreclosure will rise, just as they have in the US.  There is a possibility that the UK may face years of property falls, and a market that does not find its low until it has fallen by 20-30% lower, or even more.  If banks back away from their aggressive lending to BTL investors, then the market will need to find substantial buying from FTBers in order to reach stability.  Many dropped out of chasing property at much lower prices, many will need prices to be 30% lower or more before they become truly affordable again.

When Gordon Brown was Chancellor, he and his economy made a dangerous pact with two devils.  And he was rewarded with a ten year "miracle" of high growth.  One was the debt devil, where banks and their customers were persuaded to borrow money on more and more aggressive terms.  Of course, this triggered a rise in house prices, which then fed upon itself, in a "virtuous cycle" of higher prices allowing more borrowing.  As property stalls, this may be followed by a vicious cycle, of lower prices, requiring more debt repayment, default, and tightening which then leads to even lower property prices.  In such an environment, people will slow their spending in order to make mortgage payments, and put their finances back in order.  But this is a gradual process, which make take years to return to a safer balance between income and debt.  Many over-stretched Peakees may find themselves losing their homes and their BTL portfolios.  As this happened, these people can be expected to look for someone to blame.  The new PM will then seek to shift the blame away from himself, and onto others.  An obvious target will be the super-rich, who have been one of the causes of the big jump in property prices, particularly in London.

The other devil that Brown shook hands with, was growth in the public sector.  This put more people on the public sector payroll.  The UK economy now employs an incredible 25% of working males, and over 50% of working females.  This government-mandated spending was another key pillar of Brown's "miracle." Naturally, he will not want to slim down the public sector in a recession.  So he will have to find tax revenues to pay all those public sector salaries.  He will not find it easy to squeeze more tax revenues from the Peakees, who will be in severe stress.  And business taxes will likely decline in a time of recession.  Putting new taxes on the rich, and ending at least some of their favorable tax treatments may prove very hard to resist.

An attack on the tax benefits for the rich, would raise some revenues, and would also bring down high London property prices, as they flee a harsher tax regime. Falling property prices would be welcomed by the Property Dispossessed, who want to see much lower prices, so they can afford to buy again.  Brown's Chancellor, Alistair Darling, who is very much living in the pocket of the new PM may even throw them a tax bone or two, such as a restoration of mortgage interest relief for FTBers.  Since they are now a fast-rising segment of the electorate, this looks rather likely.  If Labour doesn't do this, then a prospective Conservative government may find mortgage tax relief to be a popular campaign promise.

The Property Peakees would be squeezed, and some squeezed greatly, by lower house prices.  Worst hit would be those who bought recently, and those with heavily-geared BTL portfolios.  A cynical politician might do his calculations, and decide that these people represent a small number voters in relation to the majority that bought much earlier (and can survive a price correction), and the rising number of Property Disposed who prefer lower prices.  If the politicians and their tame economists can blame the price slide on the departing wealthy, then they could pull off another sort of "miracle" of triggering a price slide, while blaming it on others.  Everyone needs a scapegoat, especially the most blame-worthy.

An Expat’s Guide to Investing Offshore  - So, you have decided to make your move and become an expat.   You have an income or a lump sum and your expenses are under control – things are going well and you love your new life.  You know you’ve made the right choice and you aren’t looking back.  But have you dealt with your financial future?  Life as an expatriate has never been more exciting or rewarding, but being an expatriate does not mean that you can ignore the importance of saving and investing.  At first there seem to be fewer options out there for you, as you may not be able to contribute to a retirement plan in your home country, such as a 401k, Roth IRA or equivalent plan.  That is one truth.  But there’s another more valuable truth -- expats also have many advantages with the array of offshore investments available to them, so it’s possible for you to invest and save more successfully than where you were at previously.