With home ownership world-wide at record levels, the impact of a sudden fall in house prices has had a cataclysmic effect on economic activity.

Soaring interest rates have crippled consumer spending and stalled house sales.

In the USA, new property sales have plunged for the first time in decades. In Britain, London property has been hardest hit – the buy-to-rent market has collapsed.

Second homes in Italy, France and Spain have flooded to market but there are simply no buyers.

During the first five years of this decade Australian house prices doubled. A new outlook issued last week sees a 25% drop for the next five years.

On South Africa’s Cape coast foreign property owners are stuck with expensive properties they can’t sell even at half the prices they would have expected just six months ago.

As China’s hunger for raw materials continues unabated, high oil prices continue to fuel inflation.

Families who had been fuelling their spending by borrowing against the increasing value of their homes now have no source for further funds and consumer spending is expected to reach the lowest levels of the past decade.

For the automotive industry, China is the only highlight. Luxury goods are all taking a big hit but, as can be expected in these difficult times, alcohol, gambling and tobacco are booming.

(Read the full story in the detailed Analysis/Synthesis section – for subscribers only)

ANALYSIS >> SYNTHESIS: How this scenario came to be

There is always a bubble somewhere. In a world of almost-free markets, where money moves seamlessly and on the whims of investor fashions, a sequence of boom and bust becomes inevitable. Governments can’t intervene with any success nor can they predict or anticipate the outcomes. The strong housing market in most areas of the globe has all the makings of the next big bubble.

While the word economy is stumbling along, the housing market continues to race ahead. Low interest rates have increased access to the market and lenders have encouraged re-financing, freeing up US$100 billion in the US during 2004 alone, according to the Wall Street Journal. Many see the high and increasing property values as unjustified and unsustainable. Who was it who warned of “irrational exuberance” shortly before the Dotcom crash?

Home ownership world-wide is now at record levels. The impact of a sudden fall in house prices can have a cataclysmic effect on economic activity.

Increasing interest rates may still be manageable on your primary home but when the crunch comes, second homes are the first to be put up for sale – if only there were buyers. In Britain the ‘Buy-to-rent’ market has long been seen as a weak link in the property market and is extremely susceptible to volatility.

In South Africa, property prices have boomed even as the Rand has reached inexplicable strength against the world’s major currencies.

A drop in consumer confidence results when outstanding mortgages exceed current market values. Banks become reluctant to foreclose on customers who refuse to pay in fear of not being able to move the seized properties, creating an economic stalemate.

As long-term interest rates rise, danger signs are emerging:

In the USA there is the biggest house-price boom in living memory. In Nevada house prices rocketed by 30% in 2004 alone. There is feverish speculation in property in Florida and elsewhere. Such hot-spots look ripe or a big correction. The typical American home is now worth 50% more than it was five years ago. Home sales in February 2005 were only just slightly below the all-time highs. According to the Federal Reserve, house prices have increased roughly twice as much, in real terms, as in the housing booms in 1970s and 1980s.

A bubble in the housing market may make this a particularly bad time for low-income families to move into home ownership.

As with other speculative bubbles, exotic methods of finance and questionable ethical practices have become common to entice people into home ownership or to encourage re-financing to put property funds into other lifestyle spending.

Increasingly banks are finding ways to issue mortgages with far less than the traditional minimum down payment. Some government programs are fostering this practice as well. For example, The American Dream Act allows families to borrow more than the full cost of their home by adding administrative costs and property taxes costs to their mortgage. In addition, according to some accounts, appraisers frequently exaggerate home values in response to pressure from banks. This means that many new low-income homebuyers already have no equity in their home. If they face a major repair or lose their job, they will not be able to borrow against their home to meet immediate expenses.

A substantial downturn in the housing market will make matters much worse, leaving many new homebuyers with mortgages that considerably exceed the value of their homes. The prospect of falling home prices and rising mortgage payments would put enormous strains on the finances of any family, but lower-income households are least likely to have the resources to get themselves through tough periods, and therefore the most likely to end up losing their homes.

At this stage, the best we can do is to try to minimize the harm of a potential property bubble bursting.

First, we should own up to potential homebuyers about the inflated nature of the housing market. It is simply wrong to tell people that a house is a good investment and that house prices never fall – they do and they can fall from bubble-inflated levels.

Second, banks should make customers aware of the dangers and inflationary effect of using house equity to fund short-term lifestyle consumer spending.

Thirdly, government policies that promote homeownership rather than renting, especially for low-income families, should be curtailed. Whether or not the promotion of homeownership is generally a good idea, it is definitely not a good idea in a bubble-inflated housing market. Persuading families to buy homes at bubble-inflated prices is encouraging them to throw away their life savings.

There are already signs of a more benign slowdown – the median price of houses has stayed stable in the past year and mortgage applications have slowed down. The re-financing boom of the past five years has slowed.

It could be that, at best, home owners will face a period of flat house prices. Even this could have a massive effect on consumer confidence and spending, creating dropping economic activity and lower economic growth. A cooler housing market could even have an impact on the ability of the US to finance its enormous current account deficit. A real house price bust would be an economic disaster.

What’s interesting is that over the past 30 years even crippling interest rates and recessions have never triggered material decreases in house prices. What could be different today? Perhaps a combination of this coupled with outsourcing creating a ‘sudden’ drop in employment opportunities? Perhaps a sustained high oil price?

The Motley Fool web site puts it succinctly:

“Sure, the housing bubble may burst just days after you close on a new, pricey property. Or it might inflate and continue to strengthen, buoying an investment that your ancestors will celebrate for generations. Rates might skyrocket and housing prices may plummet. Toe-tapping and hand-wringing won’t do you any good. If you buy a house (or choose not to) for the right reasons, it won’t really matter”.

The right reasons include a house as your home. For any other reason you should treat the housing market with the same suspicion and care as any other ‘hot’ investment tip.