Jean-Pierre Zigrand, pictured, is the director of the systemic risk centre and professor of finance at the London School of Economics. He is also a Luxembourger
Photo: Jeremie Souteyrat
Luxembourg has recorded a 50% increase in house prices since 2015, and still prices continue to grow.
Director of the systemic risk centre and professor of finance at the London School of Economics Jean-Pierre Zigrand gave an enlightening talk to examine the “bubbliness” of the Luxembourg housing for Paperjam Club on 2 December.
Delano summarises 10 slides.
The E=MC2 of finance
To understand the market, you have to understand what drives it. Zigrand explained prices are high not because rental is high and we value housing, but because we treat the house as an asset. This formula is the fundamental theorem of asset pricing, which says the fundamental price of the property is what the market expects.
The price of property is equal to E what you expect in future rentals. Bt is the bubble component. “If there is one, the price is bigger than the fundamental value. You pay more than what it’s worth because you expect to sell it for even more to someone else later on,” he said.
Housing supply is not the only factor
People often say supply is a problem. But Zigrand says that rental is a clear measure of whether or not there is enough housing in Luxembourg. There is a good supply of rental properties which are expensive, but still cheaper than buying. “In that sense there isn’t a lack of housing for living purposes. There’s a lack of housing for investment and housing purposes,” says Zigrand.
House prices are going up but rents aren’t. “The yield you get if you buy a house and rent it out used to be 4% in 2005, now it is 2.5%, maybe 3%. The rent to price ratio has really changed. Interest rates have come down, but fixed long rates haven’t changed. There seems to be nothing explaining this change, prices have gone up more than rentals.”
What’s driving this price increase?
“My feeling is there’s a sudden panic buying going on,” says Zigrand. “It is known that in bubble periods people buy and sell more. This is the number of apartments bought and sold in Lux. It goes up a bit, it goes down with covid on the right. It looks like a market that is becoming hotter.”
Bubbliness growing more quickly than the formula
To define bubble, the increase must be dramatic. This picture shows whether the prices of houses in Luxembourg rise at an explosive “bubble” speed. In black are prices going up, in blue is a critical line by statistics, in green is the speed of increase.
“The statistics say if the green reaches or goes above blue, then we are in explosive bubble territory. We see different episodes where prices in Luxembourg behaved in explosive ways, including in the last years on the right. My formula does not say prices should increase exponentially, the statistics say they do explode exponentially,” says Zigrand, adding: “You see there is a bubbliness that’s growing more quickly than the fundamental formula could make it grow.”
House price cycles
Some property in Luxembourg is bought using international capital, which means that cycles in other parts of the world will find their way through rates and buying into the Luxembourg market. “This makes it a bit vulnerable because that money can be pulled out again. The cycle is global and Luxembourg is no different from all the others.”
Zigrand identifies two cycles: “There’s a 13-year and 19-year cycles. These are international cycles. If there is a 13-year cycle, next year could be a down year because there are these synchronized global waves.”
Systemic risk is if the system stops working
Zigrand points out the difficulties of measuring systemic risk in Luxembourg because of two paradoxes, show in the above slide.
The blue line shows the prices going up, people don't see the cliff because they feel wealthy, and they perceive there to be a lower risk. Then the crisis comes. Nearly every measurement by companies or banks is in red.
Zigrand says: “When prices go up, you also perceive there to be less risks, because everyone is happy and you have money, volatilities are coming down […] The real risk is the one you cannot see, it’s in green. When you think there is no risk, then people take very risky positions.”
When buyers expect interest rates to stay low and prices to rise, they will borrow large amounts, building up risk.
“You don’t see it because everything looks perfect. And you cannot measure it.”
The wobbly bridge
Zigrand compared the propagation of a crisis to the Millennium Bridge in London, which was wobbly, engineers later learned, when 166 or more people walked on it. “Financial markets are the same. We don’t know what will happen. But something is building somewhere if something goes wrong there will be a feedback loop of everyone doing the same thing. We don’t know how vulnerable we are. 166 is an unknown unknown. This is a typical feedback loop. Once too much credit has been given, we see if then something happens like a shock on the top left, if all these effects will happen, people will lose money, there will be funding and liquidity problems,” he said, adding : “It’s all possible. We don’t know how close to 166 we are.”
Banana skins and accelerants
Zigrand says we should worry when houses are “bought by people who have no business buying houses, for short-term speculation: foreign buyers, who have no reason to stay in Luxembourg, buy to let, it’s easier to sell if you don’t live in it.”
Another issue specific to the grand duchy is that 85% of wealth in Luxembourg is tied up in housing. “No other country comes close to that. If house prices go down, the wealth of the nation will go down.”