House Price Crash or Correction? - The illusion of wealth

On the 12th February 2008, the Halifax has said that house price rises are expected to remain flat in 2008; an opinion that was echoed by the governor of the Bank of England the following day. The implication of these views is that what they wouldn't  be doing was falling. A year or so on and we all know better.

Between November 2001 and November 2007 the FT - Acadametrics house price index shows that the average selling price of a house rose from £121,153 to £230,504; an increase of 90%. Over the same period the Bank of England’s base rate rose from 4% to 5.75%, so it was certainly not a reduction in the cost of money that was driving the market. Nor was increased wealth as measured by net disposable income responsible. Growing by just 29% house prices grew three times faster. A flood of reckless and seemingly unregulated lending by the banks, allied to to homeowners turning on the mortgage tap to finance holidays, new cars and in some cases, school fees inevitably led to disaster.

 

Even after what is generally agreed is a 30% drop in prices from their high point he UK house price to average earnings (affordability) ratio is still at around 7/1. This is nearly double the long term historical average of 4.5/1 that applied also in 2001. In addition total personal debt in the UK in 2007 reached £1.35 billion (of which mortgage debt was £1.15 trillion), as against GDP of £1.33 trillion. As debt to equity ratios go, such a comparison (101%) usually spells insolvency.

 

What these figures tell us is that lower interest rates are not going to solve the likelihood of a correction: They could end up making things even worse in the long term. This is because interest rates at their present level will not be sustainable once other countries, most especially the US begin to recover. Recovery there is bound to put Sterling under pressure.


Another interesting ratio has been uncovered by the Royal Institute of Chartered Surveyors. They studied the relationship between interest rates and house price cycles going back to the end of World War 2. What they found was that a downturn in prices tends to kick in when rates reach the point at which they are around 60% higher than the low point in the cycle. For instance the Bank of England base rate at the end of 2007 stood at 5.5% while the low point in the cycle was reached on 10th July 2003 when it was set at 3.5%. This is an increase of 57%, not 60% but it was Libor that made the difference.


The traditional mark-up on these rates, known as libor added by the banks before setting their own commercial, or wholesale money rates has traditionally been around 0.25%. Since September 2007, when the debt crisis began to make itself felt it rose to 0.8%. So now there is an extra 0.55% to consider and when one factors that into the equation, the applicable rate of increase on the 3.5% low point in the interest cycle comes out at 73%.

Given the above, how the market can reasonably expect to settle at about its present level is therefore difficult to fathom. If one factors in higher peripheral taxes such as the reintroduction of the fuel escalator, falling living standards and the as yet unresolved question of paying back hundreds of billions in new sovereign debt it gets worse. There may be signs of green shoots but the dire condition of the economy is bound to trample on these for the next two years at least. From mid-May 2009 a further fall of 20% is much more likely before the housing market truly settles.

updated - May 14th 2008

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Your Comments

I work in the city and I can tell you it is common knowledge that if all of the leading banks valued their MBOs as mark to market today most would be technically insolvent. The last thing that any of them wants is more of them because there is practically no market for them. That is why mortgages are going to be far harder to write until this works its way through the system and we are talking two years minimum for that to happen. So a crash gets my vote.
Comment by brassica
Since the picture of Caroline Flints notes was taken we know that the government is full of sh*t when they told us that house prices had only stalled when they really expect them to fall by 10%. Perhaps one of them can tell us the truth about inflation too because its a lot more than 3%.
Comment by junglejim
The only reason house prices arent down by 20% this year is because sellers are refusing to face up to reality. They cant stay in denial for much longer though and the real collapse in prices is going to start about May of 2009.
Comment by propertypete
Can someone tell me why it is only today that Taylor Wimpey's shares fell 6% on the news that their profits bombed last year. Didn't anybody in the City wake up to the fact that house builders were going to be in deep trouble months ago and mark them down long before now?
Comment by G.Weller
In fact Taylor Wimpey has actually made a loss of £1.54 billion in the first half of this year. The reported profit of £4.3 million was before writing down the value of their land bank by £690 million plus another £860 million in respect of goodwill, intangibles and the George Wimpey brand. Another £40 million went in restructuring costs following some 900 job cuts and the closure of 13 offices. As for the drop in the share price; it had already fallen by 70% this year before this shocking news was announced. It's one thing for an over-optimistic house buyer to fail to spot that the binge in prices was bound to hit the buffers sometime but quite another for the country's biggest house builder with the all of its resources and presumed management expertise to fail to do so.
Comment by Figurewizard

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