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.

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