What’s Now Changed in the Housing Market

Brian Durrant - Mon 28 Apr, 2008

Stretched price to income ratios and a mortgage famine increase the downside pressure on house prices.

Recent headline news about the property market has been quite alarming for homeowners. The Halifax house price index fell by 2.5% in March. This fall was five times larger than anticipated, and the steepest monthly decline for 16 years. Meanwhile, the IMF calculates that Britain's housing market is overvalued by up to 30%, and could be destined for a damaging correction. Finally, the Council of Mortgage Lenders said that there was a real possibility that net lending this year could reach only half last year's level, unless something was done to unblock the lending markets.

You could argue that these headlines are hand-picked to portray the scariest possible scenario for homeowners. For example, the Halifax series is one of many indices, which can be volatile on a month to month basis. The Nationwide house price index showed a more modest 0.6% fall in March, while the Financial Times measure shows that UK house prices were flat in that same month. The UK housing market isn't plunging at anything like 2.5% a month, but the underlying trend of less dramatic falls has been in place for a few months.

And what about the IMF? It is worth remembering that five years ago the IMF also said that Britain's house prices were 30% undervalued and they have proceeded to soar by over 45% since then.

Wild monthly house price swings and perennial prophets of doom on the housing market are nothing new. What really concerns me is the paralysis in the mortgage market. This is a new development.

The big question is: are house prices on a precipice, awaiting a severe correction or will the adjustment in house prices relative to income be a more mundane affair? The second option could play out as house prices more or less flat line year after year until prices become less expensive relative to income.

In the past I have subscribed to the following view: the housing market will be the victim, rather than the assassin, of the real economy. In other words, it would require a severe downturn in the economy to precipitate a sharp fall in house prices like we experienced in the early 1990s. In the late 1980s interest rates were elevated from 7.5% to 15% to combat rising inflation. The UK economy plunged into a recession and unemployment rates jumped. A combination of rising mortgage payments and an increase in unemployed homeowners led to a massive rise in house repossessions. As house prices fell, many first-time buyers that got sucked into the housing market in the late 1980s were plunged into negative equity. According to the Nationwide house price index figures, from the third quarter of 1989 to the first quarter of 1993 house prices fell by 20%.

The good news is that the background economic conditions are not as bad now as they were then. For instance, the UK authorities were unable to cut interest rates to relieve the recession because economic policy was dedicated to keeping sterling in the ERM. That self-inflicted policy straitjacket is not in force now and the UK authorities have greater freedom to cut rates than they did then. Moreover, the UK economy is not in recession at the moment.

The spectre of negative equity is not as pernicious as it was in the early 1990s. Back in 1990, 35% of first-time buyers had 100% mortgages, creating a pool of homeowners at immediate risk from negative equity. Last year the equivalent figure was just 5%. There were one million first-time buyers in 1990, representing half of all property transactions. That constituted a shakier foundation for the property market than we see now, as 2007 saw only 300,000 first-time buyers, which accounted for only 30% of deals. In addition, today's first-time buyers tend to be older and have a bigger average deposit - 20%, compared with 12% in 1990. On the other hand, buy-to-let landlords and second homeowners, who tend to have deeper pockets, are more active in the housing market in the latest boom than in the previous one.

That's the good news. This provides the basis for hopes that the downward adjustment of the relatively high house prices to income ratio will somehow be orderly. At the moment, the level of average house prices divided by disposable income per head is about three times its long-run average of the last 25 years. If incomes rise by 5% a year and house prices remain static then the ratio of house prices-to-income would revert to its long-term average in about six years. This is the sort of adjustment that politicians and central bankers dream of. But it may be just a dream.

The bad news is that the housing market cycle is starting to behave very differently compared to previous cycles. New funds are proving hard to come by for thousands of borrowers coming to the end of cheap mortgage deals. At the same time, lenders continue to withdraw their most competitive rates and load higher premiums on to larger loans. According to Moneyfacts, the number of mortgage deals on offer has fallen by 46% since the start of March. The Alliance & Leicester and Woolwich raised mortgage rates in the same week as the Bank of England cut them, while the Nationwide actually raised rates on the day of the official interest rate reduction.

A year ago borrowers could obtain two or three year discount deals for less than the base rate. Now many new rates are one percentage point or more above base rates. Moreover, it is the latest entrants to the housing market that will have the more difficult time. Borrowers with equity of less than 10% in their property are being excluded from the best deals, which are reserved for those with 20% or more equity in their homes.

In essence, banks do not want to lend money to homeowners that are at risk of falling into negative equity. In the context of the state of the housing market, this is eminently sensible. The problem is that it has come as a shock to those who were seduced by reckless mortgage deals offering loans at 125% of house price values.

The Council of Mortgage Lenders reckons that there will be a £30bn shortfall in mortgage funding this year; if so, house buying activity will dry up and prices will drop further. The first-time buyer has become an endangered species this decade. Many have been waiting for prices to come down so they can get on the housing ladder-only to find that now prices are slipping, they cannot get a mortgage. Furthermore, demand from other sources like would be buy-to-let purchasers and second home buyers are also in retreat. Indeed, capital gains tax changes coming into effect this month introducing a uniform 18% rate may increase the sales of buy-to-let properties as owners’ cash in their capital gains.

At last the Government has reacted to the paralysis in the wholesale money markets by allowing banks to swap their slightly iffy mortgages for government-backed bonds. This is not a giveaway. For example, for every £1,000 of AAA-rated mortgage securities with under three years to maturity swapped with the Bank of England, a bank receives £880 in government-backed paper. For the highest risk paper admissible under the scheme, the bank gets £730. These terms are somewhat more onerous than expected, and there is no guarantee that the banks will take up the facility. It is clear that the scheme is not intended to take us back to the excessive lending of a year ago.

The moves are intended to free up lending between banks, thereby bringing inter-bank interest rates back down towards official rates. If it works, it will take time for this new funding to be reflected in the market. Indeed, three-month Libor rates remained almost one percentage point above base rates after the announcement. Furthermore, Abbey increased its fixed rate deals for borrowers with only 5% equity from 5.99% to 6.60% that day, and also withdrew from the buy-to-let market.

There has been a lot of hand-wringing about the Government chucking £50bn of taxpayers' money into the banks' begging bowls. This is a distorted caricature. Something had to be done otherwise high interest rates would start to cripple innocent businesses outside the financial sector. In any case, when an overweight person is on the operating table after a heart attack, the lifestyle lectures can wait until after the patient is saved.

Back to house prices, and it is not difficult to see which sectors of the property market will be hit hardest by the credit crunch. New developments in regenerating areas of inner cities that attracted first-time buyers look vulnerable, as do areas of the country that participated most vigorously in the house price boom as it entered its final stages. As far as the housing market goes, it's last in, first out.

There are marked regional variations in housing markets around the country. In some areas as many as one in 10 mortgages have been issued to buyers with a chequered credit history. On this basis, areas vulnerable to greater house price drops include Newport and Cardiff in South Wales, Teesside and Sunderland in the North East, Manchester, Wigan and Oldham in the North West, and Wolverhampton and Walsall in the West Midlands.

On the other hand, urban areas in the South East tend to have a lower percentage of sub-prime borrowers with mortgages. More than one in four apartments in East London are not owner-occupied, while in Central London over 20% of mortgages are buy-to-let. These areas have a different problem from the sub-prime areas, but it still leaves them vulnerable. Developers in these areas who have not already sold their properties off-plan will have to drop their asking prices by 15%-20%.

So which region of the country is the least vulnerable to either a sub-prime or buy-to-let inspired meltdown? The winners of this particular postcode lottery are in South Wiltshire.

All in all, the changing structure of the mortgage market has changed my perspective on the housing market. The view that a house price correction required a sharp deterioration in the underlying economy is no longer necessarily the case. It follows that an orderly decline in the house price to earnings ratio over a period of years is now a less likely scenario.

The UK housing market has carried itself beyond its own clearing level and has to adjust for that. The mortgage famine will accelerate that process. So how far will prices fall? A commonly quoted figure is 30%. This chimes with the IMF model. Furthermore, futures in UK house price indices have recently pointed to a 14% decline 12 months hence, followed by a similar decline in 2009-10, again very close to the 30% number bandied about. Many commentators suggest we are destined to follow the US' experience. Personally, I think this sort of fall is extremely unlikely.

Futures markets in house price indices are not the most liquid of markets and can exhibit an in-built bias of traders who want to hedge against their own property portfolio. The US housing market, at its peak, was characterised by daunting over-supply, whereas here we do not have such a supply/ demand imbalance. Over the year you can expect to see falls in the realm of 5%-10%. What happens thereafter depends how quickly the mortgage market gets unjammed.

Finally, I have been intrigued by one of the UK government's responses to this mortgage crisis. Earlier this month the Prime Minister Gordon Brown said: "We are making the dream of a new home more affordable for thousands of low-income first-time buyers." He wasn't, of course, referring to the downturn in house prices but new government measures to encourage first-time buyers and key workers to participate in its Open Market Homebuy initiative. Under the scheme, qualifying buyers take out a mortgage for a percentage of their home and then another loan - known as a shared equity loan - from the Government and lenders to pay for the balance.

These poor souls sucked into this scheme are likely to face the spectre of falling property prices, negative equity, rising mortgage costs on the basis of their creditworthiness, the loss of the 10% income tax band, rising transport, food and utility bills. And to add insult to injury they will have to pay stamp duty at 1% for the privilege. This is not the time to encourage the less well off to buy property and the Government should know better.

Regards,

Brian Durrant
For The Daily Reckoning