Can the UK wean itself off its property price addiction?
Expectations of continuously rising property prices were one of the prominent features of pre-crisis Britain (and, of course, the US). While analyses of the origins of the crisis will undoubtedly point to this complacency as one of the factors that helped blind people to growing risks, I think we may be missing one of the major difficulties that the lack of rising property prices play in a world of private bank-created money.
Below is a chart from Neal Hudson showing annualised house price changes by Prime Minister:
What should be clear from even a fleeting glance is that the Blair years saw prices grow at an exceptionally fast pace. Hudson’s findings are backed up by work done by Ecfin, which found that “[while] real income per household increased by 27% between 1995 and 2007, real house prices increased by 168% over the same period”. Indeed average nominal house prices tripled between 1998 and 2007 – there really were few places better for people to put their money whether to help climb the property ladder or simply as an investment.
Of course, residential property is only a part of the story. The commercial property sector was undergoing a boom of its own with prices rising almost 60% between 2000 and their 2007 peak. See the following chart from the Bank of England:
A consequence of this apparently one-way bet was that banks were happy to increase both direct commercial and residential real estate lending and encourage borrowing against real estate assets. This was despite the banking industry having suffered heavy losses from real estate price falls in the 1970s and 1990s crises. In the build-up to the latest crisis commercial real estate lending exceeded 20% of annual nominal GDP.
Yet while these figures tell us a lot about the scale of the crisis, they give us precious little information about why our economic activity before the crisis became so concentrated in the property market. By examining this point, I think, we start to get to the heart of our financial system and the reason why this crisis has proven so difficult to bounce back from.
It’s all about risk
The key to understanding the dynamics of bank created money, or endogenous money, is that when a bank extends a loan to an individual they are not transferring existing money between agents. Rather, as Joseph Schumpeter puts it, the loan represents “the creation of new purchasing power out of nothing… which is added to the existing circulation.”
This ex nihilo creation on new capital, however, is not catch free. By creating money as debt the bank is creating an obligation on the part of the borrower to repay the sum over time, plus interest, and booking the loan as an asset on the bank’s balance sheet. In effect, the bank is therefore bringing forward the future earnings of the borrower.
In the case of mortgage lending this loan is secured against the house asset. The housebuyer pledges their legal right to the property in exchange for a bank loan, but they redeem the rights (e.g. the agreement is terminated) once the loan is paid off. Indeed the word “mortgage” comes from the French “mort gage”, literally translated as “death pledge”.
From the banks’ perspective this deal makes great sense. The individual or business taking on the loan is legally obliged to repay it, plus interest, but if they fail to do so the bank is left in possession of the underlying property from which it can take its dues. This, however, relies on the value of the underlying property rising in price or at the very least holding its value over time.
Moreover, property can also be used to borrow against for other purposes. In 2009 the Bank of England estimated that “around 40% of all outstanding mortgage debt in the United Kingdom has been used to back securities”. As such lending into other parts of the economy also becomes conditional on ever-rising property prices. What this tells us is that before the crisis struck property was treated as a safe private asset that acted as a conduit of bank-created money into the real economy. Unfortunately this also means that if prices get ahead of themselves the potential of a crash poses systemic risks.
Property is a rare asset. Unlike bonds where the price and the yield have an inverse relationship to each other property tends to display a strong correlation between the two. This is fairly straightforward to understand. As the yield (rent) increases it becomes more attractive to own property, driving up prices. Yet as prices rise, an increasing proportion of the income spectrum gets priced out of the buying market and this gives landlords a captive rental market that must accept raises in rents (yields).
Of course, there are limits to this cycle. If credit conditions suddenly tighten, for example, then maintaining the pace of price increases could become a problem. Yet as long as the investment case for property remains and there are sufficient amounts of foreign buy-to-let purchases to offset the numbers of domestic potential buyers being priced out of the market the upwards spiral in prime locations such as London and the South East can continue.
The problem then is not necessarily revealed by an examination of affordability of house purchases relative to average wages. The crucial factor may well be a less tangible measure of rent tolerance.
We have already seen the impact of a falling outlook for rents in the commercial property market. Commercial property valuations are calculated using net present value of future rental income, discounted by a risk-free rate plus some ‘risk premium’ demanded by investors. If the outlook for rental income falls sharply so too must the price. As a recent Bank of England report found:
“By the end of 2007, CRE loans accounted for more than a third of the stock of lending to UK private non-financial companies by UK-resident banks. As the crisis unfolded, valuations fell sharply, with real commercial property prices almost a half lower than their 2007 peak by end-2012.”It is for this reason that UK policymakers will be very worried by the following graph:
The poor performance of wages in the aftermath of this crisis has already led to “subdued” activity in the housing market according to Halifax. But as the chart above suggests, even more disturbingly the fall in real incomes has been met with sharp increases in household costs, which have risen by 25% since 2008.
At first people can offset these rising costs by making lifestyle sacrifices – one fewer night out here, giving up a take-away there. Ultimately, however, if the trend is allowed to continue they will face a choice between essentials – the weekly trip to the supermarket or paying the gas, electric, water bills – and paying their month’s rent. No wealthy society should ever ask people to make a decision between sacrificing basic needs or losing the roof over their head.
So the residential housing market is now potentially facing something of a perfect storm. Would be first-time buyers are seeing their real incomes eroded and tight credit conditions preventing them from raising a mortgage to get any benefit from lower interest rates. At the same time falling incomes and a stagnant job market is constraining the ability of renters to pay more, limiting the appeal of house purchases as an investment.
Help to Buy is no answer at all
With falling incomes threatening to undermine the investment case for property a case could be made for an imminent market correction. Moreover many people are pushing for an ambitious government-funded house building programme to help bring prices down through increasing supply.
Undoubtedly either of these measures could improve affordability. Yet for the banking sector falling house prices could be disastrous. As Frances Coppola writes:
“Falling house prices therefore eat up banks' capital, not because they took on risky loans but because their supposedly safe low-LTV mortgages become much riskier. Banks and building societies are already damaged from the financial crisis of 2007-8. A large fall in house prices could bankrupt many of them.”
So instead of allowing or facilitating a housing correction the government appears to have decided on a policy that provides government support for prices. The Help to Buy scheme offers government loans to first-time buyers, and later a mortgage guarantee programme for new and existing homes, that should forestall a price correction (at least until after the next election in 2015).
Unfortunately, in the medium term the scheme will either prove only a temporary boon to the banking sector or would mark the long-term involvement of the government in supporting the housing market (as we have seen in the US). Even Bank of England’s outgoing governor Mervyn King has expressed his strong reservations.
What it certainly doesn’t deal with is the rent tolerance problem. If incomes continue to fall then at some point there will have to be a price correction. The only way this can be avoided and affordability can be improved without threatening the banking system is if we start to see stronger wage growth – something that the post-crisis UK has struggled to deliver.The broader problem for the financial sector, however, is whether we can return to a system built around a faith in ever-rising property prices. If not then the ramifications of the crisis may yet be seismic.