The Housing Conundrum

By Frances Coppola, Proprietor, Coppola Comment

House prices in the UK are too high. How much too high they are depends on where you are: house prices have been rising in London because rich Asian businessmen and French aristocrats are buying up prime real estate as a safe haven investment for their filthy lucre, apparently. But outside London and the South East, house prices have actually fallen over the last few years, a bit. But not much. Certainly not enough to make them affordable for young people on median incomes.

The trouble is, there are a lot of people out there who already own houses. Many of them are relying on the value of their property to top-up their pensions. And all of them have votes. The total voting power of homeowners in the UK far exceeds that of the young people who are being priced out of the housing market. It would be electoral suicide at the moment for any political party to sign up to policies that would cause a significant fall in house prices.

However, there is future electoral benefit in making it possible for young people to buy houses. At some point many of these elderly property-owners are going to want to sell their houses, and if young people can’t afford them then they are in for a big shock. It is not in older homeowners’ interests to sit on an appreciating asset whose value is not realisable in practice. Writing down the value to something more affordable is a far more sensible strategy for older homeowners who have paid off their mortgages. Young people and old people therefore have more in common than they think they do. The people who really stand to lose from a major fall in house prices are those with mortgages, particularly those who over-borrowed prior to the financial crisis and are only just managing to service their debts. A fall in house prices could force many of these into negative equity. Painful though that would be, it would enable the housing market to readjust to a more sustainable level, and provided interest rates remained low, borrowers would be able to continue to service their loans. Yes, a lot of young families would be trapped in houses too small for them because the amount of their mortgage exceeded the value of the house – as I was in the early 1990s, the last time there was a significant house price correction in the UK. But repayment mortgages are forgiving things: eventually the outstanding amount would drop below the house value and they would be able to move.

So engineering a fall in house prices looks like a good economic strategy for the medium-term, although possibly not a wise one for politicians hoping to get re-elected in 2015. But the Government is not even discussing it. On the contrary, it is doing everything in its power to prop up house prices. It is not liberalising planning laws to enable expansion of private sector building programmes, assome have suggested. Nor is it sponsoring public sector building programmes. And on the monetary side, it now has two schemes designed to make it easier for first-time buyers – the Funding for Lending Scheme, which provides cheap funding to banks on condition that they lend more to house-buyers and small businesses, and the Help to Buy scheme, which guarantees part of the purchase price of a house, thus making it possible for people to buy a house without much in the way of a deposit. Both of these schemes have been criticised for potentially increasing house prices.

This apparent short-termism is not entirely due to electoral considerations, though those are clearly a factor. A fall in house prices is not the easy solution it appears to be. In fact at the moment it would have disastrous effects on the economy. The reason is, of course, banks. And building societies. And indeed any financial institution that lends against property.

House price falls are disastrous for mortgage lenders. Mortgages are secured loans: the house that is bought is the collateral for the loan, and the loan is granted on the basis of the value of that collateral. As with all forms of secured lending, the value of the collateral usually exceeds the amount of the loan: the difference is made up with the house-buyer’s own funds. Since the financial crisis mortgage lenders have reduced their loan-to-value (LTV) ratios considerably, which has made it very hard for house-buyers with limited resources to find the money needed for deposits (this is the stated justification for the Government’s Help to Buy scheme). Good quality loans typically have a LTV ratio of less than 80%: the risk associated with the loan increases as the LTV approaches 100%. Above 100%, part of the loan is effectively unsecured. Without going into details about how bank capital ratios work, the higher the LTV, the greater the amount of bank capital required to support it, more-or-less. When house prices fall, LTV values rise – exceeding 100% for borrowers in negative equity. Falling house prices therefore eat up banks’ capital, not because they took on risky loans but because their supposedly safe high-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. Particularly at risk would be building societies and small retail banks, who tend to have lower capital levels than large universal banks because most of their lending is in supposedly “safe” mortgages. There is nothing “safe” about mortgage lending in an overblown and fragile housing market.

Improving the supply of houses without causing a major fall in house prices seems to be almost impossible. An extensive private sector house building programme would help the recession-hit construction sector, but it would force down house prices. That would apply whether those houses were for sale or for rent. Landlords borrow to finance the purchase of homes for renting out, and they carry the value of their rental properties on their balance sheets: and as rents tend to be set in relation to house prices, falling house prices would be likely to force rental values down. A major fall in house prices would therefore potentially bankrupt many landlords. And construction companies who borrow on the basis of expected returns could also be bankrupted if those returns fail to materialise because of falling prices. This is what happened in Ireland.

A social house-building programme similar to that after World War II might improve the supply of homes for rent without causing house prices to fall. Or it might not, if the effect was that people who might otherwise have tried to buy substituted into new social housing. And what if those houses were then sold to their tenants under the Right to Buy scheme? This would also cause house prices to fall, though perhaps more slowly than large-scale private sector house-building. Of all the options for improving the supply of housing without wrecking the financial sector, this looks the best. But it would require government not only to spend money, thereby increasing the fiscal deficit, but to abandon its ideological commitment to private-sector solutions and admit that we need an increased role for publicly-owned housing at the moment. I suspect hell would freeze over first.

So forcing a house price correction would have horrible effects on the economy at the moment. But for many people, housing is at the limits of affordability. The rise in the price of houses in the last two decades has far outstripped incomes, which have actually stagnated in the last ten years. Low interest rates have encouraged people to take on mortgages that stretch them financially. A rise in interest rates would force many people into defaulting on mortgages or other loans, which would also have a serious impact on the financial sector. A sudden rise in unemployment would have similar effects. And as real incomes decline due to below-inflation pay rises, benefit cuts, tax rises and underemployment, more and more people are becoming financially overstretched. They don’t default on their mortgages, but they cut spending in other areas. This depresses demand for goods and services in the economy, forcing companies to cut costs – which usually involves reducing jobs and/or wages – and even go out of business. It is a moot question whether the real problem here is low pay or high inflation: perhaps it is a bit of both. But the solution is not easy. Raising interest rates to counter inflationary pressures would cause financial distress to many households and businesses. Raising wages without an equivalent rise in GDP would be likely to create higher unemployment. And raising real incomes through higher benefits and/or cutting taxes would increase the fiscal deficit.

So we cannot force down house prices, we cannot force up real incomes and we cannot vastly increase the fiscal deficit. The housing conundrum resembles one of those games of the “there’s a hole in my bucket” variety – a mind puzzle, if you like. Many people solve it by leaving out some of the pieces – which of course is not a solution at all. Others want to do something dramatic such as a large rise in interest rates or a massive state-funded construction programme to “shock” the system into correcting – the idea being that the short-term pain would be worth it to achieve a sustainable correction. I understand their frustration, but I am not sympathetic to their solution. This Gordian knot cannot be simply cut with a sword. It must be painstakingly unpicked – and I fear that will take a very long time.

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Frances Coppola

Frances Coppola

In a past life I worked for banks...now I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management

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