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Property Bubbles

There have been property bubbles in the UK going back to at least the 1970's, with fairly small bubbles in the early 1970's, 1980's and a large bubble in the early 1990's. The problem is that each successive bubble has been larger than the previous one until in 2008 we have an enormous bubble which has just gone pop.

Unfortunately, when property bubbles burst they leave nothing much to show of their previous existence, except for a nasty damp patch. In this case the nasty damp patch includes banks suffering from low balance sheets, mortgagees facing the prospect of repossession and the whole economy in decline as the job dependencies in Building and Financial Services become apparent. As we will see the correction is inevitable whether it be achieved by house price falls, inflation or a combination of the two. Most commentators will say isn't it just bad luck to be hit by a combination of high fuel prices, high food prices and a failing property market all at the same time, whereas in fact these events are all highly interrelated. If we try to understand what is going on then we should be much better prepared to deal with the consequences, and try to see the positive side of these impacts.

Ingredients for a Property Boom

In order to view the chart you will need the Silverlight version 3 plugin. As a matter of interest the chart was built using the Visifire charting package, which I have found is very easy to use. I then used SharpDevelop to create the XAP file. The chart shows average UK house prices (taken at the June Year midpoint for the last thirteen years). The credit crunch looks to have put paid to an era of cheap credit where 125% mortgages and 'buy to let' speculation fuelled massive house price increases. To pay off the debt is now not possible, so the only way forward is to borrow more and hope that the house price falls can be contained.

The following is all text book economics, and demonstrates how the UK economy is following the classic boom bust cycle. Property booms have been likened to a fire which needs fuel, oxygen and heat to stay alight. Just as a fire cannot be sustained without any of these ingredients, a property boom must have all of these ingredients to continue :-

Easy Credit - 'The Fuel'

There are not many people walking around with a few hundred thousand pounds in their pocket and not many with the ability to write a cheque for that amount. So there is a need for loans which become increasingly large as house prices rise. Also, the risk associated with these loans increases as the ratio of house prices to average earnings becomes larger. So, immediately we see that this ratio does not necessarily cause the housing boom to implode but instead increases the risk both on the lender not getting their money back and on the mortgagee not being able to meet the payment schedule and so being pushed into a forced sale. If we look at what has happened in the UK economy over the past ten years, we take an average RPI inflation of 3.7%, but actually average house prices have gone up by over 11% per annum (Based on Nationwide figures - average house price was £58,403 and in May 2007 was £180,314. So how easy was the credit during that period? Mortgage lending increased from £419 bn in May 1997 to £1121 bn in May 2007, giving an average annual rise of over 10%. So, it was pretty easy given the relatively low inflation figures and when you add in Self Certification mortgages (which require no proof of ability to pay), silly multiples on earnings and minimal deposit requirements we have a situation which lays the groundworks for a whole host of Mortgage mis-selling claims. I first started looking at this when I asked myself the very simple question of 'where is all the money coming from?' The Building Societies were strapped by the regulation that lending had to be funded by at least 50% of retail deposits. In the old days, all the Building Societies used to say they needed seven savers to support one borrower, but we will see how this simple rule of thumb went out of the window. So, the next thing was to allow a number of large Building Societies to demutualize and overcome this restriction. But still there was not enough credit to satisfy the insatiable demand, so enter the large Investment Banks which could tap the global market. Of course for every loan made, a debt obligation had to be made, which is the other side of the equation and will be the subject of another little investigation. The easy credit side creates its own problems, but the debt repayment creates something else far worse.

Speculation - 'The Oxygen'

If people are not firmly convinced that the capital value of their property was going to appreciate faster than their savings then the impulse to invest in property would be much reduced. However, the current reasons for this speculation are all too clear because most people see property as a means of funding their retirement following Brown's cynical obliteration of the final salary scheme for those who are not Civil Servants. The 'Buy to Let' market is the epitome of speculation over the last ten years which has led to first time buyers being squeezed out of the market. Some figures showing the growth of 'Buy to Let' will be added soon.

Rapid Turnover - 'The Heat'

In order to sustain the boom there has to be a rapid turnover of housing. Unless houses move rapidly off the agents books there will be many houses available to prospective buyers so that only the prime property gets sold and it becomes a 'buyers market'. Currently (November 2007) the UK market is at the classic 'Plateau' stage, where there is a levelling off of prices as credit is restricted and people become more fearful for their employment prospects. We are still a little bit away from the panic selling phase when the speculators all try to offload their properties and realize their paper gains. The Americans have had to trash their currency in a desperate attempt to halt the slump; it remains to be seen how long the Government takes to follow and drop interest rates here.

Indicators of a Bust

When the next bust occurs everyone will know about it, because not only will it be totally obvious it will make headlines every day as people lose their homes and an old fashioned economic depression sets in. People will always argue that things are different this time. Indeed they are; never before has there been such a large source of freely available credit which has sustained the boom long past its natural life. So what signs should we look for to indicate when the property boom is coming to an end :-

Cost of Credit Increases

The first sign of problems are interest rate rises which catch borrowers and lenders by surprise. The need for interest rate rises are to counter inflation internally (maybe caused by the housing boom, caused by a war) or could be external such as oil price rises or as looks to be the case currently; all of these. Raising interest rates is normally the most effective method of cooling the market. The central banks have to tread a very careful line here between cooling the market and generating a slump. In the 70's and 80's the normal signal for a credit squeeze was to raise rates by 2 percentage points at a time, which often led to boom and bust conditions. In recent times banks have played around with quarter per cent increases at a time, which can lengthen the agony by extending the length of the crash and leading rates to go higher than they would have done otherwise. In fact a mere quarter of a percent rise will be shrugged off until the cumulative effect takes effect later on in the cycle.

Bankruptcies Increase

The number of people declaring themselves bankrupt increases dramatically. This is normally a response to credit lines being withdrawn and the person involved cannot refinance.

People in Arrears with Mortgage

The number of people in arrears with their mortgage increases. If conditions do not improve these will be joining the next category.

House Repossessions

If the number of repossessions rises dramatically, then it is a sure sign that the banks are finding the conditions difficult. The last thing they want to do is to repossess a home which potentially will lose them money as the market deteriorates.

Bank Collapses

An actual bank being allowed to collapse will only happen in extreme cases since governments know the panic this will cause. However, certain funds, accounts may start to be withdrawn. The banks most at risk will be those exposed to property in the so called sub-prime sector. However, unless individual cases are propped up the problem will quickly spread to other banks as it is discovered that actually the big banks also had a hand in the lending. NB This was written years before Northern Rock and it should be noted that it collapsed not primarily because it lent in the sub-prime sector, but because it borrowed in the wholesale market and could not re-finance when global credit tightened. How ironic! classically banks fail because the mortgagees cannot re-finance, but this time it was the bank itself that got itself in this awful state (it's management made elementary school errors and the FSA allowed it to do this). Being wise after the event is easy, but in spite of all of this it would seem to be the case that if one overall body had been in control, instead of three (FSA, BOE and Treasury), the bank could have been saved because action would have been taken in the best interests of the economy instead of each party defending their own 'patch'. But nevertheless it has served as a useful wakeup call and lessons learnt for the Government (albeit extremely expensive) for how to do things properly the next time. For savers it has been useful because it has highlighted how vulnerable their money is in the banks and it has forced the FSA to up the guaranteed limit on savings protection to £50,000 per financial institution.

Governments Start extending Credit

This happens when the banks finally wake up to the fact that a slump, bust or depression is happening. Suddenly they start injecting large amounts of capital into the system in a desperate attempt to head off the crash. This could work if done early enough but the evil this time is a massive increase in inflation and a devaluation of the currency.

What happens Next?

Perhaps we can look back as far as the early 18th century to see what happens to a bubble - namely 'The South Sea Bubble'. Admittedly the 'dot com' bubble more closely resembles this bubble than a housing bubble because at least I can hear everyone saying 'houses are real as opposed to the South Sea Bubble which was based on paper shares. However, I would argue that the similarities are closer than most people would imagine. The only real difference is that there must be a floor to house prices which means that there will always be a minimum price maybe linked to the price of land. Both bubbles were fuelled by speculation and demanded ever increasing price rises to sustain the growth. As soon as the price started to fall there was nothing that the government or bankers could do to reverse this. House prices can only recover when they become affordable to those having a need to buy (i.e. first time buyers). Any artificial stimulus such as cutting stamp duty tax, easing the interest on repayments are doomed to failure. The only stimulus that can occur is when the first time buyer has enough confidence to put down a deposit and be sure that the repayments can be met. Most of the current effort involved in bailing out the banks will be money down the drain unless there is radical change in how the banks are regulated. Just like the Southsea Bubble, the government and the banks must take equal blame for stoking the speculation. When the South Sea Bubble burst it didn't just affect the shareholders; it sent a shockwave through the whole system. People desperately tried to move away from paper shares to tangible things, such as land. But this proved futile because the share price had driven the whole economy. Once this prop was taken away the whole economy collapsed including the price of land.