Hamish McRae: Housing market shivers but it should not be as bad as the early 1990s

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The Independent Online

How bad is the British housing market going to get?

A shiver ran through the market yesterday with the news that First Direct was stopping making new mortgages. Sure, the withdrawal is temporary, the result of a flood of demand as it offered better terms than its competitors for a two-year fixed mortgage. But it is one more sign of the squeeze on mortgages, raising the awkward possibility that even if the Bank of England does carry on cutting rates through the summer, this will not be much help to the market. The problem will not so much be one of price but of availability.

There was further confirmation of that yesterday with the figures from the Bank of England on new mortgage approvals, showing a modest further fall to 73,000 in February. That is a 13-year low but to give a frame of reference, in the early 1990s it fell to some 65,000 a month, so we are still above that level. But, of course, this has implications for prices, as the "fit" in the first chart, plotted by Capital Economics, would suggest. It seems plausible that we might have two or three years of gently falling prices, possibly something worse.

How much worse? It is hard to see anything more serious than the early 1990s and actually hard to see anything as serious as that for three obvious reasons. One is that we seem unlikely to face the same surge in unemployment as we did then. Next, we do have control of our monetary and exchange rate policy – we don't have to shadow the euro, as we did the deut-schmark back then. And third, while the ratio of house prices to incomes has gone through the roof since 2001, thanks to lower interest rates the cost of servicing debt is still well below the 1990 peak, as the next graph shows. Standard & Poor's, commenting on that graph, reckons that prices will be flat this year and rise a little next but it admits that there are risks to this relatively optimistic outlook.

There is one big unknown here: the impact of the change in capital gains tax. Since gains on buy-to-rent property are now levied at 18 per cent instead of 40 per cent and mortgage costs for landlords are likely to rise, there may be a flood of properties coming on to the market in the next few months. It is not a great time to sell, of course, but some owners may feel it better to get out now, albeit at a slightly lower price that a year ago, and stick the money where it is earning interest for a couple of years. The effect may be that while the market as a whole may not fall much, some particular types of property, such as new-build flats, may do quite badly.

Let's assume, though, that the central case of house prices for the next two years being either stable or falling a little holds true. Even if that is right, the squeeze on availability of credit will curb economic activity. In the very short term, people who cannot increase their mortgages have other options to maintain their spending: they can increase their credit card debt. But that is replacing relatively low-cost borrowing with higher-cost debt. That makes no sense at all in the long run but it does seem to be happening on a huge scale.

The reason for thinking that something odd is happening is shown in the next graph. Last month, there was a sudden surge in consumer credit, a surge not associated with a parallel rise in consumer sales. That smacks of desperation. It is only one month's figures and that does not make a trend. But it would be consistent of people being forced to borrow on their credit cards to pay the bills that they had counted on being able to meet by re-mortgaging.

Whatever the explanation – and I think we should wait for a couple of months before jumping to conclusions – it does look as though people will no longer be able to support their lifestyles by taking out larger mortgages on their homes – "equity take-out" as it is called. The final graph shows how this practice surged after 2000, when at a peak it accounted for more than 8 per cent of post-tax income. We got figures for the final quarter of last year just yesterday, showing a further fall to 3.2 per cent of income, but that is before the squeeze really took hold.

So will equity withdrawal shrink to zero? It did in the early 1990s and, while the housing market may not be as bad this time, the availability of mortgages may be worse. On the other hand, many borrowers will still have substantial equity in their homes because they bought several years ago, so it is possible that equity withdrawal will remain just positive. Assume that it does, and bottoms out at 1 per cent of post-tax incomes by the end of this year or early next. That would mean that consumer spending will be squeezed quite a bit further. If the adjustment were to happen suddenly, then consumption could go negative and the economy head into recession territory but I think it is more likely, at least this year, that consumption will continue to creep upwards. If that is right, there will be a severe squeeze on consumption, but not hitting a brick wall.

All our experience is that it takes quite a long time for an economy that has been growing swiftly – over 3 per cent last year and still around 2 per cent annual rate during the first quarter of this year – to slow down. You could even say that the surge in consumer borrowing last month demonstrates people's resistance to cutting their spending. As they said in New York after 9/11, when the going gets tough, the tough get shopping. I think that would be right for a while. But only for a while. Real incomes are going to be squeezed. We have experienced that before but we have not, at least since the early 1990s, experienced a situation where people cannot borrow their way out of trouble and we seem to be in the very early stages of such a situation now.

Ultimately, things adjust. Quite a lot of the adjustment from excessive reliance on equity take-out has been made already, more than half in fact. We are looking at a situation where consumption will creep up for two or three years, not one where it will actually go into reverse. That, however, is the picture in aggregate. For those with solid cash holdings, there may be no squeeze at all, but for other over-borrowed people, getting household finances back into shape will be a nasty slog. As for mortgages, expect the new tougher terms – no 100 per cent loans, no cut rates for the first two years, etc – to last for a long time. And for the economy as a whole, I still think this year will not be the real problem; the worry is what happens in 2009.

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