House Prices and the Credit Crunch

Feeling a little more relaxed by a bank holiday which was not characterised by rain, I now feel able to approach this subject without the overwhelming desire to scream in frustration. Let’s face it, last week things got a bit silly.

On the one hand, the website housepricecrash.co.uk was registered in 2003, and now, some five years later we actually do have falling house prices. It is difficult not to have admired their tenacity in the face of the facts over the years, and now that their moment of triumph has arrived, it is not for me to belittle it with reason.

Indeed, I can even understand the position taken by Mr D’Arcy of fool.co.uk who tells us that he had the foresight to sell in 2005 and is now just waiting for a 30% correction (he hopes it will be 50%) before getting back onto the housing ladder. Selfish yes, but completely understandable.

What I find hard to accept is when someone who should know better, and is in a position of authority, publicly announces their expectation of a 30% crash. Yes Mr David Blanchflower, member of the Bank of England Monetary Policy Committee, I mean you.

Now, it may be that Mr Blanchflower, who is one of those who sets the Bank of England base interest rate, is playing sophisticated politics, and hoping to manoeuvre his MPC colleagues into earlier and steeper base rate cuts. But whatever he is doing, he is causing public worry and consternation, and should in any event leave the politics to elected politicians.

Now, we do not profess to have a crystal ball, nor do we profess to have any form of economics qualifications, but we do like to think we have a modicum of common sense. Many of those who have forecast a house price crash over the years have cited the growing gap between house prices and average incomes as the reason. Indeed, you will be able to uncover news details from as early as 2001 and 2002 where commentators were forecasting the bursting of the bubble. What most of them fail to appreciate is the role of interest rates in the whole process.

House prices do not crash because of a lack of buyers able to afford them. They may experience a modest correction, but a lack of buyers tend to lead to a stagnation of the market rather than any sudden reduction, and with lending volumes at roughly 50% of what they were, this is what is happening now.

House prices do crash when current owners can no longer afford their mortgage payments and are forced to sell, and the two main causes of payments being unaffordable are rising interest rate and unemployment, neither of which is currently forecast to any great extent.

To use a very basic (interest only) example, if interest rates were 2%, a mortgage of £100,000 would be affordable by someone earning £10,000 as it would represent a cost of just 20% of their gross income, even though the loan was ten times their income. Conversely, if interest rates were 15%, a £100,000 mortgage would likely be unaffordable to someone earning £30,000 as it would represent a cost of 50% of gross income, even though it is only just over three times income.

If house prices were to fall by 30%, it would mean that everyone with a mortgage of more than 70% would be in negative equity. When the costs of moving were added, it would probably mean that anyone with a mortgage over 65% would be unable to move unless they had additional funds from elsewhere to clear their mortgage.

This returns me to what I believe is the central question, and the question which is still unanswered by those forecasting a huge house price crash: If Mr average can afford to pay his mortgage now and would get less than he owed if he sold, why would he sell? The answer is of course, that in the majority of cases he wouldn’t. Most people will simply sit it out and wait, because they know that all the time they can afford their mortgage they do not have to give their house away, and eventually, whenever it may be, the housing market will return to some form of normality.