A 'combination of idiocies' is inflating a house-price bubble

Rising house prices shouldn't be seen as a driver of growth, but in Britain they are. Something's going wrong, says author Faisal Islam.

Faisal Islam's new book, The Default Line, isn't just about housing. But it's the bit he seems most interested in, and I know it's what many MoneyWeek readers are most interested in too. So that is what we talk about.

There is "nothing wrong with the long-standing aspiration towards home ownership in the UK", he says, but "all good things done to excess mutate at some point".

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

We are at that point: people need to understand that the policies they have long accepted have created an environment in which their children can't afford to buy houses in most places and worse, "in many places can't afford to rent".

We judge the success of a society on whether its "living standards are rising or falling" and the "very base of living standards is where you live".

You'd think it would be "blindingly obvious" to most people that what is financially good for them is not good for their children (while they are still living, of course), but many simply don't connect the two.

In 2005, "very senior figures in the Bank of England and government" who Islam spoke to were saying that "they couldn't believe people weren't kicking up more of a fuss" about this.

When energy prices go up everyone is furious. But when the price of an even more vital utility housing rises, everyone seems pleased. "High fives all around... it is patently absurd." It is also no way to run an economy.

Rising house prices shouldn't be seen as a driver of growth. Instead, they should be viewed as the obvious result of income growth. The fact that in the UK they are not, and that "an average kid can't get a home" for all that politicians "constantly talk about social mobility", should prove that "something is going wrong here".

I ask him what he thinks really caused the UK house-price bubble (the one that has already nearly crashed our economy and may well still do so). Was blowing a bubble a deliberate policy or a by-product? "Deliberate" is pushing it, he thinks.

The independence of the Bank of England was meant to prevent the political use of credit to create boom and bust. Instead, it produced a "nexus as dangerous as it has ever been".

The "market for houses in the UK is not really a market for houses, it is a market for mortgage credit". This won't be news to long-term MoneyWeek readers, but academics still debate whether it is rising house prices that make mortgage conditions loose, or whether loose credit makes house prices go up. It is "difficult to prove causality", says Islam, but he believes it's the "credit that fuels the house prices". We'd agree.

So, in whose interest is the rise in credit and house prices? There are the politicians who want to get re-elected, and the banks who profit. But the "core of the bubble machine" is not so much them, as the relativity and extrapolation at the heart of the equations that control valuations and credit.

When Islam went to look at the "plumbing and mechanics" of the mortgage system, he was amazed. He, like most people, had been under the impression that surveyors, for example, judged worth in some kind of absolute sense. But it isn't so. All values are "referenced against something else".

Then there was the assumption that values would only ever rise. At the top of the boom, Northern Rock was only making a profit on some mortgages because of the initial fee. It made nothing on interest rates practically no margin over its funding costs.There was no real plan for falling prices.

What everyone has to grasp is that likely loss levels on mortgages, and the capital levels banks should have, are all "based on econometric equations which are essentially extrapolations... there is a crystal ball quality to it".

These models clearly don't work very well witness the sub-prime crisis but they are still the basis for everything. They are "hard wired into the Basel rules", for example capital requirements still view mortgage lending as less risky than lending into the real economy, even though as one senior banker told Islam "the most toxic financial instrument out there is the mortgage".

That's why the support we have given the banks over the last few years has gone "disproportionately into mortgage lending", and in particular, buy to let. All the loan officers will tell you is that this is just "the result of our equations".

The government likes to suggest that the "tsunami of credit" that has nearly broken our financial world has nothing to do with them. But governments set the parameters for credit.

Who allowed mortgages to go beyond 25 years, to allow dual incomes, to extend beyond 100% and of course, the piece de resistance, "the interest-only mortgage" with even the endowment bit removed? So, this just isn't true.

So, who wrote the equations that assume a low risk for mortgages in the first place, I ask? "A genius Czech guy who moved to America and sold it in the first place to the world's banks as a method to calculate the likely losses on parcels of corporate debt."

They changed it so that, as its inventor told Islam, "it doesn't work anymore" and applied it to mortgages. They still do. Really? I ask. "Really."

You could look at all this stuff, add to it the "massive public policy failure" to build enough houses to keep up with demand, says Islam, and see a deliberate strategy if you wanted. But it was and is just a combination of idiocies. That said, "if I had strategised to create a housing bubble, I could not have done better than Labour managed to deliver".

If he could change things from today, what would he do? Communicate better with the older generation, for starters.

"They have to decide whether they want their children to have living standards similar to theirs." If they do, "they have to accept house building", they must not vote against governments with policies that might push prices down, and they might have to accept the massive enfranchisement of tenants with the kind of rights that will cut rents and hence house prices.

But you can still have a bubble with oversupply, I say. How about we just cap credit?

Islam agrees with this although he is convinced that supply is also a key part of the problem. He'd deal with that bit by "sorting out Basel".

If the rules on how much capital banks have to hold against which loans have such a huge impact on outcomes, there is no point in bashing bankers for lending "wrongly" when the system forces them into it.

"I believe in the role of the state here", but if the state is involved in directing lending, it should be "subsidising loans that lead to jobs and overall growth", not just house-price growth.

The whole thing, says Islam, is getting ludicrous. At this point it is surely "incumbent on people who have benefited" to realise that it makes no sense for "this charade to continue".

We will know things are turning when people stop talking about the "house-price boom" and start talking about the "house-cost boom".

He is right, of course if we want things to improve, people with houses have to stop agreeing with the government that the answer to every question is rising house prices. But I think it will be a while before those holding the nation's housing wealth come round to his way of thinking.

Who is Faisal Islam?

Faisal Islam has been the economics editor of Channel Four news for more than three years. After graduating from Cambridge, then City University, he became an economics correspondent with The Observer. After four years he moved to C4 as a business reporter in 2004.

During his time there, he has won several broadcasting awards. These include Young Journalist of the Year' in 2006 and Business Journalist of the Year' in 2009.

His coverage of the Icelandic banking crisis was widely praised and won the Wincott Foundation Award for Best Television Coverage of a Topical Issue', as well as several other nominations.

His book on the financial crisis, The Default Line: The Inside Story of People, Banks and Entire Nations on the Edge, published by Head of Zeus, is out now.