Why have house prices soared so high?

Now regular MoneyWeek readers will know that we've been expecting some sort of house price collapse for quite a while - but now city experts are predicting one too.

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Apparently house prices could well fall at some point over the next couple of years.

Now regular MoneyWeek readers will know that we've been expecting some sort of collapse for quite a while - but it's not just us who are saying it this time.

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No lesser authority than David Miles, Morgan Stanley's chief UK economist and former adviser to the Treasury, has reported that 'a sharp fall in real house prices is likely at some point in the relatively near future.'

So why does he believe this?

Miles believes that as much as half of the growth in house prices since 1996 (up about 187%, according to figures from Halifax) has been driven by speculation, with only half down to fundamentals, such as the supply and demand issues that property bulls keep citing.

He's not sure of exactly when the slump will come, but seems to think it'll be pretty soon - "it could yet be one or two years away".

Of course, Mr Miles's observation has been received with the usual barrage of denial from estate agents and property pundits. Even the BBC somewhat strangely opted to report his prediction for "a substantial fall in real house prices" with these words: "A former government advisor says house prices will soon slow down so much they lag behind general inflation." That's a very relaxed way to describe what in any other market would be described as a crash.

But anyway - back to Mr Miles. Speculation is certainly one reason for house prices soaring - but of course, if people didn't have the means to keep buying houses, regardless of how expensive they are, prices couldn't rise any further. So a trading update from sub-prime lender Kensington Group shed a particularly well-timed shaft of light on the market yesterday.

The group's shares were the biggest losers in the FTSE 350, plunging 100p to 805p, as it warned that profits would be at the lower end of City forecasts, while profit growth in 2007 would fall, due to 'intense' competition in the market.

Kensington lends to those with poor credit records, and people who can't provide evidence of a steady income history, such as the self employed. So the customers are already higher risk than those most lenders are dealing with - so youd think that taking a cautious approach to lending to them would be only sensible.

But it seems that Kensington's standards are just too high. Chief executive John Maltby said: 'We do not lend at high income multiples and our loans are low compared with the value of houses. What we are facing is increasing competition and that is what people are responding to.'

In other words, 'other lenders are willing to give more money to less creditworthy people than we are.'

Kensington's problems provide the clearest illustration of just why the housing market has sustained its growth for so long. In this market, the lender willing to take the most risk wins - in the short term. And as the short term is pretty much all investors care about (as least until everything goes pear-shaped, and they start to ask why no one was keeping a better eye on who they were lending to), banks and companies like Kensington have every incentive to relax their borrowing criteria, and very little reason to worry about what would happen if house prices, say, fell 40% - as the Financial Services Authority recently warned banks should be planning for.

So what's Kensington doing about the competition? Well, Mr Maltby reckons its 'second charge mortgages' - those second mortgages constantly advertised on daytime TV which are often used as consolidation loans' to pay off other debts - is the way forward.

"This is higher risk. But it is also higher growth and offers higher margins we believe we have good, strong prospects."

But the trouble is, as James Hamilton of broker Numis told The Independent, that "this strategy with its super margins is ideal while property prices rise. The real risk is property price deflation removing the collateral supporting the loans. Should this happen, the loan impairment charge would explode."

In other words, Kensington can be fairly free and easy with lending on second mortgages while property prices are rising, because if people default the company can just repossess the house and have at least enough to cover the loss. But if house prices start to fall, then the company effectively loses its security - and if a customer defaults, there's no chance of covering the losses.

So effectively, buying stock in Kensington is taking a massively leveraged bet that house prices will keep rising. It's not a bet that we - nor David Miles, we suspect - would recommend you take.

There's more on the UK property market in this week's issue of Money Week - out tomorrow. If you're not yet a subscriber, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek

Turning to the stock markets

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In London, the FTSE 100 ended 42 points lower, at 6,160. ICI was the main riser, up 9% at 423p, as it sold off its flavour and fragrance unit for £1.2bn. For a full market report, see: London market close

Elsewhere in Europe,the Paris CAC-40 closed down 7 points at 5,452, whilst the German DAX-30 was 16 points higher, at 6,476.

On Wall Street, strong earnings from Dell offset a plunge in General Motors' share price as billionaire Kirk Kerkorian cut his holding in the car maker. The Dow Jones gained 5 points to 12,326. The Nasdaq rose 11 points to close at 2,465, while the S&P 500 gained 3 to close at 1,406.

In Asia, Japanese markets were closed for a national holiday. Australia's S&P/ASX 200 rose 0.4% to 5,469.

The price of crude oil was little changed in New York this morning, trading at around $59.20 a barrel, whilst Brent Spot was at $58.70.

Spot gold was higher, trading at around $630 an ounce.

And in London this morning, electrical goods retailer Kesa said sales at stores open at least a year rose 9.5% in the three months to October 31 due to the popularity of flat-screen TVs and laptops.

And our two recommended articles for today...

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.