Here comes the house price crash

published 20 December 2007

I'll get straight to the point. The UK housing market is going to crash and it may well drag the UK economy into recession as it does so. The signs are all there the house-price indices are turning down. Halifax has just reported the biggest three-month price fall since 1995, while negative analyst reports are becoming more common HSBC reckons prices are 30% overvalued, while David Miles of Morgan Stanley recently said he expects prices to fall by 10% next year.

Yet most people are still in denial and hoping for a soft landing. TV's Phil Spencer, of Location, Location, Location fame, sums up the general mood. He maintains the long-term "fundamentals" are good since "unemployment looks set to remain low, earnings are rising, the population continues to grow and there is a shortage of housing". Unfortunately for Phil, each of his points is at best irrelevant and at worst, downright wrong.

Take the supply argument. When most people recall their basic economics, they remember that high demand and short supply push prices up. So rising house prices must mean there's a shortage of supply, which seems reasonable, given widely reported rampant immigration and rising divorce. It seems obvious except it doesn't add up. Most immigrants are economic migrants, come to make a better life for themselves. Many send what money they do make home. Almost all struggle to qualify for a bank account, let alone a mortgage. Meanwhile, divorce is a zero-sum game that impoverishes both sides and enriches the lawyers. How, logically, can poor people be responsible for a housing-price bubble? Moreover, a shortage of housing should have sent rental growth through the roof, but instead, until the past 12 months, rents have been growing at a slower pace than inflation.

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Either rents are already as high as people can afford, or there is no shortage of housing as such, but simply of houses for sale. Neither is good news for house prices. If rents mark the boundary of affordability then house prices will have to fall back to where rental yields are higher than borrowing costs before there is an incentive for renters to buy rather than rent, which implies a very big drop.

Alternatively, there's a specific shortage not of housing per se, but of houses for sale. Buy-to-let (BTL) investors have taken houses off the for-sale market and put them on the rental market, bidding up house prices while over-supplying the rental market in the process. BTL has also distorted the housing market in another way. Because BTL buyers can offset interest costs against rental income for tax purposes, they go for interest-only mortgages. Since the monthly service costs of a 25-year repayment mortgage can be anything up to 70% more than an interest-only loan, depending on the base rate, BTL investors effortlessly undercut first-time buyers and soon price them out of the market.

We can see this from the way that the profile of a typical first-time buyer has changed. In the mid-1990s a first-time buyer was single, in his or her mid-twenties and earned less than the national average wage. Today, first-time buyers are couples in their mid-thirties, usually with two wages and family help with the deposit. But most strikingly, the average income of a first-time buyer is just under £40,000, nearly double the national average wage and a full third more than the average household income for all sources.

It is safe to say not one of the people we used to have in mind when we referred to first-time buyers can now afford to buy a home in the South East or main city centres. Simon Nixon wrote last week that "the residential market should get support from armies of prospective first-time buyers desperate to buy". I couldn't agree more, but at what price will these new buyers want or be able to come back in? Not the current one.

It's demand and supply of credit, not of bricks and mortar, that drives property values. If credit is plentiful and cheap, property values rise more people chasing houses with more borrowed money creates higher prices. Once it becomes scarce and pricey, property values fall fewer people borrowing lower sums mean less money chasing houses. It's as simple as that. And the reason the housing market is suffering is that credit has become more expensive. Already BTL makes no sense the cost of servicing a mortgage, even an interest-only mortgage, has risen above the cost of borrowing and it will only get worse.

This week UBS, Europe's biggest bank, announced a further $10bn write-off on its US subprime exposure, strongly suggesting that the previous round of losses announced by banks in Europe and the US was just the beginning. Why is this a problem for UK housing? Well, banks lend a multiple of their core capital, perhaps ten times, so UBS's capital losses to date of $14.66bn equate to around $150bn fewer loans next year. This is equivalent to about three weeks of UK GDP. And this is just one bank. And it may not be the end of it, even for UBS.

By the time all the banks have finished totting up their full losses, outstanding loan amounts across the Western world will have to be much lower. Banks will be pickier about who they lend to, and they will try to charge more to compensate for the smaller loan book. This is how the banks' credit crisis of 2007 will become everyone's credit crunch in 2008, as BTL investors who have displaced first-time buyers as the new blood keeping house prices afloat bail out of the market.

So how bad could it get? That depends partly on how overvalued property has become so let's work it out. For a BTL tenant (who would be a first-time buyer if BTL hadn't priced them out of the market) to buy rather than rent, three things have to occur. First, house prices have to surrender the premium caused by BTL investors only having to service interest-only mortgages. At today's base rate, that difference is about 30%. Plus, despite the recent cut, the base rate at 5.5% is much higher than the low of 3.5% in July 2003. That's made even 25-year repayment mortgages 23% dearer to service (for interest-only it's an increase of 57%).

Added to this, the credit crisis means that even mortgage lenders are finding it hard to borrow at less than one percentage point above the base rate, and in some cases as much as two. Since lenders are going to make fewer loans next year and on wider margins to compensate, borrowers will find it hard not to pay at least 7% and in many cases significantly more. This is the hard reality of a credit crisis once it reaches the high street. Banks are nothing if not adept at passing on the pain.

Putting these two effects together, the difference between what a first-time buyer will have to pay in 2008 (about 8.5% a year, once you include repayment contributions) compared with the 5% or so the average BTL investor was paying at the start of the year the last time BTL made any sense (when interest costs and rental yields were roughly equal) implies about a 41% decline in house prices. Such a decline brings us to the final thing that has to occur before house prices can bottom. Sentiment has to run its course.

No market stops rising just because the fundamentals are satisfied. They overshoot, carried by momentum and speculators riding on the tail-coats of the rise. This is especially so when the punters are using borrowed funds to finance their enthusiasm. Look at the dotcom bubble, which initially went up on the sensible idea that the internet would change everything. Stocks soon traded way beyond justifiable valuations but did it matter? Of course not. Money to speculate with was cheap, share-price momentum meant you could often make a satisfactory return in a week, and the higher prices went, the more so-called professionals' were proven to be out of touch with the new paradigm.

Besides, many people argued that since a bear market was a 20% drop and a full-blown crash about a 30% drop, the gains being made outweighed the risks. But in the end, some dotcom stocks fell by as much as 99% and prices never regained the bubble highs in the majority of cases. The moral of the story is that the peak price achieved in a momentum-driven, debt-fuelled bubble has little or no bearing on where the market will end up. Inconceivable drops need to be considered. If the housing market goes into a downturn, the momentum argument will work in reverse. The further prices have to fall to find new buyers (which looks like 30%-40% to me) the more likely prices will overshoot to the downside. And a deteriorating economy will make this problem even worse.

Phil Spencer and other optimists argue that fundamental factors underpinning long-term market stability include low unemployment and rising earnings. Yet wage growth and unemployment are functions of the economic cycle, which is driven by consumption that's fuelled by debt, which in turn comes from house-price growth. House-price growth boosts people's perceived savings via what economists call the wealth effect (how many people confuse a £500,000 mortgage debt with their "pension"?).

Higher house prices also make mortgage equity withdrawal (MEW) easier, through which people can boost their spending money by increasing the size of their mortgage. MEW as a percentage of disposable income had already fallen to 4.5% annualised by the end of June, down from the first quarter of 2004 when it was nearly 9%. As long as house prices keep rising, even if rates are hiked, MEW is still possible, but it's less attractive. Borrowers can no longer take money out and still keep monthly payments flat, as they could in the days of falling rates. So MEW has fallen, but so far has not collapsed. The collapse will come when house prices respond to rising rates by falling, or a credit crunch makes lenders less willing to remortgage. Then MEW often drops to near-zero (as happened for the five to six years between 1993 and 1998).

The trouble is, for the past three years, MEW has added about 6% of disposable income, or more than 4% of GDP, to households' spending power. Take that away and consumption demand plunges. Given that consumption accounts for 70% of the British economy, this is bad news. Falling consumer spending means falling corporate profits and that means job losses. In the US, where consumption accounts for a similar chunk of economic growth, the house-price slump has already seen unemployment tick up dangerously.

Over here, unemployment had turned the corner in the early part of last year. Although it's well below the sorts of recessionary number it hit back in the mid-1990s, unemployment tends to rise more sharply when recession hits than it falls during good times. Remember that job losses don't tend to happen until the economy is already in trouble. Firms don't get rid of people when times are good profits have to be falling before mass redundancies kick in. So to cite low unemployment as a reason for optimism is to misunderstand the business cycle by the time job losses begin, it's usually far too late. That's why it's important to prepare for the downturn now, when markets are still not expecting it. We show you how below.

So if the economy is heading for recession, what should investors do about it? It's fairly straightforward to suggest which sectors to sell out of or avoid altogether. An obvious one is commercial property. Having been among the most popular investments among retail investors in recent years, the bottom is now falling out of the sector rapidly. For example, this week New Star cut the value of its UK Property fund again it's fallen 17.9% since July, and it's far from being the only one in trouble. The credit crunch has hammered the sector by raising borrowing costs, but even before August, as with buy-to-let property, the cost of borrowing had risen above rental yields. Investors are now pulling out of the sector in droves, which could well force funds to start selling assets at fire-sale prices. And commercial property's problems will only get worse if there's a recession. As City offices cut jobs and high-street retailers shut up shop, there'll be more trouble as demand for property falls back.

Banks also still look vulnerable, despite their apparently low price/earning ratios and high yields. The focus has been on the exposure to subprime and what that's done to financial groups. But amid all this worry over new-fangled bad debt arising from credit derivatives, it's easy to forget that there's plenty of old-fashioned bad debt building up, too. Consumers are more indebted than they've ever been and so if there's a downturn, there will be more bad debts than ever to be written off. Personal bankruptcies are likely to pick up again next year now that banks have come to an agreement with providers of Individual Voluntary Arrangements (IVAs, or bankruptcy-lites' as they are sometimes known). So we would be avoiding banks for now as well there's a good reason that they're cheap.

So what can you buy to take advantage of a recession? As regular readers will know, we believe gold and precious metals are always a good place to be in a downturn. And with the pound likely to weaken against the dollar as the British economy falters, it's not a bad idea to buy into dollar-denominated commodities just now not only will you benefit from growth, but also from the foreign exchange gains. ETF Securities (Etfsecurities.com) has sterling-denominated gold and silver tracker funds that you can put in your ISA.

In terms of stocks, pawnbrokers Albemarle & Bond (ABM), and H&T (HAT) should continue to do well. As credit becomes hard to find elsewhere, people will be forced to turn to pawnbrokers more and more, and as their loans are effectively secured, they are safer than other lenders. ABM is on a forward p/e of 16, while HAT trades on 15 the shares have risen 13% and 17% respectively since we tipped them last October, but they still look good value. Simon Keane in Shares magazine likes the look of subprime lenders Provident Financial (PFG) and Cattles (CTT).

Now that banks are tightening lending criteria, business has picked up for doorstep lenders, which have more experience of the sharp end of the credit market. It's an interesting view, but it is risky. Doorstep lenders' activities frequently come under attack from consumer groups, and if the downturn is as serious as we suspect it might be, even these lenders won't be immune to rising bad debt problems.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.