How the credit crunch will hit property

The number of personal bankruptcies is at record levels in the UK - and many of those have gone bankrupt simply by spending too much, say Andrew Selsby and John Robson of RH Asset Management. But things are set to get much worse as lending criteria are tightened by both lenders and central banks - and that's very bad news for property markets on both sides of the Atlantic.

There was a fascinating news item this week.

Bankrupts and remember at present, personal bankruptcies in the UK are at record levels are victims not of life-changing events such as divorce, surprise tax bills or business failure, but instead of having taken on too much credit. They spent too much money on things they mostly didn't need with money too easily borrowed.

A recent survey found that 83% cited excess expenditure over income as the reason for financial failure. In other words, they did it to themselves amazing! Many significant providers of credit are not under the control of central banks in the way they once were, hence the uninterrupted orgy of credit during a period where the Federal Reserve in America has been tightening. Whilst the Fed was tightening, GE Capital, the biggest non-bank of them all, was progressively easing.

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In his most recent letter, Austrian Economist Kurt Richebcher, quoted from Melchior Palyi, who, in 1972, wrote of the 1914-1936 period:

"Excessive debt accumulation was, of course, the reciprocal of the credit expansion that "heated" the prosperity. It was a prime ingredient in the financial condition that was to overtake a large sector of the economic system: illiquidity. It was, indeed, an illiquid, overexpanded colossus of debts, rather than an excessive money supply, on which the price structure of the late 1920s rested."

In such extraordinary times, it is not surprising that central banks worry about inflation because they are very aware of the excess credit supplied to the market and their own propensity to increase the money supply. However, the confusing aspect is that these actions have not caused a rise in wages nor consumer prices; in fact, much of what we buy today is very much cheaper than it was only a few years ago the Chindia effect.

The reality is that excessive credit and money supply is inflationary. However, when the price of a washing machine can't go up, the excess money and credit has to find another home and this is what has caused the dramatic rise in asset prices. The housing market is so high because (a) nominal interest rates are low and (b) lenders are willing to lend without proper and prudent processes so that the barrier is raised to admit almost anybody who has an inclination to buy.

If subsequently, their financial position is insufficient to service the loan, then further credit is available elsewhere. Nobody knows at this stage how many people out there are paying their mortgages with money borrowed from a secondary source, overdraft, credit cards, store cards and the like.

Monetarising debt has become an everyday sort of thing to do. If you believe that the value of your assets is rising at 10% pa and you are accumulating interest at the rate of 5% per annum, then you might think that taking on more debt to pay the interest is not an issue. That's where the American, and to some extent the UK, economies are today.

The most important asset that stands behind this debt nightmare is the housing market, which in America is crumbling. Chickens are coming home to roost and debt deflation is likely to be hatched from their eggs.

Once the loose credit process goes into reverse, and we think it has already started, then the suppliers of credit will gradually remove themselves from the market and anybody out there who wishes to continue to monetarise their debt won't be able to. Instead they will unavoidably default and the truth will be out.

Nobody will readily admit that this situation is getting worse. However, the Council of Mortgage Lenders' latest estimate is that by the end of 2007, mortgages more than three months in arrears will number 130,000. Their previous estimate was 120,000. Meanwhile, repossessions are set to rise to 15,000, compared to the CML's previous estimate of 12,000.

They are guessing and hoping. The fact that the numbers they are guessing are being marked up is evidence that the situation is deteriorating. Once it starts to deteriorate, banks won't be able to help themselves but tighten their criteria, which will trigger more defaults, which in turn will cause more tightening.

This is no longer an interesting theoretical possibility, it is the realistic outcome of the current deterioration in asset prices, should it continue.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

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