When will the housing bubble burst?

published 15 December 2006

Here's a question from the Harvard College Bowl, a sort of Harvard University in-house version of the BBC's long-running University Challenge: "Typically one expects that as the price of a good goes up, the demand for it goes down, but an economist noted an interesting violation of this rule during the Irish famine. When the price of potatoes went up, the number of potatoes bought increased because potatoes were still the cheapest staple, but their increase in price took up the discretionary income that used to allow people to indulge in food other than potatoes. For 25 points, what name is given to a good when the demand for it increases despite a price rise?"

Answer: a Giffen' good. Giffen goods are among the most rare and obscure theories in modern economics, yet we may well be living with an example of one right now. You may even have bought one recently yourself. I'm talking about UK houses.

Subscribe to MoneyWeek

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

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

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

However, as the bulls rightly point out, with houses it's not just about price. People who aren't using the proceeds from a previous house sale largely finance their purchase with debt. Consequently, the real driver is not the relationship between house prices and after-tax incomes, but between the monthly payments and after-tax incomes. Interest rates were much higher more than three times higher back in 1990, so we've nothing to worry about today.

Or so the argument goes. But even so, affordability is increasingly being recognised as a problem. "Mortgage payments for someone on average earnings now take up around 42% of take-home pay, compared to 32% three years ago," says Fionnula Earley, chief economist at Nationwide, quoted in The Sunday Times. If the newspapers and dinner parties of South West London are anything to go by, this statement has rather put the cat among the pigeons.

However, Fionnula Earley is being somewhat disingenuous in taking a three-year view. No one, including myself, was especially worried three years ago, not least because by these sorts of calculations the numbers weren't particularly scary. But that's not to say that they have suddenly become worrying overnight. Last year, by my calculations and using the same assumptions as Nationwide, average mortgage payments took up an even higher 43% of take-home pay. How so? Even though house prices and wages were both 4%-5% lower last year, interest rates were actually 0.25% higher.

So for all the headlines and the sudden realisation, in reality affordability has not got any worse over the last 12 months indeed it has got a tiny, marginal amount better. But it still looks like a frighteningly large proportion of income is being spent on servicing mortgages. According to Capital Economics, we are now, as a nation, spending more than 20% of disposable income servicing all our various debts, including mortgages and credit cards. This proportion was exceeded only once on record and

However, as Disraeli wryly noted, there are lies, damn lies and statistics. A closer look at the numbers reveals an even more disturbing picture. First, bear in mind that when the likes of the Halifax tell us average house prices are 5.5 times earnings, what they actually mean is that the average house they lent a mortgage for cost 5.5 times the average earnings of their customers. Nationwide at least use national average earnings data, but they have a very low exposure to the South East and virtually nothing in London, so their number for national average house prices could be understating the true figure by as much as 20%.

For the most comprehensive house-price data, we can look at the national Land Registry, which shows that in February the average house price in England and Wales was £192,745. If you take a more up to date, but still fairly comprehensive survey, we get numbers like £203,080 from the FT for May and £217,580 for asking prices in July, according to Rightmove. I'm going to be conservative and take the Land Registry number, but bump it up by about 2.5% as a reasonable approximation for price rises since. So on that measure, today's national average house price is £197,500, or seven times the national average income (about double the long-run average).

From that, I calculate that a 100% mortgage on the average house requires 49% of the average income to service it. House prices are currently on close to 9.5 times after-tax disposable incomes. The only thing keeping this sustainable is interest rates of 4.5%, which are at almost a 50-year low. Low rates allow people to afford house prices that are such large multiples of their incomes, but as we've already seen, prices have now got so high that even with such low rates, mortgage payments are close to being as unaffordable as they've been. Just imagine what would happen if inflation caused rates to rise significantly from here.

But hold on a second. As I said earlier, interest rates at the 1989-1990 peak were three times higher than today. Yet house prices at seven times earnings are still only 55% more than the 4.5 times earnings they reached back then. So surely the situation was worse then than it is now? If houses were only two-thirds the price, but the cost of debt was three times higher, then monthly outgoings back then should still have been about double today's as a proportion of income, shouldn't they?

On the other hand, the 1989-1990 base rate hit 15%, so the interest-only rate at that time might have been about 15.5%, yet a 25-year mortgage rate, including repayments, would only have been 15.84%. Bizarrely, when rates are high, the compounding effect results in a dramatically lower requirement for the repayment portion, resulting in this case in a monthly payment premium of just 2.2%. This is the true scandal of endowment policies sold during the late 1980s and early 1990s: not that they suffered shortfalls, but that they were allowed to be sold at all in a high interest- rate environment, when interest-only mortgages offer almost no payment-discount to repayment mortgages.

This means that back in 1989-1990, the only other time, by most measures, in the last 30 years when the housing market looked even more overbought than today, mortgage payments on the average house would theoretically have taken up 71% of the average salary. This compares to 49% today. You might think this leaves people with some breathing space, but unfortunately there are at least two factors we have to take into account.

First, we have so much more unsecured debt today than we've ever had before. So we must add in the service burden of this debt to the mortgage obligations before we can see the true strain the household sector is under. On top of that, we haven't even seen the effect of all those student loans coming through on the next generation yet. Is it any wonder that the average age of the first-time buyer is now ten years older than it was a decade ago and that half of them require help from parents or grandparents with deposits or loan guarantees? Not really, when you consider that these days the 10% deposit is pretty much equivalent to the average person's entire post-tax annual earnings.

Second, and rather more mysteriously, back in 1990 people had already responded in a logical and easily anticipated way to such a hostile housing-market environment. Mortgage approvals had already dived to less than half the levels of two years earlier, as willing new buyer numbers dried up sharply. In fact, mortgage approvals started diving into negative territory on this basis as early as mid-1988, as soon as interest rates jumped to 12% and mortgage payments reached 57% of average income.

Charles Handy, visiting professor at the London Business School, wrote in his 1989 book, The Age of Unreason, that a frog put into hot water leaps out, but one placed in cold water that is slowly heated keeps adapting to each small incremental increase in temperature until it is boiled alive, never able to realise that the environment is turning so hostile. Back in 1988, interest rates leapt from 9.5% to 12% in a matter of months. House buyers quickly noticed they were going to be in hot water if they didn't react.

But not this time. Interest rates have risen, but marginally, from a low point of 3.75% at the end of 2003 and, indeed, the last move was a drop from 4.75% to today's level of 4.5%. Instead, this time the pressure has almost all come from the rise in house prices themselves. Every month people who are not in the market feel they are being left behind. The market hasn't corrected, they reason, so it isn't going to. Time to get back in.

So here we are, looking at a good (housing) that looks expensive on all historical comparisons, has been rising in price faster than wages for a decade and yet seems to be experiencing a resurgence in demand. When the price of potatoes during the Irish famine went up, if you remember, the number of potatoes bought increased, but their increase in price used up the discretionary income that had allowed people to indulge in other things. What are people foregoing today?

As house prices have risen, people haven't bought fewer of them. Instead, they've applied for more mortgages and chased house prices to new heights, letting their pension provision and other savings slide. Our official household savings ratio of 5% has halved since the mid-1990s. Not only that, but the way we measure the savings ratio exaggerates our savings compared with other countries. At first glance, that 5% may not look too terrible besides the US's ratio, which is now slightly below zero ie, US consumers are drawing down their savings to keep spending.

One example of putting all eggs into the housing basket is the way that in the last five years house prices have gone up so much more than UK equities, another measure of the country's economic health. Stocks, of course, are the obvious alternative way in which people will save for their retirement. However, whereas house prices have run out of steam recently they're only growing about 1% faster than the rate of wage growth stocks, even after recent falls, are growing about three times as fast.

House prices have so far achieved the Bank of England's soft landing. Even so, this so-called soft landing' has already knocked UK GDP growth down quite sharply from the 3.75% rate of mid-2004 to 2.3% now. Of course, the interesting question is: why did UK housing soft land' (at least so far) and does that mean it won't now have a crash? The UK economy/housing market certainly slowed sharply, but so far there's been no recession/crash and the outstanding reason why not appears to be the big increase in public-sector employment.

However, house prices have risen to levels where the debt-service burden is almost unbearable, at least based on the evidence of what the UK economy could bear from the past. Furthermore, there are good reasons why the bursting of this particular debt-fuelled housing bubble has not immediately led to the usual vicious circle of rising unemployment and recession. Unfortunately, with zero growth in private-sector employment, this economy and its housing bubble is now being supported entirely by the public sector.

And public finances are not as robust as they were. Including the Government's public finance initiatives, public sector net debt, which was less than 30% of GDP four years ago, is due to go up above 40% of GDP for the first time since 1994 thereby breaking one of Gordon Brown's self-imposed rules. But then he doesn't plan to be at the Treasury much longer does he? Cometh the hour, slinketh away the man.

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.