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.

UK house prices: a crisis of affordability

By most measures, UK house prices have doubled in the last five years. They are now unarguably expensive. Halifax claims that house prices are about 5.5 times incomes, compared to the previous record of 4.5 times set back in 1989-1990. That peak marked the start of a seven-year stretch of falling real prices, so it may look a pretty bad omen for the future of the housing market.

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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

that was you guessed it back in 1989-1990.

UK house prices: understanding the statistics

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?

UK house prices: the effect of interest rates

But that's not the case the situation is much worse today than it looks at first glance. This is where we come to a strange quirk of the mathematics of compounding. You may quite reasonably think that if rates are one-third of what they were in 1989-1990, mortgage payments (on the same sized debt) would also be only a third. But you'd be wrong they're actually about half.

This is so counter-intuitive that it's best illustrated by a factual example.

Today, with base rates at 4.5%, interest-only mortgage rates are about 5%. Once you include the repayment of the loan principal, annualised repayments on a standard 25-year mortgage work out at about 7% of the original loan amount. This is a 40% premium to the repayments on an interest-only mortgage (where, of course, the payments are only meeting the interest, not repaying the principal).

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.

Uk house prices: other pressures on homebuyers

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.

Yet today, mortgage approvals have recovered after a rare drop and are running at a marginally higher level now than two years ago. Why, therefore, are people coming back into a market that is looking so expensive on a historical basis and which must be stretching their finances to the limit? The answer may lie in the mystery of the boiling frog.

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.

Uk house prices: squeezing discretionary income

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?

Most people buying houses now justify the expense by assuming that their house will in some way become their de-facto pension. This is despite the compelling evidence that most people need both a house to live in and an income to live off in retirement. Unfortunately, for today's home buyer, there is precious little discretionary income left to finance such things as a pension plan.

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.

UK house prices: the economy as a whole

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.

There has been virtually no growth in private-sector jobs for the last five years, whereas the public-sector payroll has grown more than 20% since 1998, to 7.9 million jobs. If Gordon Brown had not played so

fast and loose with the nation's chequebook, then the extra 1.4 million (rather unproductive) public-sector jobs that he's created might instead have gone onto the unemployment statistics and UK unemployment would not be 1.6 million (5.3% of the workforce), but instead three million souls, or 10% of the workforce.

In the last 30 years, unemployment has only gone above 10% twice: in the immediate aftermath of the two full-blown recessions of 1980 and 1991. So it looks pretty likely that this big expansion of the public

sector is what has so far saved the UK from a normal' credit-fuelled housing crash/recession. It remains to be seen whether such an inherently unproductive solution merely postpones the inevitable, or can actually save the day.

House prices have not yet followed the script. At first, mortgage applications dived. Yet although house-price growth was briefly negative in real terms, house prices have never gone down. Prices and market activity levels are now popping back up as buyers get sucked back in.

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.