07.05.10

By John Plender

Housing market dynamics that defy the rules of past recessions

In past recessions in the UK, one thing could safely be relied upon: house prices would start to revert to the mean, in terms of their relationship with average earnings.

Yet despite the severity of this latest recession, real house prices have fallen only 15% from the peak, compared with 22% in the early-1990s recession. There have been fewer repossessions, banks mortgage losses have been lower and prices remain stubbornly high in relation to earnings.

The contrast with the US is extraordinary. There the recession was not as deep as in the UK with a peak-to-trough loss of output of 4% against 6% over here.

Yet Ben Broadbent of Goldman Sachs, from whom I have taken these figures, points out that UK house prices are actually slightly higher than they were in mid-2006, and US prices have fallen 30% over the comparable period. Among other things, this tells us that the recession we have just experienced was different. There has been no consumption-led decline in domestic demand. The recession was driven instead by a dramatic fall-off in private sector investment.

In the meantime, the dynamics of the housing market are very different from those in the recessions of the early 1980s and 1990s. A paper from the Bank of England identifies three main causes of the rise in house prices and mortgage debt relative to income over the past two decades. The first is demographics. Post-war “baby-boomers” reaching middle age has led to a bulge in the population with the biggest demand for home ownership. The secular increase in rates of divorce and reduction marriages has been another key influence.

A powerful factor has been the decline in long-term interest rates. This is partly the result of central banks’ efforts to curb inflation. It also reflects the accumulation of savings in Asia, northern Europe and the petro-economies, which fuelled demand for government bonds and led to yield compression. A further by-product of the decline in inflation is that mortgage payments are no longer frontloaded. Lenders do not need a fat premium in interest rates to compensate for the loss in value inflicted by high inflation.

I would add to these factors the credit bubble. Banks increased leverage and engaged in more securitised lending. Lending standards collapsed and marginal borrowers enjoyed easy access to mortgage finance with lax loan-to-income or loan-to-value ratios. Unlike in earlier recessions, the banks also financed a buy-to-let boom — although residential rents have, as in previous slumps, risen.

Quite as important in the rising market was the lack of supply. Since 1997, planning restraints on the residential market became more restrictive and new building failed to keep up with the expansion of new households. Developers were unable to respond robustly to the market’s price signals.

This largely explains the difference between the US and UK. In a global market, the equity, bond and commercial property sectors each respond to the movement of capital in a fairly uniform way. Residential property is not so sensitive to global flows, but the local balance of supply and demand is key. In the US, supply constraints are far less than in the UK, so there is nothing to underpin the market in a downturn.

Reverting to type

So is the idea of a reversion to the mean now an irrelevance? Not necessarily. After these long-run changes in the structure of the banking and housing markets, new trends are emerging. We know, for example, that the regulators will punish the banks with an increased cost of capital through a new Basel Accord. This will be passed on in the form of a higher borrowing costs.

As Jamie Dannhauser of Lombard Street Research points out, a big concern is the £250bn overhang of residential mortgage-backed securities (RMBS) issued by banks but not placed with investors. This has been dumped on the Bank of England as part of a liquidity-support operation that will be removed over the next two years. Then the cost of financing bank’s mortgage books could rise dramatically. At the same time, the long-term fall in real interest rates could be over.

Supply is admittedly still tight. But at the very least, the rise of house prices relative to household incomes is probably over. The rules of the housing game are changing once again.

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Source: Property Week (www.propertyweek.co.uk)