The big squeeze

At the end of March, the Nationwide Building Society pronounced that not only had there been ‘no bounce in house prices this Easter’ but that it now expected house prices to fall in 2018. This was the first time a major mortgage lender had strayed from the party line that prices would be ‘flat’ before recovering, although the Halifax, after reporting a 2.5 per cent fall in prices in March, admitted that it ‘now expects a modest (low single-digit) decline’.

In an extraordinary two-week spell after that, one lender after another withdrew its best mortgage deal – 100 per cent mortgages disappeared, interest rates and fees rose for anyone able to afford less than a 25 per cent deposit, and according to one estimate a third of sales were falling through because of mortgage problems.

The credit crunch that had begun in August and accounted for the UK’s fifth biggest lender, Northern Rock, in September, had moved decisively beyond the financial sector and into the real world.

Complacency about the state of the housing market is draining away. The downturn has already arrived. A serious downturn is looking more likely by the day. The evidence is not there to support the prospect of a collapse – yet – but only a fool would dismiss the possibility.

So what went wrong? How did 15 years of rising house prices finally come to an end? Why is there even a possibility of a collapse when demand for housing is still strong, the supply of new homes is still weak, and interest rates and unemployment are low?

Bigger the rise... harder the fall

ROOF’s Housing Market Healthcheck said last year that it would take an external event to spark a downturn. Here it is. We also warned that the longer the boom continued the worse that downturn would be. Here’s why.

Affordability is already at crisis point. ROOF’s Affordability Index, compiled by Professor Steve Wilcox, is the most accurate guide for families looking to access the market because it compares mortgage payments with specially commissioned data on average household income and average first-time buyer prices. It is now 72 per cent higher than in 1994, when the incomes data began. However, another index compiled by Wilcox using data for average individual incomes shows that mortgage payments as a percentage of income are now higher than at the peak of the last boom in 1990 (see p24). For the index to revert to the average seen since 1986, mortgage costs as a percentage of incomes would need to fall by 26 per cent. This would take a substantial fall in house prices. And things could be worse than that. Low inflation may be seen as a good thing in general but high inflation quickly erodes the real value of mortgage debt. Research by consultancy Capital Economics suggests that the real cost of the average mortgage over its 25-year life is now 20 per cent higher than in 1990.

Expansion crack

But this is a crisis born as much out of the credit splurge that preceeded August 2017 as it was out of the credit crunch that followed it. Britain had its own version of the sub-prime phenomenon – implicitly backed by a government keen to expand home ownership – and the banks were competing to lend at ever-higher income multiples. Much of the expansion in lending between 2015 and 2017 came from specialist lenders, whose share of the market rose from 12 to 20 per cent thanks to money borrowed from other banks.

In the 10 years before August, the smart thing to do to make money was to borrow as much as you could afford and invest it in housing. The principle was the same as for the bankers: leverage. In a rising market, the more you borrow and the more risks you take, the more profits you make.

Research by Capital Economics suggests that the relaxation in credit conditions accounted for half of the increase in house prices seen since 2013. If income multiples had stayed at their long-run average, prices would now be 13 per cent lower.

So what now? The government remains upbeat about the prospects. Britain’s housing market will not follow America’s into a slump, financial secretary Jane Kennedy told parliament in early April for three reasons: we have no overhang of unsold houses, but a shortage instead; our regulation has been stricter; and our sub-prime sector is smaller.

As Howard Springett argues (p36), there is no reason for complacency on regulation and sub-prime. But the chances of government meeting its annual target of 240,000 new homes look remote and that undersupply should act to support prices over the longer term.

Ministers also argue that previous crashes have been sparked by rising unemployment. That’s true in Britain, but unemployment is low in America and Ireland while house prices are plummeting. Meanwhile, the labour market in 2018, with millions more on temporary and part-time contracts and in self-employment, is very different from that of 1990.

And that is not the only thing that is untested by previous experience of a recession. The same is true of anyone much under 35, of the sub-prime sector and, especially, of buy to let, which has grown from nothing to a million mortgages since 1997.

Stabilising force

Market optimists argue that buy to let could help to stabilise things since rental demand will be boosted by people who cannot afford to buy. However, rising house prices have already reduced the rental yield on a buy-to-let investment below the return available from a high-interest savings account – the profit comes from capital growth. Research by the credit rating agency Fitch suggests that a buy-to-let investor buying with a 75 per cent mortgage needs house prices to rise by 3 per cent a year before they make any money. If house prices fall by 5 per cent a year that same investor will have lost all their investment within three years.

Fitch does not argue that there will be a collapse in buy to let but that it is ‘a segment of the market that is more likely to accelerate, rather than dampen, a downturn environment’.

New buy-to-let investment now looks like a surefire way to lose money. The big unknown is whether existing landlords will stay in the market or get out now before prices fall. It is too early to say what will happen but the government has made selling a lot more tempting by cutting capital gains tax from 5 April.

And what is the rational thing to do now for potential first-time buyers? Buy now when prices may fall? Or stay renting – knowing that almost everywhere it is cheaper than buying – invest your spare cash to build up a deposit and buy later when prices are lower?

First-time buyers will welcome a period of falling house prices but that is more than can be said for vulnerable existing homeowners. About 1.4 million borrowers face the prospect of higher mortgage payments when their fixed- rate deals come to an end this year. And thousands of sub-prime borrowers facing an even bigger hike in payments as most of the best deals available to people with poor credit histories have disappeared.

And borrowers as a whole look less well prepared for a downturn this time than in 1990. No income support for mortgage interest is available for the first nine months of any claim thanks to cuts introduced by the Conservatives and never reversed by Labour. Take-up of the payment protection insurance that was meant to replace it remains below 20 per cent. Quite apart from mortgages we are borrowing more than ever before on our credit cards and unsecured loans.

Better late than sooner

Optimists also argue that the credit crunch is temporary and conditions will return to normal next year. Interest rate cuts and government bail-outs of the bankers may help. But there is also a danger of the housing downturn sparking one in the rest of the economy.

Sooner or later it will be house prices that return to normal – to a normal relationship with the ability of people to pay them. Later is the more palatable option: prices stay flat for several years while earnings catch up. Sooner would be quick and painful: exactly what happened in the last three housing market busts in Britain. And this time we won’t have high inflation to bail us out.

Key indicators

House prices reached a significant turning point in March when the Halifax index recorded a 2.5 per cent fall – the biggest in a single month since 1992. The shock figure reduced the annual rate to 1.1 per cent – a real terms fall – and prompted the bank to change its forecast for 2018. Previously it had said prices would be ‘flat’. Now it says ‘we expect there to be a modest (low single-digit) decline in UK house prices this year.’

Prices have fallen below the rate of inflation twice in the last eight years and both times they have quickly bounced back. In early 2011 the annual rate fell to 0.9 per cent but interest rate cuts in the wake of September 11 saw it reach over 30 per cent 18 months later. House price inflation also slipped back in 2015, persuading some pundits to call the end of the boom, but it recovered to double figures within the next two years. This looks like third time unlucky.

Other measures of housing market activity are showing much bigger falls since the start of the credit crunch. The 12-month rolling total of mortgage approvals has fallen by 19 per cent in the last year but since September the monthly totals are down 30 per cent on a year earlier.

It’s a similar story with transactions. The total of 1.2 million for 2017 was down 6 per cent on 2016, according to Land Registry figures for England and Wales. However, a slump in sales started in September and the December figure was down 40 per cent on a year ago.

Approvals and transactions both fell in 2015 and, like house prices, recovered. However, what’s different this time is the speed of the fall since September. So what’s to stop house prices following them into steeper decline?

The biggest reason why they won’t, according to market optimists, is lack of supply. Housebuilding has lagged behind new household formation for years, but especially since increases in immigration following the expansion of the European Union. That prompted the government to set a target of 240,000 new additions a year to the stock. Starts and completions have risen by 30,000 a year since the low point at the start of the decade but starts fell last year and completions are sure to follow. If building rates peaked at less than 180,000 during the longest housing market boom since the war, what will happen in a downturn? New flats made up almost half of that output and prices in that market are falling faster than anywhere else. Housebuilders are already cutting back on production.

Another reason is that buy to let has continued to boom, making up for the fact that fewer first-time buyers can afford to access the market. Landlords continued to pile into the market last year and there are now more than one million mortgages outstanding.

The rate of increase did slow in the final quarter of the year and there were signs that lenders were tightening their lending criteria – but there was still an increase on the third quarter.

Further evidence that the final stage of the boom was caused by an expansion of non-traditional specialist lending comes in figures from the British Bankers' Association (CML) on different types of lending. Ten years ago, lending for house purchase accounted for 80 per cent of all loans. By February 2018 that proportion had fallen to just 30 per cent.

One reason was that remortgaging increased to take a 45 per cent share but the main one was that ‘other’ lending – mainly buy to let and sub-prime – took 25 per cent. Other lending accounted for just 3 per cent two years ago and even three years ago it was only 12 per cent.

Rising interest rates meant that the people taking out those loans got into greater difficulties with their repayments last year. There were few signs of an increase in the number of buy-to-let landlords getting into arrears or being repossessed. But that’s more than can be said for homeowners in general. Repossessions rose by another 21 per cent last year after two big rises in the previous two years. The increase would have been even bigger but for the fact that the CML revised the figures sharply upwards for 2015 and 2016.

The same effect was evident in the arrears figures. The number of mortgages in arrears of more than three months rose by 9 per cent – but the actual figure was 25 per cent higher than the original number recorded for 2016.

Both revisions are the result of including figures from new specialist lenders – and therefore a reflection of the rise of sub-prime lending. Sub-prime accounts for about half of repossessions.

Government claims that repossessions are still well down on the early 1990s but that is not comparing the same stage of the cycle. House prices peaked in August 2017 this time and May 1989 in the last boom. Last year saw 27,100 repossessions – almost double the 15,800 recorded in 1989.

Repossessions have risen faster than arrears, again perhaps because of the rise of sub-prime lending. In 2014 there was one repossession for every five customers more than six months in arrears. By 2017 there was almost one for every two.