The UK’s property boom is sputtering and stuttering. You should be very worried about what happens next.
House prices fell nationally in the last three months reported Halifax. The Royal Institution of Chartered Surveyors (RICS) house price index hit zero in February. It was a bigger drop than forecast by any economist polled by Reuters and the lowest since March 2013.
The latest results mean demand for homes in the UK fell for the 11th month in a row. Sellers are putting up a record lack of properties and buyers are not registering with real estate agents.
If you’re a glass half full type, you’ll be delighted. The figures suggest that Brexit is having the intended effect.
Property demand and prices outside of London are still doing well. Property demand and prices in London are languishing. The great rebalancing of our nation is taking effect. No longer is prosperity tied to one city. The rest of the nation has some catching up to do.
But the problem is that house prices are dangerous by nature. A drop in London values could trigger a crash nationally.
Thanks to the vast amount of leverage you need to buy a home, falling house prices represent a huge amount of risk for the banking sector too.
But the real risk is in house price expectations. Because if expectations change, the entire equation for buying and investing in property could trigger a serious economic crisis.
Rising house prices suck in everyone
If everyone expects house prices to rise, that changes the calculations for affordability. For the buyer and the lender.
When house prices rise, the borrower who can’t afford their mortgage can simply sell their home. The profit makes them wealthier. It feels risk free to own property. You just need to get on that ladder somehow. It’s more of an escalator to wealth.
Many students in the US bought homes during the housing boom by lying about their lack of income to the bank, and then paid off their student debt by selling the house when they graduated. It’s an extraordinary windfall that sucks in many unsavvy investors.
It’s not just the borrower who is misled by rising house prices. The bank is protected more than anyone else when house prices rise.
The value of their collateral is going up, so even the worst possible borrower can repay their loan by selling out. The worst-case scenario is that the bank recovers their money by repossessing the house. In this world, lending is a risk-free deal. They’re willing to lend to anyone. It doesn’t matter who they are.
Last, but not least, in this environment, the entire lending and property developing industry gets away with anything too. If there’s ever any problem, they’ll be bailed out by rising house prices.
The danger of risk free
But all this can change. What happens when people stop believing house prices inherently go up? They don’t even have to go down, just stop going up. Suddenly, the entire premise of borrowing, owning property, and lending falls apart.
Borrowers no longer demand unaffordable debt because it no longer enriches them. And lenders’ collateral values no longer inherently safeguard a loan. Suddenly, the lending decision is about default risk instead of collateral risk. Far fewer people can borrow in that environment.
Under those circumstances, the lending business becomes a matter of risk management instead of simple lending volume. Banks stop fighting for market share and start panicking over their default rates.
Without the presumption of rising house prices, the demand and supply of mortgages are not artificially influenced in a way that justifies widespread lending and buying. The incentives to buy property and lend against it disappear.
The demand for property and supply of credit contract. Meanwhile, people who do own property want out. You get a crash that puts the rest of the economy and the banking sector at risk.
Assigning the blame
Where does the belief in rising house prices come from? The obvious answer is experience. House prices have been steadily rising for a long time now. So that’s what people expect.
Some would argue it’s all about animal spirits and bubble psychology. But that’s inadequate.
There must be a reason for an asset bubble like a housing bubble to form and continue in the first place. Something must change for animal spirits to suddenly take hold in the direction of greed over fear. And then continue on beyond the market factors that would rein it in. Why does everyone suddenly become more greedy at the same time?
Given the nature of the mortgage industry, a culprit is not hard to find.
In economics, if a price is set above or below the equilibrium of supply and demand by a government agency, you get a surplus or shortage of that good. If the government sets the price too high, people won’t buy it and producers will overproduce it – a surplus. Set the price too low and you get a shortage as people want to buy a lot, but producers don’t bother producing.
This is effectively what happens in the mortgage market during a house price boom, but with a unique twist thanks to the nature of debt and money. After all, money and debt can be created out of nothing.
If the central bank sets interest rates below the market equilibrium interest rate set by savings and borrowings, it creates artificial demand for debt. Normally this would result in a shortage. But the loanable funds market is unique.
In the process of moving the interest rate, the central bank doesn’t just declare what the new interest rate is. It adds the required supply of funds to push the rate where it wants it.
In this way, the central bank triggers and finances a mortgage borrowing bubble and thereby housing bubble. It increases demand by lowering the price and then increases supply by injecting loanable funds to meet that demand.
This artificial support to demand for property is what begins a bubble. And the bubble usually forms in property because this is the most interest rate sensitive asset.
Animal spirits may indeed kick in. But in a free market the demand for more funds would increase their price — interest rates — and this would prick the bubble. But in a market run by a central bank, the price does not fluctuate according to supply and demand. They are set by the central bank.
Low rates and artificial funds continue to finance the artificial boom—now a bubble. The more market forces try to increase interest rates to prick the bubble, the more the central is forced to provide funds to maintain its low targeted interest rate.
But what happens to the belief that house prices could fall? Usually greed is kept in check by fear. Central bankers have this covered too.
Former Federal Reserve chairman Ben Bernanke was famously asked in 2005 what would happen if house prices across the US fall. He refused to answer the question: ‘Well, I guess I don’t buy your premise.’ It had never happened before, Bernanke told lawmakers, so it would never happen.
Given that a central banker’s role is to set interest rates, and those interest rates operate primarily through the mortgage market, which strongly influences the demand for housing, this statement is extremely powerful. It effectively meant a national drop in house prices could not happen and the Federal Reserve would not allow it to happen.
In the stock market the same phenomenon became known as the Bernanke Put. Of course, it also meant that when house prices did fall, all hell would break loose.
The point is that the stability created by central bankers is what creates the belief in rising house prices. They promise to rescue us, making property seem like a one-way bet.
Asset price booms and leverage are a dangerous feedback loop. Rising asset prices lead to more leverage and more leverage pushes asset prices higher. Economists writing about the US sub-prime bust diagnosed this after the fact. But very few identified the phenomenon before the bust.
Signs of trouble
It’s not just property prices you should watch as a warning sign. The banking industry itself breaks down when property prices fall. That’s because banks stop lending to each other in fear of a default.
As I explained late last month:
The good news is, keeping an eye on pressure in the banking system is surprisingly easy. Introducing, the Libor-OIS spread.
Libor measures the price banks charge to lend to each other. OIS measures the rate at which central banks are willing to lend to banks.
They should be pretty much the same. Unless you’re expecting a bank to default. In which case Libor spikes while OIS remains the same.
That means, a divergence between Libor and OIS tells you the level of suspicion and perceived risk in the banking system. The difference between Libor and OIS is called the Libor-OIS spread.
Well, the spread has doubled since the beginning of the calendar year. Any higher and it’ll be at the highest level since the European sovereign debt crisis.
Well, the US dollar Libor-OIS spread just his hit a six-year high. Not since the height of the European Sovereign debt crisis have banks charged such a premium to lend to each other.
What are they worried about?
Until next time,
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