Low interest rates - morphine for the terminally ill housing market.

The Financial Times reports today that the indications are that the low interest rates are helping house prices to rebound. Personally I am horrified by the fact that such a situation is not being highlighted with greater concern by the government, economists and sane people generally.
The article itself hardly highlights the worrying matrix of fundamentals that means that any such rebound is likely to simply result in more people overstretching themselves and house prices taking longer to correct to a more realistic level reflecting earnings, affordability and available finance.
At the height of the boom there were some who warned that the housing market was becoming overheated and that the Bank of England needed to consider raising interest rates to control the growth rate of house prices which was outstripping any increase in wages. The BoE, whose main point of reference for setting interest rates is an inflation measure which takes no account of house prices did not react (or certainly did not react sufficiently) and house prices continued to show hyper-growth. Compare this to inflation generally (whether CPI or RPI) which, whilst higher than the levels considered "safe" did not even come close to house price growth levels (and thankfully so). The fact is people who own houses are happy with double-digit growth in their value as it means more equity and therefore, with banks happily splashing the cash, more money for them to spend now and worry about paying back later.
House prices have now fallen slightly and may, in some areas, reflect a fair value. If you look at annual house price inflation on an annually compunding basis from 1983 until today the annual rate is 6.55%. Some might not consider this too high. For the period from 1991 until 2009 annualised wage inflation on a annual compounded basis was at 4.2% (based on the LNMM index figures from the ONS). House price inflation over the same period was about 4.63%. That difference in growth could even be a statistical error.
However the real issue now is one of liquidity and equity. The FT highlights this by referring to the fact that the rebound has been effectively caused by low interest rates. But rates will not remain low forever and when they increase all those people managing on SVRs at or below the fixed rates they took out will suddenly be faced with increases in their monthly outgoings. Apart from the handful of bankers with huge bonuses most of us are not anticipating any pay inflation this year! This at a time when many other costs will have already increased as a result of the fact that we have not seen the massively overanticipated deflation. The risk is that we then see a rush to sell up and downsize to a more affordable house with the oversupply finally bringing much needed liquidity to the market and almost certainly a reduction in prices. The number of people able to buy and the amount they are able to spend is reduced due to lack of finance and so house prices will have to fall.
Therefore, triumphally declaring that low interest rates have saved the housing market from collapse is equivalent to saying that giving morphine to the terminally ill patient has saved his life. You can take away the pain for a time but eventually time runs out.

CML slashes repossession forecasts - are they right to?

The FT this morning carries the news that the CML has slashed its repossession forecasts for the year. Let me give you a brief precis of what it says:

The CML lowered its forecast for property repossessions in 2009 to 65,000 from its previous estimate of 75,000

The CML said:

Although the economic backdrop remains challenging, the vast majority of homeowners continue to meet their monthly payment obligations. The large cuts in interest rates have benefitted many, making it easier for households who suffer a loss of income to continue to pay their bills.

This is all very nice and, indeed, the CML may be correct that their original forecast was wrong. However, do not read into this message, as many undoubtedly will, that, to quote the song by Yazz, "The only way is up" for residential property prices - I think that there must be at best stagnation and at worst (or even better for those hoping to buy) further falls to come.

The fundamentals

The boom in residential property prices was caused by a number of different factors. The most important of these were:

• demand (especially within London and the South East)
• disposable income (bonuses)
• cheap lending
• belief that values could continue to grow
• lack of housing stock

Let's consider some of these fundamentals in turn and the outlook

1 Demand

Demand for property was very high towards the height of the boom. This demand was fuelled by:

• more people looking to buy their own home
• the buy-to-let market
• expectations of windfall profits
• immigration and migration to London and surrounding areas

Most of these factors no longer exist. The buy-to-let market is still available if you have the cash to invest and are prepared to take the risk. There is no longer an expectation of windfall profits as people will be happy just to make a reasonable profit and keep a roof over their heads. Large job losses in the financial and services sectors and general downsizing resulted in and will continue to result in a decrease in movement into the UK and we may even see emigration and certainly migration away from densly populated and expensive areas such as London.

2 Disposable Income

Apart from Tube workers who believe they have a right to inflation busting pay-rises whilst the rest of the world goes to hell, most people are facing stagnant pay (or pay cuts in real terms). At the top level of the market (the banking, legal and other professionals) where pay was boosted by bonuses for so many years the size of the important bonus (if it exists) is significantly lower. Therefore, in terms of ability to pay monthly interest and/or repayment sums the amount that can be paid is less. Further the lack of job security means that the inflexible nature of owning a property with a mortgage is less attractive to, otherwise, mobile individuals.

Put in simplistic terms, there is significantly less money out there even before you consider the availability of debt.

3 Cheap lending

Not sure I even need to spell this one out. However there are actually two factors to this. First there is the fact that prior to the credit crunch the margins banks imposed on their mortgage deals were paper thin. Tracker rates below base rate were available. The reason for this was that with the magic of securitisation banks did not expect to hold on to their loan book for long so what did they care if the initial rates were 'loss-making'.

However, the Government and the Bank of England (along with other world economic leaders) have forestalled an immediate crisis caused by a sudden jump in the cost of borrowing by cutting interest rates drastically (0.5% in the UK). For those on base rate tracker deals this has resulted in them paying almost nothing (some are literally paying nothing). For those on fixed rate deals, when those deals have ended they have come on to a standard variable rate on average between 4% and 5% (about the level their fix was at in 2007). The CML has expressly stated that this is a major factor in their expectations being revised.

But interest rates cannot stay this low for too long. Predictions of deflation and very low inflation (below the BoE target of 2%) have thus far proven false. CPI is still above the target rate of 2% although the BoE have justified avoiding any rises on the basis that deflationary risks outweigh inflationary ones. This is probably correct in the immediate short term but as inflation begins to creep in (petrol prices are up significantly and at the end of the year VAT reverts to 17.5%) how long will the BoE be able to sit back and not act?

When the BoE does react (and even if it is not for a year from now) those homeowners who have been sitting on standard variable rates are in for a rather nasty surprise. Those rates will go up quickly (and quite possible faster than the base rate). Many who bought or refinanced in 2007 will find themselves in difficulty. New mortgage deals will not be open to them as the equity in their homes is likely to fall below the 25% level required to get a decent affordable deal and those fixed rate deals will continue to increase in expense. Meanwhile the interest payments will seem unaffordable as incomes stagnate and the cost of living rises.

In such circumstances will a bank avoid repossessing whilst there is potentially some profit in a sale which would cover its expenses when waiting will mean triggering a real loss on its books as values potentially fall and arrears mount? Will borrowers avoid selling to realise a small amount of equity whilst the arrears begin to rise and renting is a realistic option?

Conclusions

There is some inevitability that interest rates will rise again. Many suggest this might happen sooner than expected. When this does homeowners, loaded up with debt from the boom years which they are unable to refinance at affordable rates, will be forced to consider selling or defaulting. This will result in more properties coming on to the market on a distressed basis and this will further depress prices.

House prices in London and the South East may have cooled off but they have not really fallen. That fall will happen unless someone can wave a magic wand to make the debt disappear. As someone looking to buy I selfishly hope that magic wand does not work!

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Addendum: Check out the FT on Fitch's report that 10% of borrowers are now in negative equity. If you classed negative equity at 90% LTV (on basis that you cannot borrow 90% today) I wonder how many then fall into the trap?