The origins of today's market mayhem: thank the housing bubble

myhouse wrote: »

I just don't understand how you can separate the housing market from the credit crunch so easily.

It was not simply risk mis-allocation, but excessive lending at all levels of the market.

Unsustainable amounts of money were being pumped into the housing market forcing prices onwards and upwards.

People who should never have been lent money (sub-prime) had money thrown at them.

Lets be absolutely clear about the three distinct and separate issues which you, geneer and Graham seem hell bent on conflating.

1. The credit crunch.

2. The wholesale markets, UK banks and UK lending standards.

3. UK house prices and UK affordability.


First, the Credit Crunch:

The credit crunch was a direct result of one thing and one thing only.

American banks bundled some truly horrific sub-prime loans together and with the complicity of ratings agencies, mis-sold them on the global markets as AAA investments. These were bought by pension funds, banks, investment funds, etc all over the world.

To illustrate the scale of the problem, a new word was invented. The NINJA loan.... No Job, No Income, No Assets. Ignorant people were being mis-sold these loans on an epic scale. People without a job, without any income, and without any assets were being give $500,000 mortgages on a 1% introductory teaser rate, with no understanding the rate would revert to 5% within a year or two and the loan would inevitably default.

And then of course, the inevitable happened. American sub-prime mortgages started defaulting in very large numbers, up to 30% of loans written by some lenders, and the losses caused the biggest US sub-prime lender, New Century Financial, to file for bankruptcy in April 2007.

Contagion then started to spread throughout the American financial system as the scale of these mis-sold American sub-prime backed AAA investments was realised. And just 3 months later, in July 2007, Bear Stearns Investment Bank, one of Wall Street's biggest, announced that investors in two of it's hedge funds would get little, if anything, back on their investments.

At this point, the contagion goes global.....

By August 2007 BNP Paribas announce that investors will get nothing back from two of it's funds because it can't value them, owing to "complete evaporation of liquidity from the system".

Banks all over the world stop lending to each other, and the wholesale money markets dry up, because nobody knows who owns these American mortgage backed obligations, how big the problem is, and who will be left holding the bag.

At this point the ECB pumps 200 Billion Euros into the system to fight the liquidity crisis, and the Federal Reserve, Bank Of Canada, and Bank of Japan also intervene.

By September 2007, the LIBOR interbank lending rate, the rate at which banks lend money to each other to fund consumer lending such as mortgages, rose to 6.8%. UK banks started hoarding capital, and UK wholesale funding dried up.

Those banks whose business model relies most heavily on access to wholesale funds, such as Northern Rock, start experiencing a cash flow crisis and turn to the Bank of England as lender of last resort.

Word of this gets out in the media, and we have the first run on a UK bank in 150 years. The UK government steps in to guarantee deposits at Northern Rock, and the run ends.

But it's not just Northern Rock that's in trouble. ALL of the UK banks are having trouble accessing funds. It makes no difference whether you're Northern Rock, RBS, HSBC, LLoyds TSB, or BOS, the global wholesale money markets have frozen up, and whether you're a good lender or a bad lender is immaterial.

The financial system was in melt-down. And absolutely none of this so far has anything to do with UK mortgage lending standards, UK sub-prime, UK mortgage default rates, or UK house prices.

Which brings us neatly around to point 2......

The wholesale lending markets, UK banks, UK lending standards:

Northern Rock relied heavily on the wholesale money markets, rather than savers' deposits, to fund its mortgage lending. And contrary to the belief of some posters on here, Northern Rock did not fail because of it's mortgage lending standards, or because of sub-prime loans it wrote, or because it's defaults made it unprofitable.

It failed purely and simply because it's business model relied on the ability to borrow short and lend long, then securitise the mortgages and resell to repay the original borrowing. When the wholesale markets dried up due to the global credit crunch (and not just to NR, to ALL banks in the UK) this business model was unsustainable, and Nationalisation was the end result.

Now it also so happens that Northern Rock was one of the most aggressive lenders in the UK as far as sub-prime was concerned, and indeed had a greater concentration of non-traditional loans on it's books, such as 125% mortgages, Self Cert, etc. But this had absolutely nothing to do with the reason it failed. It wasn't defaults on it's loans that caused it to fail. It was it's business model of borrowing short and lending long. A model that became unsustainable with the end of RMBS and the freezing up of global money markets.

Indeed Northern Rock's old mortgage book of all those supposedly sub-prime loans, the so-called "bad bank", remains profitable to this day. It made £300,000,000 profit last year alone.

Because the quality of mortgages written, whilst perhaps lower than traditional UK standards, remained an order of magnitude better than the real sub-prime slime written in the USA, that was the sole cause of the credit crunch.

And so on to point 3......

UK house prices and UK affordability.

With regards to this......

If you double the housing prices in 10 years then the new prices have to be long term sustainable - people's earning power needs to have doubled. What we saw of course was that houses doubled, salaries didn't. .

House prices "doubling in 10 years" is a nice sound bite, but of course it's not remotely representative of whether or not houses became unaffordable. Because people's wages also increased during that time, costs of living fell, and the cost of servicing mortgage debt decreased as well.

Not to mention of course that house prices move in cycles, and comparing a trough to a peak is, well, a bit misleading.

There is nothing to say that house prices at the absolute bottom of a cyclical trough (as they were in the mid 90's) are the "right price" for houses. Just as the same argument can be made for prices at peak.

So we have a situation where prices in 2007 are arguably too expensive, and prices in 1997 are arguably way too cheap.

But too cheap or too expensive in comparison to what?

The house price to single salary ratio is deeply flawed as it does not take into account changes to household income, dual earners, lower interest rates, falling costs of living, changes to after tax income, etc. And as the "long term" average for this was skewed through being set over the three decades of the highest rates in the BOE's 300+ year history, and at a time when women typically worked and earned less than today, it's essentially of no relevance.

But even this measure suggests that houses are not particularly over priced today.

According to Halifax, the long term average for house prices is 4.0 times male, mean, average salary. Whereas the average house price today is 4.5 times male, mean, full time salary. Now given the structural change to the interest rate environment and increasing prevalence of dual income households, this should tell anyone with a bit of common sense that house prices aren't really overvalued at all.

As surely even the most vocal housing bear should be able to realise that what is affordable to a single wage earner with a non-earning spouse and two kids, paying higher taxes, higher essential costs of living, and 15% interest rates in 1990, will be radically different to what is affordable to a Dual Income couple today, paying 5% interest, and with lower taxes and lower essential costs of living.

Of course, you could also use the percentage of after tax income required to service a mortgage. Perhaps a fairer measure, as it takes into account wage inflation, taxation changes, etc.

And on this measure, a mortgage for a new purchaser today would require just 29% of after tax income, versus the long term average of 37%, and versus 68% in 1990. So again, on this measure it is clear that housing is certainly more affordable today than the long term average, and massively more affordable than it was 2 decades ago. (indeed, even in 2007 with higher rates and prices, affordability on this measure remained massively better than it was in 1990)

But even those measures really miss the point, which is this.

There is no reason house prices should stay at a particular level, or ratio of affordability. Indeed, house prices have done exactly what you'd expect in an open and free market. Increased dramatically as a response to the critical shortage of housing that we have in this country.

Now don't get me wrong, if you remove 70% of mortgage funding from a market, prices will crash no matter how much of a shortage exists. But the difference between house prices inflated by a speculative bubble, and house prices inflated by a genuine supply and demand imbalance can only be seen AFTER you remove the funding.

So when here in the UK we removed 70% of funding, prices fell by 20%, and promptly recovered half those losses to sit at just 10% below peak today. (Nationwide)

Whereas in Ireland, prices fell by 48% and are still falling, and in the USA by 38% and still falling. And all that despite the fact that all three countries responded with ultra-low interest rates, liquidity support, bank bailouts, help for homeowners, etc.

And the reason why the three markets responded so differently is clear.

Housing vacancy rates:

Ireland = 17% and rising

USA = 13% and rising

UK = 3% and falling.

And so here we are in the UK, with endemic mortgage rationing but stable prices. Whilst rents soar to new record highs instead.

Because we added 470,000 people last year, formed around 270,000 new households, and built just over 100,000 houses. And even in the boom years, we never once, not even for a single year, built enough houses to keep up with population growth and household formation changes. It should therefore come as no surprise that prices remain high today.... after all when you only build 30% of the houses you need, only the top earning 30% of households need to be able to afford them. That's how markets ration goods in short supply. Through price.

Now look, I understand why so many posters are desperate to believe prices only rose because of "lax lending"..... Because the reality, that we are short a million houses already, and need another 3 million built in the next 10 years just to keep up with growth and keep prices at today's levels, is a staggeringly hard concept to grasp if lower prices are your goal.

In fact, any rational person would have to concede that we haven't a hope in hell of meeting those targets. Therefore any rational person would have to also concede we haven't a hope in hell of seeing cheaper housing costs over the medium to long term.

Hamish, Post 13 was one of the best I have ever read on an HPC or economy website. Thank you (too good just to merit just the normal "thank you").

You're welcome folks.