The end of the house price boom is what will finally sink Brown

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Gordon Brown
Gordon Brown

Like Wile E Coyote, the cartoon character who stays aloft long after he has run off the edge of a cliff, the British housing market has constantly defied gravity. Until now. A raft of figures in recent days has confirmed the inevitable: the great British housing boom is finally at an end. That, far more than the illegal funding scandal currently engulfing the Labour Party, is the news Prime Minister Gordon Brown should truly dread.

As long as house prices kept rising, boosting people’s wealth, the 70% of the British population that own their own home (usually courtesy of a massive mortgage) were ready to put up with a lot. They turned a blind eye to Britain’s relatively weak economic growth, falling competitiveness, surging budget deficit and even rising taxes. While property prices went on rising, Mr Brown’s (over-blown) reputation for economic competence was guaranteed; there was nothing anybody could say or do to change this.

No more: Labour has seen a 28-point lead on economic competence in September turned into a six-point Tory lead (even though the economic ability of today’s Tory leaders is entirely untested). The Tories’ impressive 11-point lead in voting intentions in the polls coincides with a growing realisation that the housing boom has ground to a halt. The switch of sentiment to the Tories was triggered by Mr Brown’s dithering over calling an election, the Northern Rock fiasco, the loss of child benefit data and the Labour party fundraising scandal. But it is the end of the house price boom which will strip Mr Brown of what remains of his Teflon coating.

Halifax’s figures on Wednesday show prices slumped 1.1% in November, following drops of 0.6% in September and 0.5% in October, the first house price fall for three months in a row since 1995. This will deal Mr Brown a triple blow: the decline in house prices is set to reduce consumers’ wealth, cut economic growth, boost the budget deficit and destroy the electorate’s confidence in the state of their own (often parlous) personal finances; a surge in interest payments as a share of incomes is hitting their take-home pay as surely as any tax increase; and low yields combined with zero or negative capital gains tax will halt the buy-to-let market in its tracks, upsetting hundreds of thousands of people’s plans for their retirement and investment.

Take just two series of devastating statistics that show the trouble Mr Brown is in: according to figures from the Council of Mortgage Lenders, interest payment as a percentage of income has shot up from 14.9% in February 2006 to 18.6% in September 2007. Almost all the increase in wages during that time has been gobbled up by higher mortgages; combined with higher taxes, petrol prices and inflation, it is hardly surprising consumers are beginning to feel as if their purchasing power and disposable income is declining.

This will only get worse: 110,000 households a month come to the end of their fixed-rate mortgage deals over the next year; with two-year fixed mortgage rates 1.5 percentage points higher than in October 2005, this means interest payments will shoot up by a third. Standard & Poor’s, the rating agency, calls this “one of the largest payment shocks witnessed since the 1990s”. On Tuesday, the Financial Services Authority warned that mortgage lenders would batten down the hatches so borrowers should brace themselves for “very difficult” market conditions next year; at least 1.4m homeowners face a sharp jump in loan repayments. It was the last thing Mr Brown needed to hear.

The second set of statistics to give Mr Brown nightmares is that gross rental yields on buy-to-let properties are about 5.3%, before costs are deducted, when mortgage rates are at about 6%. So this market is set to crash. Gross yields were 10% in October 2001. Excluding inflation, JPMorgan estimates rental yields have fallen below those on 10-year gilts for the first time since 1992. Some estimates show net yields to be a mere 2.5%.

With house prices starting to tumble and mortgages costing far more to service than rental income, the buy-to-let market, which accounted for 11% of mortgages last year, is a train wreck waiting to happen.

While the Bank of England has kept rates on hold since July, market interest rates have spiked as the crisis in the sub-prime housing sector forced lenders to tighten their belts, making fixed rate mortgages far more expensive. Lenders have tightened their lending criteria, demanding larger deposits and better documentation of income; wholesale lenders – who are neither banks nor building societies and more likely to take on sub-prime risk – are fleeing the market.

HSBC this week warned that house prices are about 30% over-valued. JPMorgan, whose housing model is based on data going back to 1973, estimates house prices are overvalued by 24% – surpassing the 23% at the peak of the late 1980s bubble. The International Monetary Fund last month calculated that homes in Britain were overpriced by up to 40%. Goldman Sachs calculates that if rents do not go up, house prices would have to fall by 20% for yields to return to their historical level. Morgan Stanley is predicting a drop in prices next year.

Dresdner Kleinwort, the investment bank, says the last time British property was as expensive as it is today was in 1948, when homes were in short supply after the war. In analysis updated for The Business, David Owen, Dresdner’s chief European economist, says the price of the average home is 7.23 times average household disposable income. That is higher than previous peaks of 1973 and 1988. The ratio has only been higher in the late 1940s when it hit a record of 9.16 in 1948. No wonder first time buyers, at least those under the age of 30, have almost died out and that Nationwide says first-time buyers’ mortgage payments are now worth 50% of take home pay.

After each peak house prices fell by around 30% in real terms. When inflation was high the fall in prices was less obvious than it would be in today’s low inflation environment when nominal house price falls would hurt more. So will the impact of falling house prices on the wider economy.

The consensus view in the City is that economic growth will be around 1.9% next year; but that assumes house prices are roughly stagnant in nominal terms. A decline would reduce growth further by hitting consumer confidence and reducing mortgage equity withdrawal (one of the drivers of the credit-based consumer boom). There is a strong correlation between the strength of the housing market and the robustness of consumer spending and overall economic growth in Britain. If house prices continue to fall, fewer jobs will be created and unemployment could start to rise, reinforcing the decline in the property market and threatening a vicious cycle of falling house prices and slower growth.

A weaker economy, consumer spending, pay rises and corporate profits will automatically reduce the government’s tax receipts. Public sector net borrowing has already reached a worrying £24.2bn so far this fiscal year – £6.7bn more than in the same period of 2006/07, even though the economy has been doing very well, growing by more than 3%.

The current housing slowdown has come too late to affect those figures much.

When the going gets tougher next year, the deficit is bound to surge further; it is now almost certain that Chancellor Alistair Darling will overshoot his budget deficit forecast of £38bn. The prediction by Ingenious Securities – that the deficit will reach £50bn in the 2008-09 fiscal year – was originally dismissed as scaremongering; it no longer looks so wild in the context of a drastic slowdown in the housing market.

The exchequer will also suffer from the decline in housing transactions, which is the key driver of its stamp duty receipts. The number of mortgage approvals for new house purchases fell from 108,000 in August to 102,000 in September and a mere 88,000 in October, the lowest since February 2005.

This decline in the market in turn will lead to job losses at estate agents. Repossessions will rise as buyers who extended themselves when base rates were 3.5% find themselves unable to meet their commitments. The Council of Mortgage Lenders expects the number of people losing their homes to hit 45,000 in 2008 from 30,000 this year but still well below a record of 75,540 in 1991.

The gravity-defying performance of the housing market over the past decade was helped by four factors.

First, a boom in the City of London; second, the influx of overseas money, particularly from tycoons from Russia, China and the oil-rich Gulf states looking for alternative assets, and perhaps a pad in Britain; third, the structural fall in nominal and real interest rates, which led to a step-change rise in housing values; and fourth, employment has been at record levels and unemployment at record lows, giving homebuyers greater confidence that they will be able to meet their payments.

But, while house prices will certainly fall over the next year, there are good reasons not to expect a crash. Previous price slumps were triggered by a sharp surge in unemployment, caused by a policy error such as membership of the European Exchange Rate Mechanism or a recession. While the housing downturn itself will hit the labour market, the global economy is so robust that Britain is very unlikely to suffer an outright recession, despite the credit crunch. At the same time, vast inflows of immigrants mean that the demand for homes is still increasing.

Official interest rates are likely to fall, which will eventually filter into market and interbank rates and mortgages. While the Bank is keen not to underpin house prices, it has already indicated two rate cuts are needed to stop a slump in inflation and growth. Foreign money will also continue to pour into Britain, propping up demand.

Last, but not least, a structural shortage of homes will continue to underpin prices. Britain has not seen nearly as strong a response by homebuilders to high house price inflation as Spain and Ireland have done, largely because of excessively stringent planning laws. As a result, in the long run, (over the next decade) property will recover and do well.

But in the short term, which is the only thing Mr Brown really cares about, the only question is whether, like Wile E Coyote, the housing market will suddenly plummet to the ground; or whether it will glide gently back to the ground.

The good news is that price falls over the next year are unlikely to be more than a few percentage points. Property prices are still most likely to readjust primarily over the next three years by growing more slowly than incomes; but what this means is that the housing market will be a poor investment, at least until the start of the next decade. It also means that the economy will grow only very slowly, that consumer spending will be badly affected, that unemployment will rise and that the budget deficit will surge, putting pressure on Mr Brown to rein in spending or put up taxes yet again, which would be a disastrous option. There will be pain and many people will default on their mortgages; but fortunately, it will not be another early 1990s-style crisis.

For Mr Brown, the looming correction in house prices will be the most serious blow yet to his fading reputation for competence. But it is better than the alternatives – either a housing market that irrationally keeps on defying gravity or a proper crash – both of which would be real Looney Tunes outcomes.

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