2) Housing - Why So Expensive?

The Modern UK Housing Market - Arguments?
Very few people argue that property is cheap today. By every measure, with the exception of first year “affordability”, housing costs more than ever before.

However, it is far from certain why this has occurred. Many press articles and “expert” reports concentrate on one explanation or another. But it’s a complex and thorny issue and there are quite a few arguments for either side. It is here that the bear-bull discussion gets more heated, with the “bears” generally using various arguments to assert that house prices are too high and will eventually (always next quarter) revert to some historical mean, whilst the bulls gather arguments that assert that it’s different this time and house prices are fair, and can continue to grow rapidly year on year forever with no risks and no consequences…

So why are houses so expensive? There are many theories, but generally they can be broken down into a few themes:

- Low interest rates
- Supply vs. demand
- Expanding money supply and the Global system
- Financial innovation
- Speculation and a psychology led market

Low Interest Rates

In the late 1990s it was very popular to ascribe the increase in house prices to a natural and sensible adjustment to low interest rates. Interest rates had dropped significantly since the early 1990s and the “common sense” position was that this justified the rise in house prices.

Unfortunately it is not that clear cut. The first confusion comes from a lack of general understanding regarding nominal vs. real interest rates. There is a fundamental difference. Nominal interest rates are those that are quoted by the press and generally known, whilst real interest rates account for inflation and are of real significance.

Looking at the graph of nominal interest rates below it can be seen that the house price booms of the 1970s and late 1980s actually occurred during times of high nominal interest rates. Futhermore there has never been a study that has found a link between nominal interest rates and any long-run determination in house prices.

Source: Andrew Farlow

Real interest rates take into account the inflation rate, and thus measure how the loan actually feels to repay. A 20% nominal rate with 50% inflation would feel very easy to pay after a few years, as your income would be freely growing by more than the debt costs you, but a 10% nominal rate at 0% inflation remains hard to pay, as your wages wouldn’t be increasing in the same way. In the first case the real interest rate is -30%, whilst in the second it is +10%.

If you look at the graph of real rates below you can see that real interest rates during the house price inflation of the late 1990s and early 2000s do not differ significantly from the preceding period, and are significantly higher the 1970s (a time of negative real interest rates - and when the concept of the housing ladder was born).

Source: Farlow

So throughout the 1990s real interest rates were similar and thus debt was no more affordable… But of course this is discussing the rational, real, cost of a mortgage over its entire lifetime. What lower nominal rates can do is increase the initial monthly affordability of the payments, and thus give the appearance of a cheaper mortgage. However, as outlined in part one, this is an illusion. All that really happens is that the payments for the mortgage are pushed further back into the lifetime of the loan, flattening the payment “pain” curve. Thus, whilst lower interest rates can be described as a facilitator for higher house prices, they are not a rational nor sensible driver, and we may be storing up problems for the future.

It also seems very unlikely that interest rates were the sole driver, as even nominal rates dropped long before the upturn in house prices, and prices continued to rise even though nominal interest rates rose by 35% in 2004, and again in 2006.

Source: BBC News

Supply vs. Demand

In recent years, as nominal rates have risen, it has become increasingly popular to ascribe the recent rocketing house prices to simple supply vs. demand.

Supply
The supply scenario was highlighted by the UK government’s 2004 Barker report, which detailed a chronic failure of UK housing supply. In the late 1960s over 400,000 houses were built each year in the UK. Whilst in 2002 only 183,000 houses were built, of which 138,000 were built in England. Yet household formation in England is expected to increase by between 155,000 and 179,000 per year, and ran at an estimated 196,000 households per year from 1990 – 2000. This is clearly a problem.

Source: Barker Report

The Barker report went on to stress that to achieve a real annual house price trend increase of 1.8% an additional 70,000 private sector houses are required each year. Alternatively, to reach the EU average of a 1.1% real price increase per year then an extra 120,000 houses are needed each year - nearly double current output…

Demand
The Barker report also notes that the average size of UK households has been falling for some time, and that this results in some of the demand pressure.

It's worth noting that much of the figures that the Barker report was based upon were from government statistics and the 2001 national census. Thus they miss what has recently been quoted as being another major potential drive in house price demand: immigration.

Migration Watch UK predict that 2 million people will arrive in the UK every 10 years for the foreseeable future, and that the average immigration rate between 1998 and 2004 was around 166,000 per year. Some higher estimates put eastern European migration at over 500,000 per year since a number of states, most notably Poland, joined the EU in 2004. This could obviously lead to increased demand, and due to the nature of immigration this demand is likely to be heavily regionalised, with many migrants settling in the south east of England.

Source: BBC News

However, whilst supply vs. demand is often quoted as a key an issue in the UK, and at face value the figures seem stark, the control that supply vs. demand has over the full magnitude of recent house price inflation remains contentious.

This is particularly true within economic academia. Whilst a limited supply is noted, many economic modellers are unable to match the predicted consequences of this under-supply with the rapid and significant price increases experienced in the late 1990s and early 2000s. Furthermore, the undersupply has been relatively constant, yet price increases vary in rate significantly. The economic modelling of Muellbaur and Murphy, a pair of academics from Oxford University, suggest that the supply shortage of today (~0.25% of total dwellings) should push up real house prices by just 0.5% per year. That’s clearly a big disconnect from what has really happened, although the model does make many assumptions, not least requiring perfectly rational and fully informed consumers. But if the model is in anyway close to correct then there must be other variables that matter too.

Many argue that changes in family size and the trend to smaller household formation is an additional factor for housing demand. But the key point is that it is just that - a trend. It has been happening since the 1960s and as such is a gradual feature that has long existed in the market. Gradual societal changes are not clear explanations for the recent significant and rapid gain in house prices. The only recent step-change event that has occurred recently is the expansion of the EU in 2004, and the significant immigration experienced by the UK in subsequent years. Yet prices have been rising rapidly since the mid 1990s, with the rate of increase actually lowering from 2004.

There is one final point that casts doubt on the simple supply-demand driver: house prices have been rising globally. From the US, to Australia, Belgium, France, New Zealand, South Africa, Ireland, to Spain and others. Nearly every major economy (and many developing ones) have experienced a huge inflation in the price of property.

Supply / demand is clearly an issue in the UK. However, the international nature of property inflation is demonstrably not just a local phenomenon that can be explained by the peculiar characteristics of a single country.

Expanding Money Supply and the Global System

Another more technical reason that has been proposed as a driver behind high house inflation is the expansion of money supply.

Money supply is simply a measure of all the money (hard cash, loan debt, and saving accounts for example) in an economy. The total money supply can be expanded or contracted by central banks, such as the Federal Reserve or the Bank of England. This control over money is in practice a combination of setting interest rates, banking reserve ratios, and the purchase or sale of government securities, which are basically just an interest charging IOU from the government.

In an expanding monetary system the purchase of government securities releases funds to private banks that can then be loaned on to customers through fractional reserve banking (where the banks only have to keep a small percentage of their liabilities in reserve). Thus money from the central bank effectively multiplies as it moves through the banking system. Similarly a decrease in the central bank interest rate can make it more attractive to borrow (and loan on) monies. Effectively, the central banks “print” money.

In classic economic theory, if the supply of money is expanded too quickly then it will cause inflation, as there is more money chasing the same amount of goods.

One theory is that the rapid house price increases of the late 1990s and 2000s are the consequence of a more rapidly expanding money supply, as central banks effectively printed money in an effort to prevent worldwide recession and deflation, and an increasingly globalised economy kept interest rates at historic lows.

In the late 1990s many policy makers and economic commentators were worried about the dramatic entrance of two billion Chinese and Indian workers into a rapidly globalising worldwide economy. As these combined with falling commodity prices, falling bond yields, and falling producer prices economists began to fear that this would cause serious deflation, a terrible outcome for western economies that were heavily dependent on debt, and that had witnessed the decline and fall of Japan’s once triumphant economy.

Source: The Economist

Source: The Economist

At the time of these worries the dot-com boom was in full growth and western economies were still growing. Indeed, the US Federal Reserve was actually raising rates. However on March the 10th 2000 the NASDAQ hit a high of 5,048 and the tech bubble burst, with the rapid fall continuing until 2003. As a result the major central banks worried about a major recession that would deliver the spectre of major deflation, so they rapidly eased monetary policy to encourage growth (and thus encourage inflation rather than deflation). This process was compounded by the 2001 terrorist attacks, when both the ECB and Fed dropped rates by ½ a percent. All in all, in an effort to prevent the imminent recession becoming a global collapse the Fed dropped interest rates eleven times by the end of the year, from 6.5% to just below 2%. The Federal Reserve, as central bank to the world’s reserve currency, led the way and other banks followed.

It is arguable that this process worked. The western economies did not experience a major recession. Inflation dropped to an historic low in the early years of this century and may have gone negative if it were not for these accomodative low rates and general continued growth.

However, the cure may have had significant implications for the housing market and the general balance of the economy.

The increased money supply was further facilitated by the rise of China and other developing economies on the international foreign markets. Globalisation meant that US and western consumers could buy cheaply manufactured goods from China, driving the feared of deflationary pressures. Determined to keep its economy growing China pegged its exchange rate at a low level against the dollar, stabilising its access to its most important export market. Increasing foreign trade and rapid growth then provided the Chinese government with a huge trade surplus and a flood of foreign exchange. China has consistently re-invested this primarily in US bonds, enabling the US Federal Reserve to keep interest rates lower than they would have otherwise done. The strong demand for government bonds means that China has basically been increasing their price and lowering their yield. The effects of this are two fold. One is that the purchase of the bonds at higher prices effectively adds to the money supply, and the second is that their decreased yield means that other investors are forced to chase higher returns elsewhere. Whilst this effect is American-centric, where the Federal Reserve and the dollar lead, the world follows.

The theory is that a rapidly increasing money supply flooded the market with cheap credit, enabling exuberant house purchasers and investors to “afford” ever higher prices. Additionally, those stung by the stock market busts at the turn of the century distrusted the markets, preferring to invest in bricks and mortar than pensions and funds. Furthermore, institutional investors chasing ever decreasing yields in traditional markets looked at other potential avenues of investment and revenue creation.

Thus a very loose monetary policy injected a huge amount of cash into the financial system. Traditionally this would have been associated with rising inflation, and yet consumer inflation has stayed low for years, even whilst oil trades at $60 a barrel!

Some of this low-inflation effect is due to fundamental changes in the global workplace. Today, western workers competing with international labour are less able to increase their wages. Additionally, the huge production capability of the developing world has kept the supply of consumables high, and modern measures of consumer inflation low. As a result, whilst western economies have grown, western workers have received gradually less and less of their countries GDP in wages (the difference going to the owners of capital) and their real wages have increased only slowly. As staff costs are a major driver in inflation this has helped keep inflation lower, for longer, than it might have done in the past.

But all that money still had to flow somewhere. As the money supply has not found its way into workers wage packets it has been primarily distributed by financial institutions. Their business is lending to home-buyers, and investing. Thus the flood of money has flowed in those directions, directly into the things that have inflated in price: housing, commodities, bonds...

All in all, this rebalanced the nature of the western economies such that they became dependent on consumer spending for growth. Borrowers were able to access cheap housing loans, house prices rose, and earlier owners felt richer and spent their paper wealth instead of saving, or even accessed the paper capital through mortgage equity withdrawal. As Eddie George, ex head of the Bank of England, put it – the UK spent its way out of a recession, driving growth with debt led consumerism, which is in turn ever dependent on house price increases.

However, the difficulty with assuming expanding money supply was the sole driver for house prices is that whilst the rate of house price increase did accelerate at this time, house prices had been rising in the UK since 1995. This rapid monetary easing cannot thus be held account for the entire boom, although it is likely to have been a major factor to its continuation, along with a closely related theme…


… Financial Innovation

Another suggested potential factor in driving the house price rises of recent years is financial innovation. The last 25 years of the 20th century saw a huge revolution in finance, as the intense competition in the world’s financial capitals led to a range of innovative products and the creation of complex financial instruments.

The earliest of these can probably be credited to Lewis Ranieri, a college dropout. His key creations were Mortgage Backed Securities and Collateralised Mortgage Obligations. Simply put, these are a financial process that, for instance, converts the future revenues owed to a mortgage company by a suite of home loans into interest earning bonds that can be sold on to investors anywhere in the world.

Banks in the late 1970s were struggling with sky high interest rates and finding it difficult to make money out of home loans just as demand from the baby boomer generation was surging. Their risk aversion meant that it could take months to get a mortgage approved. The newly packaged Mortgage Backed Securities spread risk and attracted investment, cutting the interest rate differential on mortgage loans (the difference between the lending bank and central rate) and making Salomon Brothers billions of dollars as MBS trading accelerated through the 1980s. The market grew grown rapidly. By 2000 the MBS market in the US over took the federal treasury market and by the first quarter of 2006 it was worth approximately $6.1 trillion.

This culture of rapid financial innovation continued throughout the 1990s, by which time J. P. Morgan and Merrill Lynch were marketing credit derivatives. The most common credit derivative is the credit default swap (CDS). A CDS is basically a financial vehicle that enables a bank or company to package up a stream of future revenues and further transfer the risk of the future revenues failing. For instance, a mortgage issuing company can package up a suite of mortgages into a Mortgage Backed Security and sell this to a second company. The second company can then manage its risk by issuing a further “interest” bearing credit derivative. This would earn the purchaser, a third company, an income, but at the risk of being forced to pay out to the issuer if the mortgage payers could no longer meet their obligations and the revenue stream of the Mortgage Backed Security failed.

This suite of complex financial products enables much wider trading and hedging of credit risk, facilitating companies to spread their risk according to their appetite – the mortgage issuers or MBS buyers can minimise their risks, whilst companies with an appetite for more risk can access a revenue stream. Additionally it allows the debts and derivatives to be recorded as assets on many companies books, and thus effectively removes institutional barriers to lending, as banks can draw on essentially unlimited funds to loan.

It is difficult to put a precise figure on how much this has affected the housing market. It is clear that this spread of risk had the effect of reducing the wariness of the mortgage issuing companies. The interest rate premium above the central bank rate lowered and application/vetting procedures eased. In general, whilst the market is very opaque and poorly understood, it can be safely said that the derivatives market markedly reduced the perception of risk across the entire industry. When combined with a loosening monetary policy and a pre-existing growth market it ensured that a flood of money entered the property industry chasing a piece of the action in the search for yield.

At the same time that financial innovation was removing barriers to money entering the housing market, regulatory change was providing a direction for the money to flow in the UK. In 1988 the UK’s Housing Act abolished security of tenure for tenants. In the late 1990s Buy to Let mortgages caught up with the legislation and became available to conventional borrowers (because of advanced risk management). Additionally, Mortgage Equity Withdrawal loans enabled those sitting on large paper wealth to access it. This enriched those already in property, and the money was either spent in the debt-led consumer boom, or it was invested, which leads to …

Source: Housepricecrash.com

Source: Housepricecrash.co.uk

… Speculation and Psychology
A final explanation for house price inflation is pure and simple speculation. Every expanding market has always attracted speculators and the housing market is no different. It has been suggested that the current market is strongly led by money pouring into it simply because it has grown so well over recent years. Participants don’t necessarily look at fundamentals, just that as the market continues to grow, or even accelerate, investors will pile in and prices will rise further and further. Some are investing in heavily geared Buy-to-Let properties, where the rental yield doesn’t cover the debt payments. Others simply leave the house empty, planning on selling at a later date. In the UK it is certainly clear that property market has become about more than just providing a roof over one’s head, and the percentage of Buy to Let investors has rocketed since the late 1990s. Commentators suggest that they have taken the role at the bottom of the market that used to be occupied by First Time Buyers, who now make up a much smaller percentage of the market than the historical norm.

The house price feeding frenzy has been further exacerbated by past rewards (an entire generation of owners have seen their wealth increase massively), and the resulting shift in press and television media attention. This has driven house prices to be regular front page news, and increases heralded as a boon for the economy. Furthermore, there is now an entire generation that has never experienced a major recession. Common sentiment is that house prices should be as high as they are, and that they are a good thing. Speculation and Psychology combine.

However, as with all of the suggested drivers behind the market, it is unlikely that speculation alone has driven the entire magnitude of house price inflation. It is likely simply a contributing factor.

Conclusion
All in all it can only be a fabrication to ascribe the significant house price rises of recent years to a single driving variable. Press reports, for the sake of readability, drastically over-simplify reality. There are likely to be many factors that are critical, and the relative influence of each is likely to have varied through time.

- House prices are at an all time REAL high, and the low inflation environment means that the real lifetime cost of the mortgage debt is also at a REAL high. Low interest rates do not have a fundamental affect on this, but low nominal rates do give the appearance of more affordable mortgages, encouraging consumers who have learnt only to measure cost only on an initial monthly basis.
- Supply and demand is clearly an issue in the UK, but doesn’t explain the global reach of house price inflation, nor its recent rapid and significant rise (immigration is a possible factor, but doesn’t tie well with the history)
- A loose monetary policy likely increased the money flowing into an already growing market, kicking off greater rises and triggering increased speculation.
- At the same time financial innovation reduced the financial industry’s traditional aversion to risk and enabled mortgage banks to meet the ever growing demand…

In a sense it's the perfect storm. But is it sustainable? What can we say about the future? And if nothing changes, what are the implications?