I’ve been following house prices on and off for a couple of years now. I’m very much looking forward to not renting anymore once the rest of my circumstances fall into place. When I first started work 2 years ago, many people were saying that I should get on the ladder as soon as possible because the bottom rung would only get further away the longer I waited. That was true for a little while but I had a feeling that house prices had been going up at such a rate for such a sustained period that something would have to change eventually.

One of the metrics that I think is particularly interesting and that you don’t see very often in the news is the ratio of average house price to average (annual) earnings, which both Nationwide and Halifax produce along with their other house price indexes. Here then are two plots of this metric that show where we’ve been and possibly suggest where we’re going…

Nationwide first time buyer house price to earnings ratio

Halifax all houses price to earnings ratio

Looking at these plots, clearly where we have just been with the average house costing around 6 times the average earnings is an above average value for the ratio compared to the last 25 years. Therefore the questions that I’m asking are how low will it go this time around?

As an interesting final thought, even at the top of the peak when you could get a mortgage of 5 times your annual salary, the FSA’s advice was that single people should borrow up to 3 times salary and couples 2.5 times combined salary.

Here’s an interesting one…

What day of the year do you think we used up all the natural resources the Earth will produce this year?

According to the Global Footprint Network it was 23rd September this year and is (unsurprisingly) getting earlier every year. To put it another way, since 23rd September we have been living beyond our ecological means.

Now living beyond our financial means is something that many in the West have gotten quite used to. Even our governments do it. We see talentless “celebrities” living lavish lifestyles in the tabloids and think that we deserve that lifestyle too. Unfortunately, many who’ve fallen into this trap don’t have the celebrity income to pay for it. I watched In Debt We Trust (you can watch it here) last week. It highlighted to me again that we have developed this sense of entitlement in western culture – “the people on TV have fancy cars and the latest fashions so I deserve to have those things too”. However, just because you can’t afford doesn’t mean you shouldn’t have it, just put it on credit.

In recent months, we’ve started to see the fruits of our behaviour. The credit has dried up and people and businesses are feeling the force of a mess that has been repeatedly covered up by borrowing more (or by Gordon Brown manufacturing growth by redefining it).

How long before we have a similar ecological crunch?

Here’s a final thought – we now need 1.4 Earths per year for our existence to be ecologically sustainable. Until that number goes down to one, we are stealing from our children.

The economic collapse was not entirely unexpected (by a guy called Peter Schiff at least)…

Here he explains to a conference of mortgage brokers (note this is in 2006, before it all came to pass) how giving mortgages to people who can’t afford to pay them back will only work as long as house prices go up.

As he says, lending to people who can’t afford to pay it back does actually work if house prices go up because if people default, the bank gets the house and by then it’s probably worth more than the amount they originally loaned so they’ve made a profit on their original investment (any deposit plus the interest on mortgage repayments thus far plus the increase in value of the house). Easy returns for the mortgage lender – if the borrowers keep paying back the loan, they make money on the interest and if the borrowers default, they still make money as long as the value of the house has gone up.

Unfortunately nobody seemed to notice that this set up a positive feedback in the market:

• House prices go up
• People see that house prices are going up
• Houses look like a good investment so demand increases from two camps – speculators looking for quick returns on buying 2nd, 3rd, 4th, etc houses and first-time buyers who couldn’t previously afford a home but will overstretch to get on the ladder before the first rung moves even further away. Overstretching is ok because once the value of your house goes up you can effectively pay off some of the mortgage with that increase – any increase in the value of the house goes in your pot, not the mortgage lender’s (I’m gonna call this “positive equity” since it’s the opposite situation to “negative equity“, although I suppose it’s actually just “equity”).
• If demand for houses goes up and supply doesn’t increase, the price goes up
• Loop!

As long as the housing market as a whole goes up, the subprime mortgages are profitable for the lenders whether the borrowers default or not. Originally the market was going up for other reasons (second homes, buy-to-letters, etc) but then the lenders spotted this opportunity to make some extra money out of otherwise inaccessible customers who could hang on the coat-tails of the ever-rising market.

This only works when the market is going up.

With the price of houses going down the opposite situation occurs, a lender will lose money on a defaulted mortgage (they repossess the house but can’t sell it for enough money to recover their original loan) so they reduce their risk by increasing interest rates and suddenly a lot of people find themselves with increased repayments and an outstanding mortgage that they couldn’t pay back even if they sold the house. As more people default on their mortgages, more houses come onto the market – supply increases. Everyone sees that the market is falling – not a good time to buy a house now – demand decreases. The people that can afford to (the multiple home owners / buy-to-letters) jump ship and take the hit but this floods the market even further with houses that nobody wants to buy. Supply increases further, demand decreases further, prices go down further.

How far down remains to be seen.

As the US government cave in and bail out AIG, those hoping the financial world would be fully re-introduced to the concept of moral hazard may be disappointed. Today, HBOS is next up on the chopping block as the market worries about their significant exposure to the failing housing market. The general consensus is that HBOS is too large for the government to allow it to fall but possibly too expensive for the government to save. It looks like LloydsTSB may be the government’s knight in shining armour, riding in to rescue HBOS-in-distress and returning the “Big Five” banks to four (or a “Big Three” and “Giant One”).

It seems as though the governments have had no choice but to bail out these failing banks (or offer favourable conditions to other banks coming to the resuce). The livelihoods of too many voters were tied up in the big financial messes that they had made for themselves. In fact, some traders have been taking advantage of the guarantees that HBOS wouldn’t go under to make money as the share price fell.

It looks to me like the City have been pretty succesfully pocketed all the profits from the risks they’ve been taking over the last few years but now it’s all starting to tumble and their gambles aren’t paying out, they want the government (and so the taxpayer) to pay out instead.

It’s like they’ve persuaded the owner of the casino to pay out when they win but foot the bill when they lose.