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segunda-feira, abril 21, 2008

Falling houses prices

Location: London
Author: Shahin Shojai
Date: Monday, April 21, 2008

Early in 2008, when the U.K. house prices had just started to experience some downward pressure a number of economists suggested that no one should be too worried about the situation since a fall in house prices should have little or no effect on the real economy. They claimed that, ceteris paribus, the losses experienced by the house owners will be offset by the gains made by those who wish to buy the now cheaper homes, many of whom are first time buyers wishing to get onto the property ladder.

But, of course, as I mentioned back then, “life rarely has a situation where ceteris paribus holds. In an environment where house prices have been used by many citizens to finance their life styles, a fall in that price would mean that they will spend less. For an economy that is highly reliant on consumer spending that could, without ceteris paribus, have significant implications and could cause those same people waiting to get on the property ladder to lose their jobs and not be able to afford the homes at all anymore.”

Well, a few months have now passed and it seems that despite some modest falls in prices, which now seem to have been much more severe than many had initially thought or were willing to acknowledge to the markets in fear of investors talking themselves into a recession, the situation is much worse for first time buyers than at anytime during the boom period.

This is exactly what anyone who looks at the macroeconomy would expect. In a situation where falling house prices could cause a fall in consumer spending, as was demonstrated in the U.S. and will certainly happen in the U.K., the risks to the overall economy can be severe and banking institutions will typically become less willing to lend. This is especially the case when in January of 2008 many had become aware of the fact that one of the major causes of the recent housing crisis in the U.S., and to a lesser degree in the U.K., was the significantly relaxed attitude that lenders had towards issuing mortgages to those who would under a normal due diligence process have significant difficulties in getting mortgages, and certainly at those rates and for those amounts.

Lenders were so sure that prices have only one way to go that in many cases they did not bother checking whether the person was actually making the kind of money they were claiming on their mortgage applications. They also lent such a huge proportion of the value of the property, sometimes in fact more than what the property was actually valued at the time of transaction, that any small correction in the market would have pushed the owners into the negative equity state.

Given that we had access to this information in January 2008, it is astonishing for some economists to have suggested that all that will happen is that the first time buyers will gain hugely from the situation and that their gains offsets the losses made by homeowners, so, ceteris paribus, there would be no impact on the economy.

Of course, first time buyers are benefiting from falling house prices but the problem is that they now need to be able to borrow to buy them, something that is becoming much harder. Despite a recent highly scientific study by the Daily Telegraph, borrowing for house purchases has become significantly more difficult. What the highly scientific study by Daily Telegraph forgot is that the issue is not that people might be able to borrow at not much worse an interest rate than a few months ago, but that they will no longer be able to borrow at the multiples that they used to.

They are now required to meet much more stringent requirements and they will get mortgages that when in a genuine relation to salaries will make it hard for someone who is earning 4 times the national average to buy anything larger than a studio flat in central London.

If it is proven that banks have been less than forthcoming about the actual rates they have been paying each other for borrowing in the inter-bank market, and as a consequence the LIBOR rate is in fact higher than the published rate, then the situation can only get worse. Banks might be forced to increase the rates they charge lenders, putting further pressure on an already fragile market.

During a recent discussion with a top economist, and a Nobel laureate, an interesting issue was raised, which was: didn’t most economists believe that house prices in the U.S. and the U.K. are too high by economic benchmarks and demanded that the monetary authorities used the tools at their disposal to help correct them? If so, why are so many of them now asking for the governments to cut rates by so much as to recreate the unsustainable bubble that they were complaining about last year? Well, it could be that they realized that economists who demand a correction are not necessarily immune from market slowdowns. That they will also be impacted by a falling property market.

Those who have seen the value of their homes fall are now working overtime to persuade monetary authorities that it is in the interest of the economy that rates should be cut in order to prevent a severe housing market correction, something that was just 12 months ago deemed necessary. Furthermore, if falling house prices are expected to not have any impact on the overall economy then why is everyone trying so hard to have rates cut in order to prevent a housing market collapse?

It seems that while on paper economists were demanding action from the monetary authorities to correct market prices on the belief that they were inflated and believed that the correction will have no impact on the broader economy, in reality they have realized that the world does not work under ceteris paribus rules. They have come to realize that a fall in house prices does not mean that everyone else keep their jobs, that borrowing rates would be as low as they were prior to the crash, or that people could continue to borrow on unrealistic terms. But, of course, we will go through this same cycle with economists every time we are in a similar situation.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai ( Shahin Shojai is the Editor of The Capco Institute journal (

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