UK House Prices Are Overdue A Correction

I constantly under-estimate the power of this Labour government to rig the markets and the economy – always at enormous cost to the tax-payer.

This extract from Money Week sets out how they have rigged the UK property market to cushion the impact of the latest recession. But time is now running out.

The nightmare for our country is the scenario that Gordon Brown has done enough to convince the financially illiterate that the current economic crisis had nothing to do with Labour and Labour is the best option going forward. This would be the ultimate con and Britain could very well descend into a Zimbabwe type melt-down were Labour to continue their current policy of denial.

What caused the house price surge?

Remember the subprime crisis? A quick recap. Banks used to make home loans using the money that savers deposited with them. The savers got one rate of interest, the borrowers paid a higher rate, the banks made a profit in the middle, and everyone was happy.

Then banks realised they could parcel up the loans and sell them to other people. So rather than having to attract savers, they wrapped up home loans and sold them to investors. Demand for these packages (home loan-backed securities, or MBS) was so high that banks couldn’t write loans fast enough.

Hence borrowing costs and standards plunged, house prices surged, lots of people got home loans who shouldn’t have, and it all went pear-shaped when some particularly dodgy debtors in the US started defaulting before they’d even made a single payment.

Fine, we all know the story. But what happened next? The securitisation market dried up completely. Demand for MBS shut down everywhere. That was a problem for British lenders. Because between 1999 and 2007, according to the CML, new lending for house purchases outstripped retail deposits by £180bn. In other words, that £180bn didn’t come from savers, it came from investors.

So when investor demand for MBS vanished, lenders were left in a fix. They didn’t have anything like the amount of money they needed in order to write the sorts of quantities of home loans they’d been writing before.

So the government stepped in. Two schemes were introduced to prop up lending for home loans, and by extension, the housing market and house prices. One was the Special Liquidity Scheme. This effectively allowed banks to swap MBS with the Bank of England for gilts, then swap the gilts for cash at very cheap rates. A full £178bn has been borrowed by the banks in this way.

The other scheme is a Credit Guarantee Scheme whereby the Treasury has guaranteed banks’ fund-raising. £134bn has come through this route. As Robert Peston points out on his blog on the BBC website, “that is £314bn of credit provided to lenders by us, the taxpayers.”

Why house prices will fall again

Trouble is, the bill is coming due. The £178bn has to be paid back by the end of 2012. Meanwhile, most of the debt guarantees also expire in 2012, or by the latest, 2014. As Peston says, 2012 might seem far off at the moment. But not if you’re writing 25-year home loans. If you know that you’re going to have to repay all that debt in a couple of years’ time, you’re not going to be keen to keep writing new loans.

If the banks had to raise that kind of money privately to repay the loans to the government, then they’d be competing for capital with lots of other institutions and companies. What happens when demand for something (investors’ money) goes up while the supply remains the same? You guessed it – it gets more expensive. So the banks will have to pay more than they currently are to get their hands on that money.

Lloyds Banking Group recently raised £4bn via an issue of MBS, reports Norma Cohen in the FT. The bank had to pay more than 1.85 percentage points above 3-month Libor (one of the key rates at which banks lend to one another) to get private investors to buy the stuff. What happens when all the banks try to do the same, particularly when the MBS market is still very fragile?

And of course, if the cost of funding for the banks goes up, then the cost goes up for consumers too. So you’ll have to pay more for your home loan (not to mention personal loans and small business loans). And as the price of credit goes up, prices of houses will fall again.

The trouble is, the banks can’t really afford for that to happen either. They’ve only just got to a stage where they can pretend that their loans aren’t massively underwater, because prices have ostensibly rebounded so sharply.

So the CML is clearly hoping for some sort of extension to the lending schemes. “We are not suggesting that government pour vodka in the punch bowl. We are asking how government can get the patient to sober up without too much shock therapy,” said the lobby group’s Rob Thomas.

The last thing Britain can afford right now is more debt

But can the Government afford to extend the schemes? This is where Greece comes back into the picture. Investors are starting to look at us, then look at Greece, and wonder where exactly the difference lies, beyond the climate. Both countries have hugely over-extended public sectors. And at least Greece is talking about cutbacks. In Britain, neither party is willing to talk tough before the election.

Sterling tanked against the dollar yesterday while gilt yields rose. It’s as if investors had suddenly thought: “Wait a minute. Greece is implicitly backed by Germany. Who’s propping up Britain?”

In short, the last thing Britain can afford right now is the spectre of even more debt being piled onto the books. As US economist Simon Johnson, formerly of the International Monetary Fund, put it: “Unless you [Britain] can persuade the markets you’re really going to bring the budget under control in the foreseeable future, you’re going to have big trouble.”

The time for open-ended bail-outs is passed. Governments can’t afford to take on any more dodgy debt from the private sector. That almost certainly means that the price of credit is going to go up. And the price of everything else will go down.So those are UK House Prices overdue a correction.

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