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The news that the Financial Services Authority is considering new mortgage rules that would cap loans at three times the borrower's salary (see here for more) has really spooked the property pundits this week.
As we've already noted, this is yet another after-the-horse-has-bolted policy. Most lenders already have similar stipulations in place.
But it brings to mind that wonderful law, The Law Of Unintended Consequences.
If ever there was legislation conceived to bring about a capitulation in house prices, it's this. Elsewhere, the government says it's acting to shore up the housing market – and when interest rates get lowered to near zero percent you have to believe them.
But the impact of this legislation will be to bring back house prices to just above three times earnings – and that's pretty much where house prices should be, judging by the long run average.
However, to get there, we have to fall an awful lot further...
Why house prices need to fall...
As we all know, the boom in house prices in the past decade or so was down to easy credit. By 2007, things were so out of hand that couples could borrow seven times their joint income, while Northern Rock offered the 125% mortgage. The credit available sent house prices out of all proportion to what people earn.
Activity in the housing market has stagnated because sellers are still trying to achieve prices somewhere near 2007 levels. There are also comparatively few forced sellers as artificially low interest rates have kept down monthly repayments.
Meanwhile buyers are reluctant to pay 2007 prices, or they cannot because they simply cannot borrow the money. So there is a standoff. This stand-off will remain until houses are affordable again.
The best cure is for sellers to lower their prices to a level that buyers are willing and able to pay. In other words, only significantly lower prices will bring activity back to the market.
But here's the thing: while the average house price in the UK is about £150,000, the average wage is only about £25,000. Three times that is £75,000, plus deposit. So roughly speaking, a return to three times earnings means a 50% drop from here.
...but will they really drop that much?
Will prices really fall that far? Let's have a look.
I'd like to thank Scott Adams for sending me this chart. It shows the proportional rise in wages (blue line – data from National Statistics) and house prices (red line – data from Nationwide) since 1971, if you index each to £100 in 1971. As you can see one has become way out of kilter with the other – house prices have risen way faster than average wages. Either wages have to rise from here – only possible with a massive boom or hyperinflation, neither of which looks imminent – or house prices have to fall further.
The chart was put together at the peak of the boom, so that pink line is already on its way back down to its home by the blue. In fact notice that after the 1989-94 correction, the pink line actually went below the blue. In other words, the correction overshot to the downside as house prices fell and wages continued to grow.
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Here are some interesting statistics to consider, based on 2007 prices. The average salary multiple over the last 37 years (1971 to 2007) is 4.54. At the 2007 average wage of £24,000, that gives an average house price of £109,000 – a fall of 40% from the peak. But if you exclude the bubble years (from 2001 to 2007), you get a 4.17 average salary multiple – which would give an average house price of £100,091, a fall of 45% from the peak.
Of course, if you then start to restrict the multiples that people can borrow, and the deposits they have to put down, the average falls even further. For example, a 3.5 times salary multiple with a 10% deposit gives you a £93,333 average house price (a 49% drop).
And of course, this isn't considering what would happen if house prices return to three or four times the average wage, but the average wage falls, as is quite possible if we do end up in deflation.
Perhaps this is just what we need?
Perhaps understandably, property experts have rushed to condemn the FSA's move. Melanie Bien from Savills said, "If you insist on putting a limit of three times salary … Prices will have to come down even further for first time buyers to afford a property." Meanwhile Trevor Kent, a former president of the National Association of Estate Agents, described the move as "suicidal".
They're both right. But maybe suicide is what we need. The faster we get back to normal, the better it is for everyone. We all know where we are going. There's no point dragging it out Japan-style for 20 lost years.
Until they do, we will have stagnation. The good news is that the FSA's new rules might just help to speed up that process by forcing house sellers to accept reality.
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Dominic Frisby
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