WHAT’S GOING ON WITH THE HOUSING MARKET?

An interest rate inflated economic bubble that is about to burst

As fears continue in the media of a house price crash and possible recession, Raphie de Santos looks at the economics behind the current crisis of capitalism.

Brief history of economic bubbles

The latest news of the first monthly decline in the average selling price of a UK house indicates that the bursting of one of the great economic bubbles of modern times is well underway. We will show that the UK housing bubble is much larger than in the US because the low interest rate policies of the early part of the new century have been compounded in the UK by two other factors. The graph shows that the average UK house price has increased 4.5 times since the start of 1987 this is compared to about a peak of 3.5 times in the US. We are therefore, likely to see a much larger fall in house prices in the UK than in the US where house prices have already fallen 11 per cent from their peak. In the UK we expect to see a fall in house prices of between 20 per cent and 40 per cent from the peak, meaning that the average peak house price of £184,000 would fall to approximately between £147,000 and £110,000. This will have serious consequences for the economy and individuals which we will discuss later in the article. We will also, show that despite what Brown is saying the main reason for the housing bubble in the UK is the Bank of England’s policy of dramatically cutting interest rates to avert a recession and revive the stock market at turn of the last century.
Economic bubbles are nothing new of course and have been around for several centuries. The first was the tulip bubble in the Netherlands in the 17th century which saw the whole Dutch population taking part in a speculative frenzy based on borrowed money which resulted when it burst in many individual bankruptcies and the Dutch economy slipping into what we would now call an economic depression.
Bubbles are characterised by a frenzied greed where all rational decision making and valuation is thrown out of the window. Investors bury their heads in the sand refusing to face the real value of the assets they are buying, the fact that buyers will eventually run out and that external factors beyond their control which will affect the value of the asset itself or the economic condition of the investors.

20th Century Bubbles
In the 20th century there have been three great economic bubbles. The first two started in the stock market ñ the 1987 crash and the Japanese equity crash of 1989. The former had no effect on the general economy while the latter took the Japanese economy into a recession and stagnation that it has not really emerged from some 19 years later!

The Wall Street Crash
The final one is the one that most resembles what is happening today with the US and UK housing markets. That is of course the famous Wall Street crash of 1929. This started around a recovery in the US economy in the early 1920s and individuals started to buy the shares of US companies. They borrowed heavily from banks to do this and they were highly leveraged. The banks took as security against these loans the actual shares that were being bought. A speculative frenzy drove the price of US shares to way above what their real economic prospects indicated. A correction on Wall Street started panic selling as investors tried to sell their shares to repay their loans. This drove the stock market down by 89 per cent over a period of 3 years and it took until 1954 for the market to recover to its pre-crash level. Banks across the US went bankrupt as they could not recover the loans and the price of the shares they held as security had fallen in value radically. This slowed the whole economy to a halt as both individuals and banks went bankrupt and the economy slipped into the great depression of the 1920s/30s which spread throughout the world.
The 1929 crash had started in the performance of the US economy and transferred itself into the stock market then into the banks to individuals and back into the economy.

The Great UK Housing Bubble
The great 1980s UK housing bubble, which is now deflating rapidly, started with problems in the economy in 1970/80s and was inflated by:

¦ government policy around selling council houses
¦ a disastrous entry into the European Exchange Rate Mechanism
¦ central bankers cutting interest rates to avoid a deep recession at the turn of the millennium
The last major economic slumps in 1974/75 and 1979/80 saw a mass over production of goods and services with factories and warehouses stockpiled with unsold goods.
Capitalist governments sought to stop a repeat of such a crisis of over production. One way was to find alternative homes for investments; the other was to increase consumer demand for goods. The US and the UK in particular did this by privatising state industries for excess capital to flow into and by creating a climate and appetite for credit amongst the working and middle classes of the advanced capitalist countries. One way this was carried out in the UK was to sell off social housing.
This allowed spare capital to be invested in a growing private housing market and created a shortage of social housing meaning that ordinary people were forced to look at buying rather renting a council home.
The second effect was to create a feeling of wealth through home ownership which encouraged people to borrow money through credit - loans and credit cards. Thus these factors started at the beginning of the 1980s the great UK housing bubble.
A second factor which was also absent in the US was the UK’s entry in the European Exchange rate mechanism. However, because of the weakness of the UK economy and hence Sterling, the UK was forced to keep interest rates high to attract investors into Sterling assets and keep it within the bands of the exchange rate mechanism. This was not sustainable and on Black Wednesday in September of 1992, the Tory chancellor on the same day put interest rates up from 12 to 15 percent and then announced Britain was withdrawing from the ERM and slashed them to 12 percent again. This allowed the UK to cut interest rates dramatically and bring the country out of recession but at the same time create a boom in the housing industry and a growth in credit.
The final stimulus to the UK Housing market came at the turn of the millennium when the US had slipped into recession and their Dot.com shares bubble burst. The US central bank, the Federal Reserve, cut interest rates aggressively and Chancellor Brown followed suit. This fuelled a massive boom in credit and house prises with all types of liberal lending practices developing – buy to let, no deposit mortgages, loans a multiple of three times ones income, re-mortgages, loans secured on equity in homes and low fixed rate mortgages. These are the UK sub-prime loans. It is this final leg of the UK housing bubble which has just come to an end.

The Fed and Bank of England Inflates the Housing Bubble

The US central bank, the Federal Reserve, cut interest rates aggressively, during 2000/2001 to dampen the domestic recession and lift the stock markets after the dot.com shares bubble burst. They cut interest rates to as low as 1.0 per cent -in the UK they were cut to a low of 3.5 per cent. This created the conditions for a credit boom and in particular a house lending boom which because of the low level of interest rates was aimed at low income families or even families on social security. They could be charged a much higher rate than the market interest rate to compensate for the increased risk of these borrowers defaulting on their loans.
Mortgage brokers sought out these loans and then laid them off onto investment and commercial banks who repacked them as complex securities called collateralised debt obligations (CDOs). These were then sold on to hedge funds (highly speculative leveraged non-regulated investment vehicles), pension funds, insurance companies and banks all over the world reaching every corner of the global financial system. The model that is used to value these products was flawed and based on a very low default rate by the sub-prime borrowers in the US and a very low estimation of the close relationship between these borrowers.
When the Federal Reserve staring putting up interest rates to cool the credit boom and curb creeping inflation the default rate amongst the sub-prime borrowers picked up dramatically and the closeness of the relationship between these borrowers turned out to be much greater than at first estimated. This caused the value of these CDOs to fall rapidly leading to loses throughout the global financial system. Loses so far are estimated at $US300billion to $US500billion with the International Monetary Fund believing that the final loses could be nearer $US1trillion (1,000,000,000,000).

The Chickens Come Home To Roost

In August 2007 this caused the money market to dry up as nobody would lend to each other as lenders did not know what risk the borrowers were carrying. This is an unsecured lending market and the interest rates quoted are based on the borrowers and lenders having the highest credit rating called Triple A. There are now only two major banks which still are rated at Triple A and one of those is on a negative watch - that is it could be downgraded. This meant those lending money put a premium on the rates they would lend at to other financial institutions depending on their view of how risky was the borrowers business.
No matter how low central banks cut interest rates - where they would lend to the Triple AAA rated banks - it made no difference to the rate where these banks would lend on in an unsecured manner to other financial institutions.
This is the so-called credit crunch and it is filtering through to every level of society right across the world.
The credit crunch is what is causing the deflation in the UK mortgage market as all the exotic cheap deals end, lenders put up the rate that people borrow at to buy a house and also will only lend to the most secure borrowers because they themselves can now access a much smaller pool of money.
Therefore, the demand for property will fall sharply with fewer buyers seeking to purchase house. It’s a simple economic law of over supply and under demand which leads to a decrease in the price of an asset. This decline will go on for some time as it will take one to three further years to unravel the global sub-prime lending products and losses.

Recession on its Way
The consequence for the UK economy is severe in that there will be a big drop off in consumer demand as credit dries up rapidly - we are already seeing this from consumer confidence surveys -and the UK economy is almost certain to go into a recession some time at the end of 2008 or the beginning of 2009. The other economy apart from the US and UK which has large housing market is Spain and it is already experiencing house price declines. There are also property hot spots in the emerging economies of China, India, Brazil and Hong Kong which will follow the same fate as the US and UK housing markets. It is too difficult to estimate if we are going to enter a full blown global slump of 1930s or 1974/75 proportions but the odds of it happening are shortening all the time.

Alternatives to the Crisis

Socialists have an answerer to the crisis:

■ We would provide sustainable and affordable social housing for rent. The £110 billion that the UK government spent on saving Northern Rock would alone pay for 2 million of such houses!

■ We would take under common ownership all banks that were in trouble and turn their mortgages into cheap social loans.

■ We would pass legislation to stop repossessions happening and turn the property involved in the loan into socially rented housing.

The UK deflating housing bubble is just but one manifestation of an interconnected global financial and economical crisis. Socialists will have plenty of opportunities in the coming months and years to show there is rational and humane alternative to capitalisms terminal death agony.