Taming the UK’s housing market – part two. Will the lending rules come to the rescue?

7th May 2014

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UK house prices are rising strongly again despite very weak growth in earnings. But while the market is indicative of a recovering economy, questions are being asked over its sustainability. In a special two-part report, Schroders European economist Azad Zangana, looks at how the beast that is the UK housing market, can be tamed…here’s part two

MORE: Read part one of Zangana’s commentary here

Will it all end in tears…again?

The sustainability of the latest boom in the housing market is closely being examined not only by economists, but also the general public who are rightly concerned about the risk of yet another boom and bust cycle.

Judging whether the market is now in a bubble is difficult. We must consider the demand and supply dynamics, both cyclical and structural. We have already discussed how the chronic undersupply of property has been a key factor in recent years. The public tends to focus on prices being very high relative to incomes; after all, regular wages are almost 8% lower in real terms (CPI) compared to their peak at the start of 2008, while house prices are recovering at a brisk pace.

Comparing average house prices to average earnings is a favoured measure of affordability. At the peak of the market in the middle of 2007, the UK house price-to-earnings ratio hit 5.86, well above the long-run average of 4.1. As the financial crisis unfolded, house-price falls outpaced the fall in average earnings pushing the ratio down and almost returning it to its long-run average. Since then, the pickup in prices puts the house price-to-earnings ratio at 4.8, suggesting prices are too high once again. By our calculation, prices would need to fall by 15% in order to re-align with average earnings. However, the strength of the housing market suggests high prices compared to earnings are not a serious barrier for further gains. This is largely because mortgage affordability is extremely good at present thanks to ultra-loose monetary policy set by the Bank of England.

Looking at the UK overall, we find that the current average mortgage repayment is just 27.6% of average household disposable incomes. This is significantly lower than the long-run average of 35.9%, and the peak of 47.7% in the third quarter of 2007, when the Bank of England’s policy interest rate was at its peak. Low interest rates have helped borrowers afford bigger loans, therefore putting pressure on prices to rise.

At some stage the Bank of England will raise interest rates from their record low level of 0.5%. We should then see mortgage payments rise as a share of disposable income, which will eventually reduce demand in the market. The danger is whether new buyers will still be able to afford their mortgages as interest rates rise, or whether we start seeing the number of delinquent mortgages pick up.

In London, the story is similar, but more advanced in the cycle. Prices in the capital are currently 6.36 times average earnings; close to the previous peak of 6.41 times in the third quarter of 2007 – and well above their average of 6.18 times. However, just as with the UK average, mortgage affordability is by historical standards good. Average mortgage payments in London are currently 39.1% of disposable income; well below the long-run average of 47.4%, and also below the previous peak of 55.8%.

Caution required

Monetary policy remains ultra-loose, while the government continues to stimulate the housing market through loan/capital guarantees. Before the market becomes dangerously overheated, it may soon be time to take precautionary action. The obvious action would be for the government to halt its stimulus measures, or for the Bank to raise interest rates. However, there is little chance of the former given the general election next year, while the Bank is still concerned by the fragility of the economy, along with their estimates of the amount of deflationary spare capacity in the economy.

A more likely course of action is likely to come from the Financial Conduct Authority (FCA) in partnership with the Bank of England’s Prudential Regulation Authority (PRA). At the time of writing, the FCA has introduced new tougher mortgage lending rules to “…put common sense at the heart of the mortgage market and prevent borrowers ending up with a mortgage they cannot afford.” The Mortgage Market Review essentially attempts to reduce ‘execution only’ mortgages, which have been the norm for most borrowers. Lenders are now obliged to give advice on the suitability of a mortgage product, both in terms of meeting the needs of the borrower and the affordability of the product at present and in the future. Of course, lenders cannot predict interest rates (economist have a hard enough time), but they will now use sensible illustrative scenarios to test affordability. If a new applicant for example can easily afford mortgage payments today, but cannot afford them when they are set using 3% higher interest rates (market expectations in 5-years time), then that applicant will have to make alternative arrangements.

Not only are lenders directly responsible for checking suitability, but they are now also responsible for checking suitability even if the product is arranged through an agent (for example, an independent financial advisor). In addition, the new rules also ban ‘self-certified’ mortgages, where borrowers who were typically self-employed, did not have to prove their incomes.

We expect some disruption to the market in the short-term, but we believe that the introduction of these rules make a lot of sense. Lenders should be more careful in whom they lend to, and hopefully these rules will not only raise standards across the industry, but also the knowledge of consumers. Incidentally, we expect the compulsory provision of ‘advice’ to borrowers to open up lenders to scrutiny from the Financial Ombudsman Service should accusations of mis-selling arise.

The Mortgage Market Review is the first step in the use of macro-prudential policy. Eventually, we could see limits to loan-to-value (LTV) ratios, introduction to limits to loan-to-income multiples, and possibly even more micro measures such as time limits on mortgages etc. The Bank of England’s Financial Policy Committee (FPC) announced last month that it expects to be ready in June to set the interest rates that should be used for the affordability tests in the MMR.

Before we become too concerned by the standards of lending, it is worth highlighting the latest data on the types of mortgages being issued. The first point to make is that the return of first time buyers to the market is a welcomed development. First time buyers now make up just over 20% of the market – over twice the proportion in 2008. Meanwhile, more risky mortgages such as those with LTVs of over 90%; those with LTVs of over 90% and high income multiples; those for borrowers with impaired credit; and those where the borrower is increasing the size of their loan all fell considerably since the financial crisis, and have not returned in a meaningful way (chart 12).

The absence of the previous risky lending is good news and suggests there is less urgency for immediate policy tightening. Good affordability and a severe lack of supply in some areas are driving prices higher. Affordability will eventually deteriorate, which will put pressure on the government to provide more help. However, the only real policy that has any chance of working in the long-term is the provision of additional supply. As discussed earlier, construction of new homes needs to double just to stabilise supply relative to population growth. However, the private sector has historically never been able to produce the number of homes that are now required, regardless of market conditions.

The government must consider entering the construction market, and if necessary, to compete with home developers that continue to horde land. If they fail to do so and house prices continue to rise aggressively, the UK could find that the average household will no longer be able to get on to the housing ladder, which will ultimately raise demand for social housing, and therefore costs for the exchequer in the long-run. It’s time to build again.

2 thoughts on “Taming the UK’s housing market – part two. Will the lending rules come to the rescue?”

  1. Noo 2 Economics says:

    “However, the only real policy that has any chance of working in the long-term is the provision of additional supply”

    Of course there is the policy of population control – not immigration control but population control…….

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