Recession Problems

Economic View: Our best chance of staying out of recession may be to back the Treasury against the Bank

By Sean O'Grady
Sunday, 27 July 2008

Housing crashes are always worse than expected. A mood in which people believe that property prices only ever go up is usually a reliable leading indicator of a crash. The psychological factor in housing booms (and busts) is too little noticed, presumably because it is difficult to pin any kind of numbers on a zeitgeist. Still, it matters greatly.

An only mildly muted state of irrational exuberance was, roughly, where we stood at the start of this year. The consensus among observers – City economists, the CBI, the mortgage banks and the academics – was that property prices over the next 12 months would be "broadly flat".

The team at the Halifax, for example, put out a press release in the following confident terms: "The UK economy is in sound shape. Strong market fundamentals, a structural housing supply shortage and pent-up demand from a large number of potential first-time buyers will support house prices, preventing a sustained and significant fall." Even allowing for a vested interest, that was a truly brave face.

Well, as we journalists sometimes say of the stories that somehow don't quite come true, the Halifax may have been "right at the time". However, a few short months on, those "fundamentals" do not seem half as sound. The economy grew by a rather sluggish 0.2 per cent in the last quarter, after a similarly lacklustre 0.3 per cent in the first three months of 2008. A recession next year is perfectly feasible.

The biggest single contributor to the slowdown is the collapse in the construction industry, and in particular in private housing starts. Perversely, that may mean a bounce in prices a few years out, when we would have the odd confluence of an end to the credit crunch (one hopes) plus a drying-up in the supply of new homes, since Barratt, Persimmon and the others have almost frozen their building projects. But for now, the overhang of unsold properties and a glut of inner-city regeneration flats are going to stymie things. Values are falling catastrophically in some parts of the country. Add in the effects of consumers being able to borrow less on the shrinking equity in their homes, the "feel-poor" factor that will depress their spending further and the decline in demand for furniture, new carpets and household appliances, and you can easily see the property slump knocking 1 to 3 per cent off economic growth.

And we all know what is holding the real estate market back: the "pent-up demand" among first-time buyers that the Halifax identified at the beginning of the year is staying pent-up, thanks to the refusal of the Halifax, among others, to lend them any money. The credit crunch has ensured the disappearance of the 100 per cent mortgage. Buyers aren't even looking around, or bothering to try to take out a loan. They may well have judged, rightly, that the next move in house prices will be down, and decided they can afford to wait. (Here is that psychological effect in reverse – "house prices will never rise".)

The Royal Institution of Chartered Surveyors confirms this. New buyer enquiries – people popping into the estate agents to check out the scene – have collapsed. Transactions are down by a half, driven by the absence of those first-time buyers. The scale of the collapse in new mortgage approvals for house purchases is astonishing.

Economists are wary of extrapolating short-term trends, so we shouldn't get too hysterical. But after a two-thirds drop in a year in bank lending on prop- erty, as reported by the British Bankers' Association, it would not take long for new mortgage lending by the banks actually to cease, killed by a combination of low supply of funds and low demand from pessimistic buyers. Cash buyers, a few lucky souls, will be in an extraordinarily advantageous position when the market hits rock bottom.

What will rock bottom be? Anyone's guess. House prices have fallen about 8 per cent since their peak last year. Just as some of the earlier estimates were wildly optimistic, perhaps we should be careful about some of the more bearish forecasts now. Adding a little inflation on to nominal falls of 30 to 40 per cent leaves house prices in real terms perhaps 50 per cent off their 2007 peak, resulting in millions of households in significant negative equity – that's on the gloomiest outlook. Unlikely, but possible – and worrying.

Which is where Sir James Crosby comes in. Soon this former chief executive of HBOS will hand in his report to the Chancellor on strategies to revive the market for mortgage-backed securities, and, thus, help the banks raise the money to lend to homebuyers (at its peak, about 30 or 40 per cent of our new mortgages were funded in this way). By far the easiest way of doing this would be to extend the Bank of England's Special Liquidity Scheme.

So far, the Bank has swapped £50bn of older mortgage-backed securities, which no one else wants, for gilts, albeit at a penal rate of interest. New mortgages are not eligible. It has helped. Now, if the Bank were to offer a similar facility for new, high-quality mortgages, that might have a similarly beneficial effect. Then the mortgage market could return to normal, house prices stabilise and the economy escape recession. Ministers would be pleased, not least for the political dividend. The snag? The Governor, Mervyn King, doesn't seem keen on the notion. Stand by for another scrap between the Treasury and the Bank. The stakes couldn't be higher.