Friday, July 04, 2008

Ba Da Bing

(not Charlton related)

Uh oh. Bradford & Bingley were on the brink of collapse last night. It turns out the rhetorical question I asked about the UK's buy-to-let cheerleader back in September wasn't so rhetorical after all. Make no mistake, this is another government-engineered bailout by another name. We'd better hope it sticks.

The UK economy is an utter mess. The relentless tide of bad news from banking to retail to housebuilders, is vindicating my long-held view that ten years of a supposed Labour-led economic miracle was nothing more than a sham.

The near-term will be extremely painful unfortunately for those with unserviceable debts, but the post-bubble shake-out is a required step if the UK is to have any hope of remaining a relatively rich nation long-term in the face of extraordinary developing country growth. The rapid and equally painful rise in food and oil prices meanwhile is not an unlucky coincidence, but an inevitable and related consequence of the same 'unstable equilbrium' that existed before.

In short, global interest rates were kept improperly low because those developing nations from whom the likes of the UK and US were buying deficit-inducing goods and commodities, were happy to continue to generate their own growth from external rather than internal domestic growth. Their exchange rates were artificially held down, and the required recycling back of our foreign currency was manna from heaven for Wall Street and the City of London.

However thanks to this apparently virtuous cycle, the developing nations (notably China, India, Brazil etc..) began to grow their own economies at far higher rates than previously thought achievable, driving up their own demand for the exact same supply-constrained commodities that we were so happy to become indebted to consume in the first place. Throw a few political mistakes (eg. biofuels) and geopolitical fears (eg. Israel/Iran) into the mix, and hey presto, you get $145 crude oil and a global inflation problem, concurrent with an enormous debt deleveraging.

'Build it and they shall come' could easily have been the slogan of the West's highly-paid financial geniuses, as they provided their eager yield-hungry customers with a tide of absurd credit-oriented products that sported ever dodgier collateral (subprime mortgages, LBO loans etc..), and even more ridiculous names (CDOs, SIVs etc..). Those that weren't geniuses after all (eg. UBS, Citigroup) ended up stuck with their own self-made mess on their own balance sheets when the music suddenly stopped.

And then one day (around about 26 Feb 2007 incidentally), the world began to realise, beginning with those backed by US subprime mortgages, that the products were utter garbage. All of the bank failures, recapitalisations, forced mergers, and write-downs that together comprise the so-called 'Credit Crunch', can be seen as an inevitable chain of events in light of the above. It may be termed the 'Great Unwind'.

And thus every day, it becomes increasingly apparent that the so-called 'NICE' decade in the UK ('non-inflationary, constantly expansionary') was infact a fraud, with growth mistaken for leverage, and permanence mistaken for merely fleeting.

Where, when all is said and done, are the great new British companies and innovators which were supposed to have driven this economic miracle? When all the French and American investment bankers have returned home, and their City employers have completed their downsizing, what will we have to show for it? If it's any consolation, the same question will be asked even more desperately in Spain and Ireland, economic basket cases if ever I saw one.

Unfortunately for some, but fortunately for most, an economy built essentially upon selling overpriced homes to one another is unlikely to feature very highly in this new world. From a personal perspective, at least I can now safely attend dinner parties and declare "as it happens I rent", without wondering whether "as it happens I'm a racist" might not have generated less social opprobrium.

The media is as ever obsessed with house prices (as I am incidentally, ableit from an opposing viewpoint). Interestingly, when house prices fall, it brings 'gloom' yet when oil prices fall, it brings 'relief'.....go figure as they say over here. Yet as Warren Buffett is fond of explaining with regard to his love of hamburgers, "...if you plan to eat hamburgers throughout your life, and you are not a cattle producer, should you wish for higher or lower prices for beef?"

Likewise, if you want to 'buy more house' throughout your life (as all but the soon-to-retire surely do), but you aren't an estate agent or housebuilder, why exactly are falling house prices such a doom-laden prospect? Nothing to do with the completely inappropriate levels of debt attached to them requiring ever rising prices in order to service, dare I suggest? Sounds an awful lot like the subprime problem to me, not that the UK has one of course.

Back in 2005 on a different blog, I posted what I saw as the seven great myths about the UK property market. Each has finally begun to unravel pleasingly, providing intellectual vindication if not yet financial:

1. House Prices Always Rise - thanks to the honesty of the vested interests like Nationwide, Halifax and RICS, I think we can safely knock that one (back) on the head;

2. Renting is Dead Money - probably my second favourite myth after no. 7 below. Rental yields are barely 5%; short-term fixed mortgage rates are 6-7%, not to mention maintenance, insurance, stamp duty, etc.. You don't suppose Myth No.2 might rely upon Myth No.1 do you? If so, you're starting to get my drift.

3. House Prices Can't Fall - The Bank of England Won't Allow It: they can't stop it, let alone allow it. And anyhow, Mervyn King is too busy writing explanations to the Chancellor about 3%+ inflation, who in turn is too busy worrying about the loan he's made to Northern Rock (as large as the UK's annual budget for defence incidentally).

4. House Prices Won't Fall in Nominal Terms: see Myth No.1. Thanks to low inflation (compared to history at least), nominal prices will have to fall further than before to return to their pre-1995 trend line (about 50% to be precise). The early 1990s bust occurred in an environment of far higher nominal inflation, and prices only fell about 16% in nominal terms (not that anyone remembers those years fondly).

5. Affordability is the Key Determinant of Value: maybe my third favourite myth after 2. and 7.. This beauty postulated that you could take out a whopping great mortgage, so long as you could afford the monthly payment. This was akin to me stating that I could afford a private jet so long as Boeing would allow me to spread my payments out over 100 years (strangely this flawed logic never fooled otherwise sane homebuyers when buying cars for example). With the refinancing window all but closed, and 2-year fixed 'teaser' rates rapidly moving onto standard variable rates, it seems the total amount borrowed did matter after all. Alas, this was another one that relied upon Myth No.1 to create a quick equity buffer, and thus be satisfied (I'm seeing a trend here - Ed.).

6. House Prices Won't Fall in the Absence of an Increase in Interest Rates: base rates were 5.75% in mid-2007 and now they're 5%, yet prices are still tumbling. Unfortunately banks and other participants in the wholesale markets don't seem particularly interested in what the Bank of England thinks, sending the rate that they lend to each other (LIBOR) rocketing. When lenders believed in Myth No.5, then Myth No.6 broadly held too. Now that they don't, they're simply not willing to lend at any rate because they know the game is up. Thus the Bank of England is irrelevant at this point.

7. Prices Will Be Held Up by Demand/Supply Factors: my all-time favourite, the great British housing shortage which miraculously has only become apparent since 1995. Ah yes, who could ignore the heartbreaking sight of all those millions of middle-class families forced to live in tented cities across the nation? And who could ignore the inexorable rise in housing demand relative to supply which miraculously did not lead to an increase in rents? There was never a shortage of housing, just a shortage of housing for sale (at a price that someone with their full faculties would want to pay for). Now according to Rightmove last week, there are 15 properties for sale per buyer; the demand/supply imbalance thus solved it seems thankfully, all in the context of most of the UK's housebuilding industry having downed tools. Incredible.

Oh well, look on the bright side....Happy Independence Day.


At 7:30 AM, Anonymous se7 scott said...

A brilliant piece and I could not agree more with your dismissal of those common myths. As a renter or social leper, as it sometimes seems, I can not wait to let the good times roll. I am finally being prived right!

At 7:53 AM, Blogger charlton north-downs said...

Good post NY- It is hard for me to accept anything other than it is still the better option to buy a property than rent . Rental costs for the property we are buying are about the same as the Mortgage we are paying. Eventually we will own the property and we are not beholden to Landlords who can exploit tenants to the extreme. The property that we eventually own will have a value which should compensate for the extras paid over the Mortgage term. It is also nice to be able to do more or less what you like to the interior. I think what you are saying is that we place far too much importance on property ownership and the UK economy is largely driven by the housing market in which case I have to agree.

At 8:44 AM, Blogger oligab said...

You must of had a very frustrating 14 years especially if you have been renting and so I am glad you are getting some saisfaction as a prophet of doom.Me ,I just love owning my beautifull house in the countryside which has probably lost 20% of its percieved value in the last year or so and may loose more but has still been a wonderfull investment.Great if more people rent than this will push up or stabalise house prices (simple maths).We are a capitalist society with a anglo saxon view to the economy all about supply and demand.In my bussiness I try to create a demand for my wonderfull product but no one will die if they don`t have it.

At 12:57 PM, Blogger Kings Hill Addick said...

NYA, I agree that you are right, and were when you predicted this last year, but historically house prices have always risen in the long term. The huge rises of the last fifteen years have been excessive, but not all that uncommon in historical terms.

As far as house prices always rising is concerned? They will. Maybe not by much more than inflation, but if inflation sits at 2% (which I think is a conservative figure) and if house prices and rents rise at the same level (realistic in the long term*) then assuming you buy a property for £250,000 and you borrow 100% of the purchase price - I know this is not likely but the maths become awkward if you calculate the return elsewhere on the 10% deposit - then assuming a rental yield of 5% (they are rising fast at the moment) and a mortgage rate of 6% (let's take interest only) then in year one the rent would be £12,500 and the mortgage would be £15,000.

Clearly renting is cheaper, however, by year ten a 2% compound increase in rental costs would make renting £15,237, more expensive than the interest only mortgage.

By year twenty five assuming rises of just inflation (which is more than credible even if all of the seven points you have mentioned above are wrong) the rental cost would be £20,507 and the value of the property would be £410,151. Thus you would be saving £5,507 a year in housing costs, and you would have made £160,151 profit on the value of the property, £6,406 a year (remember that main residence houses are free from all capital gains taxes). Thus while you are living in your own home (something that has a massive value to people that can't be measured in financial terms) you have protected yourself against basic inflation at least, and seen your most valuable asset rise by 64% tax free.

I know that you need to take into account that the value of the money (both house value and rental/mortgage costs has been eroded by inflation, but either way the myths about house prices always rising are irrelevant if you can guarantee the cost of a product (somewhere to live) against inflation for ever.

I would also point out that house prices have (over the long term) always outstripped inflation, and to average 2% inflation over a twenty-five year period is very low historically.

As far as the decision to buy or rent, or more specifically when to buy, this has nothing to do with current prices of property (to buy or to rent) but more to do with speculating on what will happen in the future. Thus it is without doubt a good idea to rent now for a while if you don’t need to buy, of course it is, but it is not necessarily the best option for the very long term. You also need to take account of the fact that most people like to own their own home, “An Englishman’s home is his Castle”. Of the people that buy homes (I’m ignoring buy to let investors) very few are buying a home to make money, they are buying the home to live in it. This, of course, makes property very different from most other types of investments – it has a tangible use. Also most products that have a tangible use (cars, clothes, electrical goods) decrease in value from the moment you have bought them, and are normally practically worthless by the time you no longer have a need for them. This kind of makes buying a house seem a lot less speculative.

*Rents have only failed to rise by inflation (and then only slightly) during the last ten years or so when the Buy to Let bubble caused an excess in demand for ownership (increased values) and an excess in supply of rental properties.

At 2:09 PM, Anonymous newyorkaddick said...

SE7 Scott: always pleased to hear from other 'rent boys'.

CND: I agree Brits are property-obsessed, and I don't think this is a good thing (look at the waste of resources used to build ugly modern city flats in the past 5 years that will become tomorrow's slums). However I also agree that long-term it's nice to own your own place, but not at the expense of a financial wipeout (to be faced unfortunately by many that got roped in during the final stages of the madness).

Oligab: it hasn't been that frustrating to be honest because there have been far more interesting things to invest in, that have risen far more over that time (the leverage aspect of housing tends to blind people to this), and which were capable of being liquidated at the press of a button (fortunate given the state of equity markets this year). In common with most, I also crave the beautiful home in the country (and congrats for getting it), but simply argue there are alternative ways of getting there.

KHA: wow, you should get your own blog :-) I agree with most things you say (I should perhaps have written that the myth was 'renting is always more expensive than buying'). If yields rise (which they are now almost by definition), and interest rates fall then the equation moves back in favour of buying (at which point I probably will, and look forward to being told I'm crazy!). A problem with your analysis (which I know is deliberately simplified), is that most people need to move at some point during those 25 years - the person with the 95-100% interest only mortgage bought in say 2005/6 (of which there sadly are several), are now in negative equity, and potentially stuck in their current property. The renter meanwhile has added the short-term money saved to his (appreciating) deposit and can step in to buy more property at a cheaper price in a couple of years. You are right I think that prices will find a bottom in 2010/11 and begin rising again with inflation (or more pertinently rents which are driven by income growth), but the interim pain is something that not everybody on the ladder will be able to survive I'm not anti-buying per se, but have been in recent years because the price rises made no sense.

At 3:12 PM, Blogger Kings Hill Addick said...

NYA, You've forgotten that in a rising housing market the flat owner will remortgage and raise the capital to buy a new house and let the flat. Clearly this doesn't work right now, but to be fair if the owner of the flat could have accurately predicted the 'crash' that has happened then he would probably not need a mortgage anyway as we would have made a fortune on the futures and options market.

At 3:52 PM, Anonymous newyorkaddick said...

...and all those flats for rent will push down rents which takes us back to square one! Anyhow, we can continue this chat over a beer at the Valley.

More importantly, when are we going to sign a central midfielder?

At 5:15 PM, Anonymous fred said...

this is a great debate, and actually you are all right in a way. KHA spells out a lot of the reasons why the mkt works in a seemingly inexplicable way quite often, and NYA spells out why those who are either late to the party (tough luck on the young) or a bit too gung-ho are going to have a tough few years. Personally, I'm in the lucky position of being old enough to have entered the mkt at a good enough point to weather a bit of volatility, but more than anything hopefully this will be the death of those endlessly tedious property/makeover tv programmes, supplements etc etc etc.


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