Tuesday, 29 July 2008

Vince Cable's perverse economics

I have an enormous amount of respect for Vince Cable, not least because he's the only current front-line politician who had a published chapter on my international political economy course reading list when at university. A very good piece it was too, covering the inconsistent pace of globalisation. However, his argument on the Today programme about how the mortgage market should proceed was irresponsibly conservative and, quite frankly, perverse. The audio file is here.

What Cable is essentially arguing is that the housing market has been growing largely because of the availability of cheap mortgage finance. He castigates lenders for allowing borrowers to secure mortgage finance for up to an amount that is five times their annual income. Such lending is irresponsible in his view, and mortgage values should be limited to three times of annual income. By pursuing this more conservative course, we will begin to open up the market for first time buyers. The economics underlying this argument are plain wrong.

If the house sale market existed in isolation then he may have an argument. It doesn't. It exists in parallel to the rental market. If people aren't buying houses they are renting them instead- they've got to live somewhere! What this means in practice is that as house prices decline, the risk-return ratio alters in the rental market. In other words, rents go up, capital costs (i.e. house prices) go down so that spurs investment in rental property. So our first time buyer still does not own a house, but they are paying more rent to support the profits of private landlords.

This point was illustrated in report published yesterday by the National Housing Federation which forecasts a 25% increase in house prices by 2013. House prices will decline in the short term but will then continue their upward trajectory because the main driver of the market is demand. We live alone for longer, live longer, and get divorced more. Whether people are renting or buying, more people need properties and supply is not keeping pace with that. What's more, unless the mortgage market is kick-started even fewer houses will be built making the situation worse.

So Vince Cable's position actually puts first time buyers in a much worse position. The market fundamentals won't change but the ability of people to get on the property ladder will be devastated unless good mortgage finance becomes more readily available.

Turning to Vince Cable's contention that the banks have been lending irresponsibly and that we should return to a three times income rather than five times income norm, this is unduly conservative. Let's do the sums using the BBC's mortgage calculator.

'Kate' has an income of £40,000 and is looking to buy in the South East where a one bedroom flat is likely to cost her £200,000. She has £20,000 savings. If she can get a mortgage for £180,000 over a 25 year time frame at 6%, it will set her back £900 for interest only, £1173 for repayment per month. Her monthly disposable income is £2300 or so. Either option is affordable. At 12% it would be unaffordable (leaving her with a monthly post-mortgage income of £400 or so.) 12% interest rates would only be seen in an economy facing collapse so exceedingly unlikely.

Now let's move Kate to Cableland. Her income is still £40,000 but she can only get a mortgage worth £120,000 now. With her £20,000 savings that means she can get a house worth £140,000. That means that house prices will have to fall by £60,000 before she can buy. That's a fall of 30%!!!!!!!!!!!!!!!!!

Of course, that won't happen because assuming that wholesale markets do recover, finance will be in plentiful supply to allow private landlords to purchase the flat that Kate dreams of before it gets anywhere near £140,000. Poor Kate unless she gets a £20,000 pay rise- a 50% increase- is stuck in the rental market indefinitely. How frustrated she will be that she can't get a mortgage even though it is completely affordable with her income and she is paying the same amount, if not more, in rent as she would be in a five times income mortgage.

Now to Vince Cable's final argument that there should be no kick-start for the mortgage markets lest we repeat the mistakes of creating a house price bubble again. His argument against the Bank of England underwriting mortgage debt because it means that the public sector will take the risk and the banks will get the rewards is curiously out of date. The Bank of England has a scheme already in operation called the Special Liquidity Scheme which protects existing high-quality assets in a manner that contains the risk in the private sector. The UK housing market is not like corporate bonds or equities. It can't suddenly junk- the basic underlying assets, i.e. houses, have a pretty sturdy value whatever the short term fluctuation may be.

Sir James Crosby's report into the mortgage market to be published today does not envisage permanent government support for the mortgage market as exists in the US through Freddie Mac and Fannie Mae. That is right but an extension of the special liquidity scheme to new as well as existing mortgage assets could be advisable. Any extension would be time bounded until wholesale markets recover.

I'm afraid Vince Cable's arguments would have a devastatingly detrimental impact: house prices would continue their decline, the economy would suffer, and first time buyers, other than the very few at the margins, would actually be harmed rather than helped. Looking seriously at providing more liquidity to the system, but in a way that prevents the public sector assuming the private sector's risk, is the way to go. And hopefully, those five times salary 90% mortgages, at good interest rates, will become readily available again and Kate gets the pride and investment potential of her first flat.


  1. Is this the same National Housing Federation that was, a year ago, predicting a 50% rise by 2013, and two years ago predicting a 50% rise by 2012?

    They're a lobbying group. They say what will get them the best results - in their case, the more they can say housing will be unaffordable, the more the Government might invest in social housing.

    House prices will, absent a government subsidy, continue to fall. Kate will buy her house - unless she's taxed out of existence to bail out the greedy buy to letters and bank shareholders, as you seem to want.

    Do we need more houses, yes. Should the government deliver them by paying to build more houses, or by paying to get people cheap mortgages? It's a no-brainer. The former would keep rents down anyway as supply goes up.

    Rents, of course, are largely set by affordability anyway. That five people want a flat at £100 a week doesn't mean that any of them can afford £120 a week. As the economy slows and more people take in lodgers, and more EU citizens return to their home countries, demand will fall.

    There won't be a new boom in landlordism if house prices are allowed to fall - the finance has dried up, and most rich people recognise that 4-5% is a rubbish return on a risky investment. Even at 7-8% if prices fall 40%, it's not a very good deal once you factor in repairs, advertising costs, and void periods.

    Meanwhile, historically, 12% interest rates aren't all that unusual - we've had a low-inflation decade, there's no guarantee we'll have another.

  2. Well, I'm afraid I disagree with almost all of your points.

    I do agree, however, that we need to build more council housing (though it could never replace private provision which rests on mortgage finance and nor should it.) I just don't think it's necessary to bring the private housing market to its knees in order for that to happen. I'm afraid the Cable argument- whether followed by lenders or imposed through regulation- would have that impact.

  3. "Well, I'm afraid I disagree with almost all of your points"

    Would you care to put forward some arguments for why they're wrong, or statistics to prove your point, or examples from history of when this has happened before and how it happened your way not mine, or do you just disagree with them because you don't like them?

    Just wondering.

    Building is slowing because there's nobody to buy. Let the public sector buy for rent, rather than subsidise private buying. Solves the slow-build problem, and is better value for the taxpayer, and less socially divisive.

  4. I can think of nothing more socially divisive than home ownership being limited to the (very wealthy) few.

    I'll quickly address the other points you make one by one (was too rushed to do so previously):

    i) NHF- a lobby group. Yes, but their argument is accepted by HM Government and elsewhere. Figures may differ but prices have a medium term upward trend.

    ii) Government subsidy of housing. Fine for where the market does not work. But a wholesale nationalisation of housing is not desirable: investment would depend on the Government's economic policy rather than need, it would have a wider impact on the economy as borrowing is massively increased, interest rates would increase and that would be detrimental. It just wouldn't work I'm afraid and it's completely unnecessary.

    What's more, it will mean that thousands of people will lose their homes. They have taken out a mortgage in the reasonable expectation that the rules of the game will not be fundamentally shifted by government policy. I actually think changing the rules of the game in the way you suggest is indefensible and will cause unnecessary distress.

    iii) 'Affordability' driving the rental market. The rental market is a market like any other, governed by supply and demand. The price reflects that not 'affordability.' Affordability is just an influencing factor on demand. Because someone is paying £x pcm, it does not mean that they couldn't pay £x-y pcm or £x+y pcm- they are two different considerations. Moreover, the influx of lots of Kates into the rental market would have an upward impact on price. Kate can easily afford the rental example you give, in fact she can afford considerably more. Her market power would outbid the tenants you describe so whether they can afford it or not, they will have to pay more.

    iv) The private rental market doesn't work argument. It does. It's a major aspect of provision. Private landlords make money from either asset price inflation or rents. If the asset price declines, they have an incentive to invest further and that is what will happen as house prices decline so I'm afraid your dreamed of 30% decline in house prices just won't happen other than as a blip. Unless your policies to bleed the housing market dry are implemented......and even then the upward trend will resume for reasons discussed.

    v)The last time mortgage rates hit 12% was in 1991. Monetary and fiscal policy is now institutionally designed to prevent inflation of the magnitude that we had in the late 1980s/ early 1990s. Should that approach change, my argument no longer holds. For now, it is a legitimate expectation that mortgage rates will remain considerably under 10% for the forseeable future. Why design policy around the very worst case and unrealistic scenario? Doing so, leads you to the nationalisation solution that you propose...

    vi) My argument is not to subsidise private buying. It is to underwrite it in a way that maintains the risk with the private sector because wholesale markets have stalled. It is a short-term liquidity boosting measure. Unless houses become junk (which they won't), there is little exposure for HM Treasury.

    vii) I would be amazed if 'Kate' didn't back my argument!

    One final point, I do think that self-assessment mortgages need to be looked at and obviously lending such as sub-prime mortgages should be outlawed. We need to ensure that people have a realistic ability to meet their mortgage payments but three times income is way too conservative. Besides, that multiple was actually a way of allocating resources rather than a measure of 'affordability.' As liquidity improves higher multiples can be offered with the caveat outlined above.

  5. Fair enough.

    A lot of my friends are 'Kate', and they sure as hell don't back your argument! They know houses aren't worth what sellers want, they're happy to wait for sense to be restored, and they'd rather borrow £120,000 at 7% interest rates than £168,000 at 5% interest rates.

    Rents are falling in most parts of the US. That's even without the scale of recent immigrants able to return home as recession bites, which we have.

    I know very few normal people who could afford a 10% increase in their rent, especially with all the other inflation. It's keep the rent down, or they live more densely, move back with family, etc.

    Therefore I am confident that we won't see rental inflation far above RPI - especially not with all the people currently scrambling to rent out the houses they can't manage/afford to sell.

    The private rental market 'works', but it is not a good investment at current yields. It looked like a good investment because of low borrowing costs, easy credit, and an asset bubble.

    Professional landlords investing their own cash, not borrowed, will invest at the right price, I agree. But that's at least 30% off the peak, if not more so.

    The NHF have, as I have pointed out, been consistently wrong in their house price forecasts. If the government accepts them, the Government is foolish. That the same researchers did work for a different group in 2005 and found that house prices were 18% overvalued compared with economic fundamentals should say something. Sure, in the long term prices will go up, but so does everything, that's just inflation...

    You say you oppose "government subsidy of housing" - but that's what you're proposing, not me! I'm happy for the Government to do commission the building and run the whole thing at a profit in the medium-term - assure building during the slumps when land is cheap, and sell off during the booms when demand is highest.

    It would saddle us with a great deal less debt than taking on responsibility for guaranteeing the mortgage market would - that would truly force up interest rates, and the cost of borrowing the national debt. Alternatively, if there is a way of keeping risk in the private sector, as you hope, then banks simply won't lend. Many of them have lots of cash, they're being cautious about lending because it's too risky - lending on a falling asset.


    "They have taken out a mortgage in the reasonable expectation that the rules of the game will not be fundamentally shifted by government policy."

    What about those of us who have not taken out a mortgage, also in the reasonable expectation that the rules of the game weren't going to be fundamentally shifted by government policy?

  6. Vince Cable the only straight talker

    As ever Vince Cable is about the only straight talking politician out there. Why should the taxpayer once again bail out incompetent, greedy and corrupt business practices that were obviously all going to end in tears?

    Far more practical policy changes to lessen the damage to the housing market would include:

    1) A suspension of the punishing Stamp Duty. After all what do we get for this? Practically nothing. This would immediately slash the cost of buying and moving and reduce the amount of borrowing required to buy a house, a significant part of which merely funds Government taxation.
    2) An abandonment of the ridiculous HIPs scheme which adds £000s more to the cost of buying or moving. All it does is to tell us what we already knew - our houses are poorly insulated, draughty, have inadequate heating and have old fashioned windows - well DOH! Do we need to pay some totally unqualified person hundreds of pounds to tell us this?
    3) Slash Council Tax for the majority by basing it on income rather than property. We now see vast numbers of UK residents enjoying the benefits of local Government services which they don't pay for at all. Surely this is monstrously unjust. Low earning home buyers and owners should have to pay practically nothing. This would also boost the housing market by freeing up much more disposable income.

    Incidentally in desperation for decent employment I actually contacted one of the Government approved HIPs training companies. They would not reveal how much the training would cost or anything about employment prospects at all. It later turned out that course costs are in the region of 7-10k - ie more than degree! They have to be joking!

    All these 'taxes' are just ways of milking the home owner. They are just about sustainable when the market is in boom mode when the Government seeks out every opportunity to get as much out of us as possible (usually from the less well off), but look like an impossible burden now conditions have swung back to bust.

    Peter Ellis

  7. I totally disagree with all of Anthony Painter's comments. What he is suggesting is totally unsustainable.

    The problem is that investors see the loans that are repackaged as risky investments that they will not touch. Why should the tax payer underwrite these loans when they are so risky.

  8. Jdc, I'm afraid you are offering 'Kate' a false choice. There is no £120,000 option that will secure her home ownership in her area of choice. Of course she wants to buy a cheaper house but what sort of argument is that? The option just isn't one that exists....

    Thank you all for your comments.

  9. "Jdc, I'm afraid you are offering 'Kate' a false choice. There is no £120,000 option that will secure her home ownership in her area of choice. "

    There will be in 18 months if the Government doesn't bung her taxes to prop up the market. Take a look at the housing futures index if you don't believe me!