Housing Loan Guarantees – a good government initiative

Owning your own home has been a particular ambition for people of all social classes in the Anglo-Saxon countries for nearly three generations now.  That it can go badly wrong is clear from the collapse of the Freddy Mac and Fannie Mae sub-prime mortgage system of government finance in the USA, which has been the biggest single source of the near-collapse of the banking system as a whole.

All is not right with the current British housing market as well, but it is important obviously to be clear what is actually wrong before disbursing tax-payers’ money.

The chief problem is that building land prices have been blown up by the 2001-2007 credit bubble so that average house prices are now over six times the average full-time male wage.  These were the years when Gordon Brown, Chancellor in the new Labour government, abandoned the previous Conservative government’s budget restraints and encouraged the financial institutions to markedly loosen restrictions on their lending.  In Canada extravagant lending of this sort was restrained by the financial authorities and as a result Canadian banks have emerged from the crisis in good shape.

In Britain many housing developers have land on their balance sheets, bought at a price which is greater than they can expect to recoup through new house sales.  Not unnaturally they are desperate for new-build house prices to rise significantly (say 10-15%) so they can do this.  This wish crashes straight into the reality that potential new build customers are looking for substantial house price reductions – again in the region of 10-15%.

What should the government do about this feature of the housing market?  Answer – nothing.  If someone has paid too much for something in terms of market value, they will have to take the loss themselves and set it against undoubted gains made in the good times.

Comparisons with the 1960’s

This decade saw a very rapid expansion in house ownership, particularly as the so-called baby boomers reach adulthood.  Typically at the end of the decade, a new three-bedroomed semi-detatched house would cost around £5,500 in the South of England – less in the North.  Mortgage interest at 6% on a 95% mortgage would mean about £320 gross per year of interest, 28% of gross average earnings.  As most wage earners could offset the interest against income tax, this gross figure reduced interest payments to about 23% of gross earnings.

Today, for an average UK house price of around £170,000, interest payments at 4% on an 80% mortgage are around £5,500 per annum or 22% of male average earnings – about the same as the figure above with tax relief.  Moreover, today few couples in the age groups trying to get on to the “housing ladder”, say 25-40 years, have only one wage; for a couple the average is more like £30,000-£40,000 after any child care costs have been allowed for.

So what is the problem and its solution?

The problem lies in the difference between the 5% deposit for a starter mortgage in 1968 and the 15-20% of house price required by the lenders – the banks and the few remaining building societies – in 2011.

Any lender whether corporate or private should be concerned with three things:

            How secure will the loan be?

            What net interest is payable?

            When will the loan be repaid?

By not asking and answering these questions properly, Western bankers have incurred huge balance sheet losses.  Not surprisingly they are being ultra-cautious in their lending today, a policy in direct conflict with the government’s desperate wish for them to lend more.  Requiring a deposit of 20% of house value is a rational response to the possible, even probable, fall of 10-15% in average house prices noted above, meaning their loan would come out at 90-95% of the reduced value, basically the same as the 1968 position.

Effect of a 20% deposit requirement

A deposit of 20% of the average house price is today about £34,000, nearly one and a half times the average annual earnings, compared with about a quarter in 1968.  This is the crucial difference which won’t be remotely corrected by a 10-15% market alteration to house prices, or any conceivable rise in average wages.

The key obstacle for the lenders is uncertainty about getting their money back in case of default by the borrowers.

The government’s housing initiative

With the figures given above, the housing market is unable to remove this uncertainty.  The British government is therefore absolutely right to indemnify lenders for that part of the mortgage from 80-95% of the original purchase price for first-time buyers.

It is likely that the money which the indemnity actually costs will be a small part only of the £400 million housing package that was announced on Monday 21st November.  This housing initiative is also noteworthy for offering to give away unwanted council houses in return for a couple’s undertaking to maintain and renovate any such property.  Unemployed and reskilled people may well eventually realise more assets for themselves this way than by any other means, increasing the nation’s housing stock at the same time.

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