A Downturn in the UK House Prices - Essay Example

To what extent has the credit crunch contributed towards a downturn in UK house prices? Background The housing slump has emerged as a worldwide phenomenon, with the effects of the credit crunch affecting property values across the world. The adverse effects of the credit crunch have spread “from the Europe and the US to the rest of the world” (O’Grady 2008). Following predictions and warnings of Goldman Sachs of the severe adverse effects of the global credit crisis on the economy of UK, which was predicted to be worst hit due to its heavy reliance on financial services, house prices declined for the first time since 1996. This has led the lenders to ask for hefty deposits, with seven of the ten leading lenders not lending to borrowers who have less than 10 per cent deposit (Gilmore & Blakely 2008). This has led to increased stock of unsold property in the market, which in turn has led to the decline in house prices. According to the figures from Nationwide, the second-largest mortgage lender, the value of an average home fell by 1.8 per cent in April. This is 1.1 percent lower from April last year, amounting to a loss equivalent to £5 per day (Gilmore & Blakely 2008). Shaftesbury, the British property company that has shops and restaurants in and around London’s Carnaby Street, announced a net loss of £91.2m for the six months preceding March 31 as against a net earnings of £212m for the corresponding period a year ago. This is the first announcement of loss by the group since 1992. This year, the company announced a fall in its net asset value by 11 percent (O’Grady 2008). The outlook for the coming quarter remains unexciting with more surveyors expecting a decline in rent. Graham Beale, chief executive of Nationwide Building Society, has predicted that this fall in house prices would continue, with further decline in prices into 2009-10. In the six months to the end of September, Nationwide had advanced mortgages worth £1bn, considering repayments and redemptions, as against £3.6bn in the corresponding period last year (Osborne 2008). The society reports an increase in arrears and repossession signalling that the adverse effects of the crisis are beginning to set in with the borrowers facing difficulties in making mortgage repayments. Repossessions doubled year on year, with 300 homes repossessed in the six months to the end of April as against 143 in the corresponding period last year (Osborne 2008). The Market Oracle predicts a 15% fall in the UK house prices over two years to August 2009 (Walayat 2008). It is expected that the UK would follow the footsteps of the US, where the housing bust of 2007 led to a recession in 2008, with the fall in the housing market of 2008 leading to a recession in 2009. Since the housing market is expected to continue to fall in 2009, the trend is feared to continue into 2010 in the UK. Another factor that is going to render London’s credit crisis really severe is the overvaluation of London’s house prices. The UK house prices remain highly unaffordable warranting a further fall in house prices “until they reach the levels of even 2002” (Walayat 2008). The Market Oracle affordability index indicates sentiment-driven housing market trends, where buyers are ready to overpay for housing at peak times and they avoid housing when the market is cheap in terms of real disposable income. Hence, with the ongoing decline in real disposable incomes, despite decreasing house prices, the affordability index may not improve until 2010 (Walayat 2008). A regional breakdown of price falls in the UK England last year saw a decline in the house prices of 14.8% with the last three months showing a 4.8% decline (Osborne 2009). The biggest drop in value of home prices was seen in East Anglia, with prices falling by 16.6% over the year. “London remains the most expensive place to buy a home in England with an average price of £257,963, compared to a country-wide average of £171,924” (Osborne 2009). The largest price falls were recorded in England, with Bristol, Bradford, Northampton and Norwich recording a 17% fall in home prices. In Northern Ireland, Belfast recorded the biggest decline with a 33% drop in house prices recorded over the last year. The average house price in Northern Ireland at the start of 2008 was £224,816 which dropped to £147,833 by the end of the year. Houses in Belfast at an average of £203,942 remain more expensive than the rest of Northern Ireland and the UK as a whole (Osborne 2009). Scotland saw the smallest drop in house prices in the whole of the UK with a fall of 8.1% last year. Remarkably, the last quarter of 2008 saw a small increase in prices of 0.1%. Apparently, Scotland was the only region in the whole of the UK to witness a rise in house prices. In Scotland, Aberdeen saw the largest annual fall of 11% followed by Glasgow at 10% (Osborne 2009). Prices were highest in Edinburgh, but here values fell only by 6%. House prices in Wales fell by 12.1% in 2008, with the last quarter seeing a fall of 2.4%. This is less than the price fall of the UK as a whole, which was 4.4% (Osborne 2009). The economics of credit crunch and fall in prices Supply and demand, one of the fundamental concepts of economics, explains the functioning of a market economy. Demand refers to the quantity of a product or service desired by the buyers. The quantity demanded is the amount of a commodity that buyers are willing to buy at a certain price. Supply refers to the quantity of a product or service that the market can offer. The quantity supplied refers to the quantity of the product the producers are willing to supply at a given price. Price, therefore, is a reflection of supply and demand of the commodity or service (Economics Basics 2009). According to the law of demand, all other factors remaining equal, the higher the price of a commodity, the less the demand for that commodity. This is because along with the increase in the price of a product, the opportunity cost of the product also goes up. As a result, the people, in order to buy that commodity, will have to forego some other commodity which they consider more essential or valuable for them. Hence, they avoid buying that product. On the other hand, according to the law of supply, the higher the price of a product, the higher the quantity supplied. This is because selling a higher quantity at a higher price gives high revenue. Time is also an important factor that affects supply, as supply is dependent on whether a price change is temporary or permanent. Economy is said to be at equilibrium when supply equals demand. At this point, the suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding (Economics Basics 2009). However, disequilibrium occurs when the supply is not equal to demand and there is either excess supply or excess demand. In a situation where there is excess supply, the supplier are producing more with a view to increasing profits while the consumers find the products less attractive and buy less as the price is too high. Excess demand occurs when too many consumers want too many of the product because the price is too low and suppliers cannot produce in adequate quantities. In such a situation, when consumers vie with each other to buy the product at a lower price, the demand increases pushing the price up. As the price goes up, the suppliers want to produce more and the market economy shifts toward equilibrium (Economics Basics 2009). Factors influencing demand include price of close substitutes and complements, income of the consumer, existing wealth of the consumer, changes in tastes and preferences of the consumer, expectations regarding future price changes, special influences regarding the product and the size of the market (Supply and demand analysis 2004, p.13). Demand for a product is very much influenced by the buying potential of the consumers. An improvement in the buying potential of the consumers will increase the demand for a product. Similarly, the expected future changes in the price of a product will also influence the demand for the product. If a fall in the price level is expected, consumers may decide to wait instead of buying at a higher price. However, this depends on the nature of the product and how essential it is for the consumers. This theory of supply and demand have played a significant role in the present crisis leading to the fall in home prices in the UK. Credit availability is a significant factor that influences home and other asset prices, as it is closely linked with supply and demand. Increase in the availability of credit generally brings about an increase in demand. The increase in demand will naturally result in an increase in the price of homes. When the credit availability decreases, there is a decrease in demand which naturally brings down the prices of homes. The reduction in the availability of credit reduces the purchasing power of buyers who wish to acquire homes and such other assets. With lesser amount of money at hand, the affordability of the buyers decreases. In order to become affordable to people with lesser purchasing power, the prices of homes are naturally brought down. Moreover, demand will not increase with fall in prices, as would be expected, if the homes are still too expensive relative to the lack of credit available (How the availability of credit 2007). This would bring about a continuing fall in prices. With decrease in demand, the resultant increase in supply of homes will lead to fall in home prices. The quantity theory of money is another concept that is of great relevance in this context. “The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold” (Heakal 2009). According to the quantity theory of money, when the amount of money in an economy doubles, the price levels also double, thus causing inflation. In other words, the consumer pays double the price for the same commodity or service. This means that with increase in supply, the value of money, like that of any other commodity or service, decreases. Hence price of commodities rise to counterbalance for the fall in value of money. This is called inflation. The Fisher Equation, MV = PT, gives a mathematical expression for the quantity theory of money. Here, M = money supply, V = velocity of circulation, P – average price level and T = volume of transactions of goods and services. The crisis explained How can bad mortgages in one part of the world lead to economic crises in other parts of the world? This is actually a chain reaction. Collapses of internet companies and catastrophes like 9/11 led to severe recession in the US. The Federal Reserve responded to this crisis by cutting interest rates to minimum, in fact the lowest for a long time – 1% (Pettinger n.d.). Lower interest rates meant more credit availability and better buying potential. This encouraged people to buy houses, which increased the demand in the property market. This led to increase in the prices of houses and the mortgage companies decided to make maximum profits from the booming property market. For this purpose, the lending criteria were slackened. Mortgage companies began selling mortgages indiscriminately. Mortgage salesmen were paid on commission and they, in turn, tried to make maximum sales without adequately checking whether the homeowners could actually make their repayments. In 2006, inflationary pressures increased in the US, causing interest rates to rise to 4% (Pettinger n.d.). Though the increase in the interest rate was not significantly high, those who had taken large mortgage payments found it difficult to make repayments. This inevitably resulted in mortgage defaults with the companies losing heavily. The increase in mortgage defaults led to the housing boom rapidly approaching its end, causing the house prices to fall. The fall in house prices led to increased demand for new homes, which continued to 2007 (Pettinger n.d.). However, the fall in house prices turned out to be very costly for the mortgage companies, as selling of houses failed to pay back the mortgage defaults. Since mortgages companies in the US had borrowed from other financial institutions by selling collateralised mortgage debt, losses to the US companies led to huge losses for other financial institutions, thus spreading crisis through the financial system across the world. Consequently, numerous financial institutions and banks world over had to write off huge amounts of bad debts. Huge losses and deterioration in balance sheets of the banks led to shortage of liquidity in money markets, as banks could not rely on each other by providing adequate finance (Pettinger n.d.). In the UK, Northern Rock, which was particularly exposed to money markets, had conducted its daily business by borrowing funds on the money markets. In 2007, “it simply could not raise enough money on the financial markets and eventually had to be nationalised by the UK government” (Pettinger n.d.). Banks being short of liquidity, sold their mortgage bundles causing further decline in asset prices, further liquidity shortages and further deterioration in bank balance sheets. Conclusion The adverse effects in the financial system seem to be moving in vicious cycles leading institutions from crisis to crisis. People having lost confidence in the banks, have been selling out their shares in the banks. The fall in the share prices were thus catalysed by short selling of stocks. The shortage in finance has led to reduced lending and mortgages, causing further falls in house prices, which in turn is magnifying bank losses from increased mortgage defaults. Inadequate finances, decline in house prices and shattered confidence of the investors have led to a significant decline in the real economy. Reduced investment and consumer spending has led to a situation of grave recession and rising unemployment. The rising unemployment, again, leads to reduced buying potential and lack of money supply, which, again, increases the chances of further mortgage defaults and bank losses. References Economics basics: demand and supply 2009, viewed 7 January 2009, http://www.investopedia.com/university/economics/economics3.asp Gilmore, G. & Blakely, R. 2008, House prices fall as bank predicts credit crunch will hit UK hardest, viewed 7 January 2009, http://www.timesonline.co.uk/tol/money/property_and_mortgages/article3850600.ece Heakal, R. 2009, What is the quantity theory of money?, viewed 7 January 2009, http://www.investopedia.com/articles/05/010705.asp How the availability of credit affects home mortgage prices 2007, viewed 7 January 2009, http://www.christonium.com/manhattan/ItemID=11910985211957 O’Grady, S. 2008, Credit crunch sends property prices falling world wide, viewed 7 January 2009, http://www.independent.co.uk/news/business/news/credit-crunch-sends-property-prices-falling-worldwide-835873.html Osborne, H. 2008, Nationwide predicts house price falls into 2010, viewed 7 January 2009, http://www.guardian.co.uk/money/2008/nov/10/house-prices-credit-crunch Osborne, H. 2009, UK house prices: a regional breakdown, viewed 7 January 2009, http://www.guardian.co.uk/money/2009/jan/06/house-prices-regional-breakdown Pettinger, T. n.d., Financial/economic crisis explained, viewed 7 January 2009, http://www.economicshelp.org/2008/10/financial-economic-crisis-explained.html ‘Supply and demand analysis’ 2004, Microeconomics, The ICFAI University, Hyderabad, India, 11-68. Walayat, N. 2008, UK house prices plunge over the cliff, viewed 7 January 2009, http://www.marketoracle.co.uk/Article4256.html Read More