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From The Sunday Times

December 16, 2007

Will further interest rate cuts boost the housing market next year?

Next year the positive effect of rate cuts will balance out the negative impact of the credit crisis

David Smith

Two years ago, it all seemed so straightforward. The Bank of England had raised interest rates five times and the housing market was feeling the pinch. House-price inflation slowed sharply, skirting close to zero on an annual basis, as buyers were deterred by the rising cost of borrowing and warnings of a price crash. Mortgage applications fell sharply, and to some it seemed only a matter of time before prices would follow.

Then something interesting happened. The bank stopped raising interest rates, removing fears that the cost of borrowing would carry on climbing. In August 2005, it cut rates by a quarter of a point, a move that famously triggered the biggest rise in house prices during the past couple of years.

Whether it did so or not is a matter of debate, as the mortgage-approval figures suggest the market was already picking up. One thing, however, is clear: an apparent housing-market dive turned into a soft landing, then a strong recovery.

Scroll forward to 2007, and the bank has delivered its equivalent of that August 2005 cut, reducing its rate from 5.75% to 5.5% on December 6. It has done so, it should be said, much earlier in the cycle. Annual house-price inflation is still strong, though it is falling sharply on some measures: the latest official reading from the Department for Communities and Local Government put it at 11.3% in October, compared with 10.8% in September. And mortgage approvals have not yet fallen to the low monthly levels they hit in 2005.

So, will the Bank of England pull off the same trick again? The comparison with two years ago falls down because of the impact of the credit crisis. Unusually, because of conditions in financial markets, the cut in its rate has not been matched by falling money-market rates.

For banks and building societies, this means that the cost of funding their lending in the wholesale money markets has stayed high. It may fall, particularly as we get beyond the end of the year, but with uncertainty still stalking the markets, that is by no means guaranteed.

There is another factor at work. Partly to cover themselves against losses on their financial-market investments, some related to the US sub-prime market, lenders are keen to increase their margins - in other words, to widen the gap between the cost of their funding and the rates at which they will lend. Rachel Lomax, a deputy governor at the Bank of England, suggested that the margin between its rate and typical rates for borrowers will remain significantly bigger than in recent years.

So, we have a situation where the Bank of England’s actions are likely to have less impact than they did two years ago. Even the prospect of more rate cuts, which the markets expect, will be less of an elixir for the housing market than it would be in normal circumstances.

How will all this pan out? My view - shared by several forecasters - is that the positive effect of rate cuts will balance the negative impact of the credit crisis, giving us flat house prices for 2008 as a whole. Others, it is only fair to say, are gloomier.

Since the rate drops, according to another article in this newspaper, will not be passed on to borrowers, it won't make any difference at all.
Bet they DO get passed on to savers though.

Dave, Basingstoke,

I believe that demand for housing will fall in 2008 largely due to the fact that lenders are beginning to be very picky about new mortgages which includes re-mortgaging. So buyers can only afford to buy as much as lenders are willing to lend on. Lenders may also want biger deposits, pushing a lot of people out of the market to buy. The buy to let investors on fixed rates may also find it difficult to re-finance, having to opt for the variable rate - but they might not be pushed to sell as people who could now not afford to buy have to rent. This will drive rent up....

I believe in 2008 onwards we will see buy to let investors move from individuals to companies / private equity firms who can secure cheaper finance... and by 2010, more than 60% of Central London 1 bed and 2 bed flats will be rental properties...

Darren Young, London, UK

This is simply unrealistic. Only two things can stoke up property prices - robust earnings growth or high inflation. Long run property prices are consistently 4.5 times earnings for a reason. Assuming a person keeps 60% of their income after tax. 1/3 of that is 1/5th of earnings; at constant earnings, it takes 22.5 years to pay off the principal. Earnings growth in the UK, especially post-tax is pretty stagnant.

What all the interest rate analysis misses is that eventually a house, or flat has to be paid for. At 9 times earnings (where the UK is now), it is tougher and tougher for a person on average earnings to pay for a house by age 65.

Meanwhile, as an investment, BTL only makes sense if property prices are going up, since yields are below deposit rates or other capital returns, let alone mortgage interest cost. Rents in London will be hit by City layoffs which are coming. Sentiment has finally turned, the boom is over, the bust starts now, and it will be hard.

MacK, London/Washington,

By Jimminy David Smith - you realy are a very uninformed man. I take it you either have a BTL portfolio, large mortgage or both, with respect sir, you're kidding yourself.
If you think interest rate cuts are going to restrart exponential house price inflation and silly borrowing then you obviously do not take much notice of what is happening around you.
People are maxed out on debt, cant do anymore, the party is over and we are waking up to the beginning of a massive hangover.
This has been a long time coming, should have happened in 2005 then it may not have ben so painfull.

Des Emmerson, YORK, UK

Mr Smith - are you living on an island?

The fundamental problems are the house price bubble and subsequent default.

Latest estimates are for default to wipe out the order of $500bn in capital. But this is for just for sub prime and just for America. If house prices continue their fall and the problem affects other groups and other jurisdictions, you can easily double this figure.

Under Basel II cpaital for on balance sheet lending has to be provided at 8% of risk weighted assets, which for mortgages has a weighting of 50%. This means if you lend Â£100, you must have Â£4 in capital. Or in other words you can lend 25 times the value of your capital.

So you can see that a $ trillion of default would take $25 trillion out of the lending system....and then add in the off balance sheet financing which now has to have capital provided because it has gone back onto the balance sheet as it should.

These amounts are not trivial and may affect prices!

harry e, London,

House prices flat??
Talk about optimism carried to the point of absurdity.

David, Guildford,

If rates had been held in 2005 we may have managed to engineer a soft landing. Now we are facing a recession and a housing crash with very little the Bank can do about it as risk premiums have detached interest rates from the base rates. There has been a ten year binge on credit we, appear now to be facing a more sober future.

david barker, maidstone,