The contrast between the mortgage market today and the market just 12 months ago is considerable. This is highlighted most clearly by the house price inflation figures.At the end of last summer, the annual rate of inflation was running at nearly 20% but latest figures from Nationwide show prices have barely risen in the past 12 months, with house prices in August standing only 2.3% higher than a year ago. Although this fall in house price inflation reflects a slowdown in activity in the housing and mortgage markets the current state of these markets represents a far better outcome than seemed likely this time last year. The market is certainly a lot stronger than pessimistic forecasters were suggesting. With the Monetary Policy Committee having raised interest rates in May, June and August 2004, it was clear that demand for borrowing was going to reduce and that potential borrowers would soon be paying more for their loans. Last September, the City was certain the MPC would raise interest rates a further 0.25% to 5% by the end of the year and another increase in February or May was considered likely. In such circumstances, it was not surprising that there was considerable disquiet about how sharp the downturn in the mortgage market would be and that gloomy forecasts of profound falls in house prices were widely publicised. But the economic environment was not the only cause of uncertainty. The looming prospect of Mortgage Day haunted the mortgage industry as the deadline approached. Would lenders’ mortgage systems cope with the new regulatory regime, and would all mortgage intermediaries be registered and prepared? What would the Financial Services Authority do if they weren’t? And how would customers react to the new process? For the most part, the mortgage industry has coped well with the added complexity and bureaucratic requirements of regulation. Whether borrowers feel more comfortable now in assessing the risks involved in mortgage borrowing after reading their Key Facts Illustrations is unclear but at least it does not appear to have had an adverse effect on borrowing. There is some evidence that the details included in KFIs may need to be simplified to meet the FSA’s principle of treating customers fairly. On the whole, the rules set out in MCOB governing financial promotions have been adhered to. And, as is often the case when it comes to regulation, Tlenders and brokers have been quick to report any potential misdemeanours by their competitors to the relevant authorities, resulting in a more careful approach to selling financial services. The FSA has made clear its intention to apply its rules strictly. For example, its mystery shopping survey results on how lifetime products were being sold showed how seriously it takes the development of more complex market sectors. This has led to some useful work by the Council of Mortgage Lenders and some lifetime lenders to ensure the sales process is as clear and fair as possible. The industry has the will to provide the best possible products and services and it is steadily establishing the most efficient ways of doing this. The impact of the economy on the mortgage market has not been quite as marked as had been feared. It is true that, as expected, demand has declined but this is certainly not the complete collapse in borrowing some forecasters were anticipating. And it ignores the fact that since the early months of this year demand has been strengthening slightly. So why has the market proved so much stronger than was feared? First, the trend in the economy was not so adverse as it might have been. Second, commentators underestimated the underlying strength of the mortgage market. And while it was expected that the MPC would raise interest rates above 4.75% last September, they remained at that level from August 2004 through to the cut last month. This stability in rates must have helped to stabilise mortgage demand but this result is somewhat paradoxical as it was the weakness of consumer spending that prevented the MPC from raising rates. And much of the weakness in consumer spending arose from the slowdown in the housing market in the final quarter of 2004. But more significant has been the underlying strength of the housing market. A collapse in the market, accompanied by profound falls in house prices, was predicted by commentators who believed that the housing market was the subject of a speculative bubble and that house prices were seriously overvalued. It increasingly appears that this analysis was wrong. There are three reasons for believing this to be the case. First, we “It is true that demand has declined but this is certainly not the complete collapse in borrowing some forecasters were anticipating last year”find little evidence of a speculative bubble in the recent strength of the housing market. A bubble occurs when people start to buy investments in the belief that they can make a quick profit from rising prices. In the short-term, this speculative demand will drive prices still higher and, for a short time, the argument is self-fulfilling. Eventually, and usually sooner rather than later, no new buyers can be found and prices fall sharply. All our anecdotal evidence from the market suggests there has been little speculative buying in the housing market. Buyers in the middle of 2004 were paying higher prices than they would have done in 2001 or 2002. But they have been prepared to extend their borrowings to a greater extent than previously – and no doubt by more than they would have ideally wished. But their purchases appear to be based on rational decisions. A typical response from buyers when paying more for a property than valuations suggest has been that the property is the best they have seen in six months of looking and is the type of property they want. They don’t want the sale to fall through or spend another six months looking for something else they like. Much the same applies to the much-maligned buy-to-let sector. There are, no doubt, a few investors who have bought on the expectation of rising prices and made a profit. But there is a limit to which such speculators can bid up the price of property. Lenders insist that the rents derived from the property more than cover the mortgage costs and this clearly caps the degree to which prices can be bid upward. And surveys consistently record that the vast majority of buy-to-let loans are held by investors who hold their properties for the income they generate and for the long-term capital gain to be expected in the next 10 to 15 years. The second and probably most significant factor suggesting that there will not be a major fall in average house prices is that it does not appear that prices are markedly overvalued. Contrary to simplistic analyses of the market, the affordability of housing remains much in line with its long-term trend. While the house price to earnings ratio has risen to record levels, the cost of meeting mortgage payments only represents around 20% of households’ income – a proportion that is comfortably manageable. It is only when average mortgage costs rise to levels above 30%, as they did in the late 1980s, that the risk of triggering sharp falls in house prices, as in the early 1990s, becomes a serious threat. Driving the stability in mortgage costs is the low level of interest rates. And this brings us to the third reason for believing house prices will not collapse and that mortgage demand will continue to at least maintain its current level – interest rates have passed their peak for this cycle. The MPC may only have voted to cut rates in August by five to four, but the base rate is now 4.50%. And while it is unlikely that there will be another cut in the short term, it is also unlikely the MPC will raise it again. There is nothing happening in the economy that is likely to lead any of the five members who voted for a cut in rates to believe rates should be higher. Peter Charles is chief economist at Mortgage Express
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