The Bubble Bursts

This article appeared in the Economist edition of 10th April 2008, and talks about the downturn the British housing market has taken in recent times. Between the first quarters of 1997 and 2007, the country witnessed a ten year long boom, where at an average, house prices went up by 215% as measured by the Nationwide’s index. However, these “happy days” are long gone and today the annual rate of growth has dropped to a surprising 1. 1%, which is the lowest since 1996, and in March 2008, prices fell by 2. 5%. The housing market has definitely started its downward spiral.

This article discusses the scenario and the reasons why the Bank of England’s quarter-point cut in interest rates is not expected to help matters much. Discussion on the actual rate of drop in prices shows that this rate might even be as high as 10%, as stated by the estate agents who have access to more recent knowledge than mortgage lenders do. In the context of the booming rates of growth Britain saw till 2007, this is significant cause for worry. On one hand, most home owners have earned a great amount of equity in the past ten years and can leverage this to protect themselves as well as their lenders from a serious crisis.

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Experts say that there are a very small percentage of households whose mortgages would exceed the value of their houses, if prices fall by 20%, and the rest will be shielded from the drop in prices. On the other hand, the premise remains that this is not the end of the drop in prices, this trend will in most probability continue, meaning that prices will fall even more. At present, the market boom has led to excessively overvalued homes. The International Monetary Fund said that houses in Britain are priced at about 30% higher than can be attributed to usual determinants of prices.

A key reason for this overvaluation is the access to cheap credit because investors were not driven to demand high returns for the risk they took on, hence decreasing the cost of borrowing and increasing the availability of funds. While this has not led to problems till now, the future appears murky: research shows that about 13% of outstanding mortgages in Britain are held with people who either have “spotty credit records account” or were not required to prove their income at the time of borrowing. Also, landlords account for another 10% of the mortgages.

Therefore, only time will tell if investors are quicker to sell of their property as compared to people who bought their houses to live in, when market conditions really go sour. The credit condition today has dramatically changed as the cost of borrowing has substantially increased. Northern Rock was just one example of lenders who had no option left but to withdraw from the market. Lenders have tightened their terms and risky borrowers are slowly left with a increasingly lower amount of mortgages available to them.

The shift in the balance of power from the borrowers to the lenders as well as the investor expectations in the property derivatives market of a housing price fall of 20% (in real terms) are both indicators for troubled times ahead. Estate agents have to work harder to push sales. As prices keep falling, people begin to expect lower prices, and this creates a “self-fulfilling downward spiral” which will ensure that the 10 year boom in the housing market is finally beginning to end.

References “The Bubble Bursts”. The Economist. 10th Apr 2008, 387. 8575: 63-64.