The end of the Bretton Woods agreement in 1973 removed the requirement for money to be backed by a store of value such as gold. As a result the world’s money supply increased at an exponential rate with paper money being created at will. The flood of paper money into the world’s banking system allowed banks to create credit easily and therefore to lend money easily. Individuals and corporations have taken on huge loans to fund purchases or to make investments. When the stock markets crashed in 2000, property emerged as the preferred investment choice and the low interest rates which followed added fuel to the property investment fire.
With vast sums of international money chasing a limited supply of property, prices rocketed during the first half of this decade. A property bubble emerged in which buyers and so called investors suspended their judgement and looked beyond the need for a working business model in the remote hope of becoming rich quick.
As is usually forgotten, the property market exists within an all dominating economic cycle however. An economy which once prospered will one day reach the limits of expansion and begin to contract. At the time of writing (July 2007) that turning point seems to have arrived. There are increasing indications in the daily press of bankruptcies, escalating mortgage defaults and failures of sub-prime mortgage providers. These issues are beginning to be factored into equity prices as investors realise that the future may not be as rosy as anticipated, leading to significant stock market falls in high trading volume. It is certainly my opinion that the downturn has already begun and it is only a matter of time before a severe shock to the financial markets scares the banks into cutting back their lending.
We have seen that, for the average buyer, house prices are currently around double their affordability at traditional lending multiples. So if banks curb lending and return to more normal multiples, property prices would be forced to dislocate, falling 50%. There would be no buyers at the higher valuation, they simply do not have access to enough money. A 50% crash may seem extreme or unlikely, but this number isn’t an estimate or a figure pulled our of thin air, it is based solely on the amount an average person could borrow in a world of tried and tested, commonly accepted, traditional lending multiples. In addition to this simple numerical analysis, past experience tells us that there is a straight relationship between bubbles and financial crises. As homeowners and investors begin to lose their jobs, the scale of their massive borrowings and the fragility of their financial position will become clear, setting off a terrible vicious circle of falling consumer spending, falling corporate profits, increased job losses, increased loan defaults, further lending curbs and tumbling property prices.
In the previous section I summarised that a continued rise in prices is not possible due to a definite cap on borrowers’ affordability. That a plateau is possible but only if economic conditions remain stable over the medium-term (5-10 years or so). And finally that any weakness in the economy will cause banks to curb lending. Given the high debt levels of the British population even minor economic weakness could have a devastating effect on lending and thus house prices. So the only question you now need to ask yourself is: “Do I want to buy a house in the current environment where high property prices are backed solely by massive debt, when the emergence of any economic weakness could be enough to cause a contraction in credit and a 50% fall in property prices?” I hope you choose the path that is right for you.