The Financial Policy Committee (FPC) of the BoE is required to produce a twice-yearly Financial Stability Report (FSR) click here to view.
The November report is very striking for its strong focus on the housing market. One can read a number of broad messages into the report’s detailed commentary and the Governor’s Opening Remarks.
The FPC is clearly preparing the ground for higher interest rates – which the unexpectedly strong economic recovery and earlier-than-expected fall in unemployment has now brought forward – and is concerned that low interest rates have built up conditions which will be adversely hit by higher rates, including higher house prices and household indebtedness;
It is also clearly concerned that house price inflation could become excessive and is putting down a marker that it will act should this happen, mindful that once rapid house price inflation gets under way it is difficult to rein in;
It sets out measures (current and possible future) to address potential future housing market problems without jeopardising wider economic recovery (a familiar problem with the UK economy). In his opening remarks the Governor said: “By reinforcing financial stability, they [the package of measures] further reinforce the MPC’s ability to provide exceptional monetary stimulus to the entire UK economy for as long as it deems appropriate.”
It should be said that because the FPC’s focus is financial stability, its report makes for gloomy reading because it attempts to identify all the major risks to financial stability. There can be no doubting the FPC has some pretty serious worries, but this is a pre-emptive strike and a forewarning, not a prediction of housing disaster.
“There is little evidence of an immediate threat to stability. But risks may grow if stronger activity is accompanied by further substantial and rapid increases in house prices and a further build-up in household indebtedness, which is already elevated for some households. These risks would be accentuated if underwriting standards on mortgage lending were to weaken as has been the case in previous house price cycles.”
The report’s warnings, and the early withdrawal of the Funding for Lending Scheme (FLS), present us with an interesting policy situation: the Bank’s worries about undue exuberance in the housing market and excessive growth in house prices vs the Chancellor’s efforts to boost housing demand through Help to Buy, especially the Mortgage Guarantee scheme (HtB2).
The FPC lists a number of “tools available to mitigate risks from the housing market” (summarised on page 64 of the FSR):
Actions already in train
FPC recommendations to raise bank capital requirements;
Stress test of UK banking system in 2014 “including resilience to housing market stress”;
Mortgage Market Review (MMR) implementation from April 2014, which includes stress testing of affordability;
Immediate Additional Steps
Ending temporary capital relief on household lending under the FLS;
Ending FLS for household lending from end January 2014 (previously end January 2105);
Requiring mortgage lenders to take account of any future FPC recommendations on appropriate interest rate stress tests in affordability assessments (i.e. beyond those already required by the MMR).
Recommendations to Treasury re Help to Buy, including whether the house price cap (£600,000 in England) and fee Treasury charges lenders remain appropriate;
Assessment of impact of HtB on financial stability at the end of three years plus “the FPC also has the power to make recommendations on the scheme at any time”;
Recommendations on bank capital requirements on residential lending;
“Recommendations on maximum loan to value ratios, loan to income ratios, debt to income ratios or mortgage term to restrict mortgages of a particular type”.
In the report the FPC identifies a number of housing and related risks to financial stability.
House prices are already rising quite strongly, across most regions, and especially in the already most expensive areas, and further increases are expected – the prolonged period of very low interest rates has contributed to the recovery in property prices in the UK and elsewhere;
Household indebtedness is already high (UK household debt/income ratio higher than in US and euro economies), made more attractive by very low interest rates, particularly among a sizeable minority of especially-heavily indebted households, in part a consequence of very low interest rates - this makes households vulnerable to an increase in interest rates;
The FPC is worried that lender underwriting standards will weaken as the market improves, as has happened in the past;
It is also concerned that borrowers will borrow at higher LTVs as prices rise, and increase their borrowing by extending the length of their mortgages – high LTV mortgages are already more readily available, and recently more than half of all FTBs are taking out mortgages with terms exceeding 25 years;
It is also worried that some lenders could again become reliant on wholesale funding – the sudden unavailability of wholesale funding was a major reason for the lending crash from 2007;
Higher interest rates and a housing market downturn would pose risks to the banks, especially as this could be associated with broader economic risks, including “if high demand for housing during the preceding upturn were to generate an excessively sharp increase in construction activity, perhaps related to a relaxation in lending standards to construction firms. A subsequent housing downturn could then lead to an overhang of unsold properties and greater defaults.”
A decline in house prices would also lead to weaker residential investment (part of Fixed Capital Formation within GDP) and consumer spending (by far the largest component of GDP).
The comments on construction activity and lending standards to construction firms highlight how the report attempts to look at all possible scenarios, not just currently emerging trends.
The report refers a number of times to “uneven” and “sudden” interest rate increases. For example: “Interest rates could rise by more, and more abruptly, than banks typically considered in their responses to the FPC’s June 2013 recommendations on interest rate risk.”
The report notes that “rising house prices in a low interest-rate environment could increase household vulnerabilities”, and says “the risk of a price correction and a housing downturn is likely to grow the higher house prices rise”. While prices remain below their 2007 peak on some indices, measures such as the house price/income and house price/rent ratio currently lie above historical averages. “Were house prices to rise further, in line with the path suggested by short-term indicators, the deviation might be greater still. In previous episodes, rapid gains in UK house prices have tended to be persistent, perhaps reflecting self-fulfilling expectations of future price rises”. In other words, the FPC is concerned that if rapid house price inflation gets under way, it would be difficult very to bring back under control – which implies a pre-emptive strike may be needed to avoid such a build-up in the first place.
John Stewart Director of Economic Affairs
Home Builders Federation
London, SE1 9PL
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