Friday, March 21, 2008

We're In The Money. Not.

Headlines about breadlines may be making a comeback

As the temples of Mammon crash around us, even the BBC is getting up to speed with the lingo of financial distress. The other morning I even heard them gleefully discussing deleveraging, and how it's driving the cataclysm.

Anyone who's read the property supplements knows how leverage works: borrow as much as you possibly can to buy a portfolio of off-plan executive flats in Liverpool Waterside, 10% upfront and the rest on completion; by the time they're built, the price has gone up by 20-30% of the contracted price, you sell immediately and pocket 200-300% profit on your 10% stake; and that's on cash that you'd mostly borrowed in the first place. Return on your equity stake, maybe 500-1000%. The outstanding power of leverage.

Actually of course, you don't even need to do that. You just buy any old property with a bog-standard mortgage, and hey presto, you're leveraged . Your liability is fixed (save for the trifling matter of interest), and your leveraged upside from the assured rise in house prices is infinite. It sure beats working for a living, as you can tell from all those telly progs showing how anyone can be a property developer.

You get a good idea how powerful this effect has been by looking at the growth of household wealth in Britain. The ONS publishes stacks of data on this, but the best overview is produced by... well, waddyaknow, no-we're-not-going-bust HBOS.

They show how in the last decade, the gross value of our houses and flats grew by 216%, reaching just under £4 trillion. That's getting on for three times our annual national income. And a staggering £2.5trn of it has showered down on us in just the last 10 years.

On a family level, that means the average British household has copped about £100 grand over the last decade from the increase in property prices, or around £10 grand pa. We're now sitting on an average £160 grand apiece in property assets. No wonder we've been feeling so flush for so long.

Of course, we have borrowed more- we now have that widely trailed £1.3 trillion of personal debt, of which £1.1 trillion is mortgage debt.

But even taking account of that, our total net assets - including financial assets such as pensions - have increased by £3.5 trillion over the last decade. And with net assets now standing at £250,000 per household, we really never have had it so good:

If only it wasn't for that nasty deleveraging business...

Because now deleveraging is the order of the day, lenders don't want to lend on those Liverpool executive flats any more. In fact, they don't want to lend on anything any more. Buy-to-let landlords can't sell on completion because nobody can borrow the money to buy. Worse, the landlords can't borrow the money for their unpaid 90% either. Defaults... repossessions... firesales... suddenly the whole marvellous wealth creation process starts unravelling.

And how do the numbers look?

Bad. Let's say we get a 10% houseprice fall (quite modest- see here for housepricecrash's survey of predictions). That's £400bn wiped off household wealth, or just under £20 grand per household.

Well, you say, a £20 grand "notional loss" isn't too bad. Ah, but remember households have been used to making £10 grand pa: they've been used to being able to borrow more against their rising property value if they want a little mad money: suddenly they can't.

And remember too that their existing debt doesn't go down: that leveraging thing now works just the same but in reverse. Belts need tightening drastically.

It's all known as the wealth effect- the impact of changes in wealth on spending. Estimates of its strength vary but a plausible level is around 5% (eg see here)- ie for every £1 of extra wealth, households will spend on average another 5p pa.

Which implies our £400 bn fall in housing wealth translates into a £20bn pa fall in consumer spending. That's around 1.3% of GDP.

Or one Big Hole in Darling's growth forecasts. And one sickening lurch for the rest of us.

PS The splendid Prof Buiter is on cracking form explaining why we taxpayers must not be made to bail out the bankers. But I also love this post, "I hate Mom", from guest blogger Prof Uwe E. Reinhardt.

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