26 March 2020

How to shore up fragile households before the next crisis hits

By

Many households face coronavirus in a precarious state. Almost half of working-age adults have essentially no savings; likewise, household debt is now at 130% of national income, up from just 80% in the late 1990s.

Perhaps most of all we are made vulnerable by another, more long-term crisis: rising house prices, diminishing home ownership, and a growing, expensive private rental sector – a large part of the reason many households find it so difficult to save.

It is often said that Brits “hold most of their wealth in their houses”. At times like these we are reminded that housing wealth is an illusion. Proper wealth is value stored that can later be used to buy goods and services. Housing “wealth” can only be used to buy goods and services if it’s no longer being used to buy housing services: in other words, you can eat your house, but then you’ll have eaten your house.

Households would be better prepared for crises like these were they able to devote fewer resources to housing, and more to saving and investment in productive, income-bearing assets. In the long run, then, the cost of housing in both the owner-occupied and rental sectors must come down to improve household robustness.

The crisis has particularly underlined the relative vulnerability of private tenants: owner-occupiers have been able to suspend their mortgage repayments, whereas tenants can take small comfort in a temporary protection from eviction. Yet owner-occupiers are also vulnerable in a crisis that threatens to pull down housing prices, and there’s still plenty of time for that to happen. Even reasonably small falls in prices can destroy the lifetime savings of highly leveraged owners.

As there’s always some crisis or another around the corner, public policy in the wake of this pandemic ought to focus on reducing household financial fragility. From a housing perspective, that means more owner-occupation and ideally a lower-risk means of buying those houses than is offered by debt-financing.

Housing costs have increased mostly because the relatively expensive private rental sector has expanded and the relatively cheaper social rental and owner-occupied sectors have contracted. Private rents as a proportion of income haven’t changed much since the early 1990s, but there are more private renters. Meanwhile, mortgage repayments as a proportion of income are only a little higher than they were half a century ago, because lower mortgage interest rates are balancing higher house prices.

Ownership is ordinarily in the financial interest of the household, then, because it’s both cheaper and less precarious. That falls apart, however, if we experience large price drops, such as those coronavirus threatens to bring about. Admittedly, price falls from a shock such as this one are likely to be temporary, though that will be of little comfort to households unable to meet their repayments and forced into sale at negative equity. For now we can only hope that lenders will forebear.

But there is another reason to worry about large and permanent price falls. A recent Bank of England paper estimated that a one percentage point increase in the base interest rate would result in an 18% house price depreciation; a two percentage point increase in the base rate would result in a 31% house price depreciation. Price falls of this magnitude would make millions of British homeowners technically bankrupt, which they’d probably resent even if they could keep up their repayments and avoid actual bankruptcy.

As it stands, debt-financed home ownership requires the household to gamble its future on the path of house prices and interest rates. One solution to this problem is offered by economists Atif Mian and Amir Sufi in House of Debt. They propose a ‘Shared Responsibility Mortgage’ which acts like an equity mortgage: the mortgage principal and monthly repayments fall with the house price, preventing the homeowner from falling underwater. The lender is compensated for providing this downside protection by taking a small proportion of any capital gain on sale.

Mian and Sufi’s work was motivated by the Great Financial Crisis; they believe that the transmission mechanism from the financial crisis to the real economy wasn’t so much via a contraction of lending, but through house prices. Specifically, after house prices fell, those homeowners that found themselves in negative equity sharply contracted their consumption spending, causing a recession. Equity financing would break the link between falling house prices and potential recession.

Should we find ourselves with a house price crash after this crisis, the Government and Bank of England could move urgently to convert existing mortgage debt to equity. The Bank could offer to replace mortgage debt held by the banking system with the government bonds it owns as a result of its quantitative easing to allow mortgage write-downs of the same proportion as the house price falls – on the eve of this crisis it held bonds of value equivalent to one third of outstanding mortgage debt. Should house prices recover and the mortgagees once again become liable for the full principal, the trade could be reversed. Unlike after 2008, both borrower and lender would be relieved, rather than lender alone.

It is up to the economics profession and the Conservative Party to prove that housing can be handled by the market in a manner which doesn’t fleece productive employees of their income in precarious and expensive rental contracts, diminish their ability to save, nor require them to gamble their lifetime savings.

If they don’t, the public might yet conclude that housing should be taken out of the market altogether, and put their faith in a party promising to confiscate and abandon private property in the name of ‘fairness’. That might sound like the stuff of fantasy, but given the scale of this crisis, the economic and political landscape could soon look very different indeed to anything we’ve experienced before.

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Conor Walsh is a Researcher at the Centre for Policy Studies

Columns are the author's own opinion and do not necessarily reflect the views of CapX.