Credit Expansion: How New Money Broke the Housing Market
When banks create new money through ever larger mortgages, house prices stop reflecting scarcity and start reflecting credit expansion - with all the distortions that follow.
This article was written by an experienced insider in mortgage lending. It is being published anonymously.
Of the many factors that affect house prices, the one most often cited is a huge supply-and-demand imbalance, with demand far outstripping supply and driving prices ever higher. On that view, the solution is to build more homes, correct the imbalance and therefore prices will fall. Whatever the merits of building more homes, this story misses a crucial point: the real story is one of credit expansion. For decades, banks and regulators have allowed ever-larger mortgages to be created as new money. This new money has broken the link between people’s earnings and the cost of buying a home. In modern Britain, the availability of mortgage credit is the main factor that drives house prices.
Most houses are bought with a mortgage and the amount a buyer can offer is limited by:
Personal / family savings + mortgage credit available from a lender + any credit available from Government schemes
i.e. credit availability strongly affects how much buyers can offer and therefore, the final price paid.
In the mid-1990s, average house prices were around three to four times average income, with mortgage lenders typically offering around three times the main income and one times the second income. These limits were set by each lender’s own appetite for risk. A couple both earning £30,000 could therefore borrow about £120,000 as the basis of an offer. Using a lower multiple for the second income reduced reliance on that income and left more flexibility for life events, such as starting a family.
Between the mid-1990s and the run on Northern Rock in September 2007, competition in the mortgage market became intense. To grow their balance sheets, lenders had an incentive to lend at ever higher income multiples. As a result, the full second income was included, and loan-to-income multiples rose sharply. The same couple mentioned above could now borrow around six times their joint income, giving them about £360,000 of available credit. Interest rates were coming down (helped by the Bank of England inflation target moving from RPI to the lower CPI in 2003), and this counter-balancing impact on monthly payments was used to justify the higher debt.
The higher lending multiples created several serious problems, notably:
When lenders grant loans, the money for the loan is created with the tap of a key, with the lender only required to hold a level of capital against the loan. Each uptick in loan-to-income therefore creates more money. The Cantillon effect allows the first borrowers at each change to use the extra funds to buy a bigger property, but very quickly all prices rise, and the same people end up chasing the same properties at higher prices, with have-nots left further behind.
The cumulative effect was that house prices trebled in 10 years, with average prices of eight to nine times average incomes. This put home ownership out of reach for many people and reinforced the belief that property prices could only rise, which further encouraged borrowers, including increasing the popularity of buy-to-let loans, pushing prices higher again.
Borrowers taking high income multiples are vulnerable to increases in interest rates and unexpected life events. Most borrowers take two- or five- year fixed rates, which are variable in all but name. For example, borrowing £360,000 at 3% over 25 years with a two-year fix requires an initial monthly payment of around £1,707. If rates are 6% two years later when the fix ends, the payment will increase by more than £500 per month.
Following the financial crisis of 2007-09, interest rates were cut to near zero, and new regulations were introduced. These rules generally limited new lending to 4.5 times joint income, while allowing 15% of new lending above that level. This was still much higher than was common in the mid-1990s. These higher limits were again defended on the basis that interest rates were very low and this was the “new normal”.
Then during Covid, interest rates rose sharply, and this return towards historical averages should have led to lower loan-to-income multiples for new lending. It did not. Higher interest rates mean higher monthly payments, so affordability should have become a constraint. Instead, lenders responded by extending maximum mortgage terms, often up to 40 years, so that higher loan amounts could still appear affordable.
In recent years, the rule limiting new lending above 4.5 times loan-to-income to 15% has been relaxed for individual lenders and stress rates used to test mortgage affordability have also been eased. Both changes allow people to borrow more and were welcomed by some as an enabler to home ownership; the reality is yet another dose of the insidious poison which has made the patient so ill already.
Lenders often point to low arrears figures as evidence that their lending is responsible and affordable, but this misses many dangerous facts. Borrowers with large loans over long terms are highly exposed to interest-rate rises. Some of the usual tools to help them in the event of rises, such as extending the mortgage term to reduce monthly payments, have already been blunted by using a long term at the outset. Falling birth rates, inadequate pension saving and falling living standards are not visible in arrears figures. Still, they are all symptoms of the problem and very real in day-to-day living, as mortgages drain lifetime incomes.
Lenders, regulators and government have all responded to the incentives placed in front of them, which is why the incentives must change. The housing market will not be fixed by adding more credit to a system already distorted by too much credit; it requires sound money. With sound money, lenders could not keep creating ever larger amounts of credit and directing it towards a single asset class. House and land prices would be lower as a result, capital could be directed to productive activity, and people could save in a store of value they could trust. It is a change only likely to be facilitated by crisis.
This article was written by an experienced insider in mortgage lending. It is being published anonymously.