Gordon Kerr is a member of Chipping Barnet Conservative Association and the founder of Cobden Partners, a banking crisis consultancy. Previously, he worked for 20 years in debt capital markets, specialising in derivatives structuring in order to game Basel bank capital rules.
There is no question that Conservatives currently hold the high ground in that most important of electoral battlegrounds: confidence in economic affairs. Even though, as Andrew Gimson recently listed, many commentators have pointed out continued weaknesses in delivery on the pace of deficit reduction, the majority of undecided voters still have far greater confidence in the country’s present economic stewards than the Opposition’s.
But this hard-won public confidence could quickly be lost. The easiest way to lose this confidence would not be by tarrying on deficit reduction (voters know how hard it is to make substantial cuts to structural components of the deficit), but by foolish public words on economic affairs.
David Cameron’s recently reported statement “I want interest rates to stay at rock bottom forever” on the ground that such low interest rates help families to “buy homes that they can afford” is a prime example of such a statement which should not have been made. The lower interest rates become, the higher house prices rise. Houses therefore become no more “affordable” than they were under the prior, higher, interest rate environment because the incremental rise in the capital cost of the house, multiplied by the now lower borrowing rate, negates any saving.
The price effect of interest rate changes on houses is no different from rate impacts on other “fixed rate” asset prices. In capital markets parlance, a distinction is drawn between fixed and floating rate investments. Consider two alternative long term investments. One pays a fixed return of five per cent per annum, the other offers a coupon linked to a floating interest rate reference such as ‘term LIBOR’ (the swap rate) which today happens to be equivalent to five per cent. If term market interest rates go up or down tomorrow, the price of the floating rate bond will not deviate from par, but the price of the fixed one will move inversely and in direct proportion to the interest rate change. The lower the rate, the higher the price will rise, and of course the converse applies – when rates rise, fixed asset prices fall.
This inverse relationship between price levels and interest rate movements of course applies to liabilities as well as to assets such as houses, bonds and shares. Another economically damaging effect of ultra low interest rate levels is that they increase the market cost today of future government liabilities such as PFI contracts, government debt and unfunded pension liabilities.
Of course interest rates are but one of a myriad of factors impacting directional movements of house prices. Others include the supply and demand of houses and buyers, banking systemic solvency, immigration policy and welfare benefits. (Why are the Calais refugee camps filled with people desperate to get into the UK?.) Stripping out all other factors in order to consider only the effect of today’s ultra low interest rates, house prices are constrained from further rises only by the average buyer’s available cash flow (wages plus deposit plus donation from bank of mum and dad) which keeps today’s price levels merely dizzy, as opposed to stratospheric.
The only cap on house prices is the presence of some positive interest rate. Even with official rates at about zero, borrowers are still paying five-ten per cent. If the total interest costs became zero, then any unemployed vagrant would be able to afford a property. If rates became substantially negative, I would give up working and buy Hertfordshire. I would borrow a gazillion and enjoy receiving my monthly mortgage interest payment obligation of a few billion.
Far from an exercise in economic fantasy, the first of these conceits became precisely the reality that prevailed in the US when sub-prime mortgage loans ruptured the western banking system. Although the interest rate was positive, never zero, the contracts offered by lenders capitalised the interest payment obligation so the cash cost to borrowers was effectively zero. This resulted in unemployed Mexican cleaners famously assuming million dollar mortgages, and one Las Vegas stripper taking on multiple 30-year mortgage loans. What a body she must have possessed.
Systemic eruption was not of course triggered by the mortgage products themselves, nor by the loans that were made, but by lenders relying wholly upon valuations of houses and ignoring borrowers’ abilities to service and ultimately repay the loans under a range of different interest rate scenarios.
This appears to be more or less the position towards which UK house prices have been drifting. I am not suggesting that house valuations are inaccurate, but the more we read of lenders designing products which maximise borrowers’ leverage, most recently of mortgages which will be repaid only upon death, so the greater this price bubble will inflate.
At some point in time it is certain that values will fall substantially, which may well systemically stress UK banking once again. This risk has been materially enhanced by years of ultra low interest rates. Our Bank of England Governor, Mark Carney, knows this, which is why back in May he described increasing house prices as the “greatest threat” to UK economic recovery.
In Cameron’s defence, his laudation of low interest rates was not part of a pre-planned speech, but a response to a question in a ‘walkabout’ environment. Nonetheless, I would urge him to reconsider his general response to such comments and questions.