Sunday, 16 September 2007

Forecasting the housing crash

Fionnuala Earley, Nationwide's group economist, said this weekend she expected house price inflation to slow to around 3 per cent next year. The forecast represents a major downward revision for Earley, who has a long and dubious history of talking the housing market up.

Nevertheless, one could be forgiven for thinking that this even this forecast of modest real growth seems somewhat disconnected from this summer's events. Last Friday, we witnessed the first run on a major high street bank in living memory. Over the last year, interest rates have risen sharply. Throughout the global banking system, there are billions of dollars of worthless US sub-prime mortgages. No one knows where this rubbish is lurking. However, everyone knows that it is out there, threatening the financial viability of any institution that has it on their balance sheets.

As a consequence, the interbank market has ground to a halt; fear is the order of the day. Moreover, every conceivable housing market indicator, from house price to income ratios down to rental yields are screaming one message - the UK housing market is at the tail end of an historically unprecedented bubble.

Yet, despite all this, the Nationwide still thinks that house prices will still keep on growing. Such forecasts from the mortgage industry need to be first decoded and then re calibrated. Lets start by decoding the 3 percent forecast.

Earley and others like her in the mortgage industry now work in a deeply conflicted environment. The needs of her employer struggle desperately with the reality of a collapsing bubble. The Nationwide need house prices to keep on rising. It is a frantic need, for if prices stall or start to fall, the Nationwide and institutions like it, will be faced with a avalanche of repossessions. Far too may home buyers have gambled their financial futures on ever appreciating housing values; buy-to-let idiots, second-homers, and housing-as-a-pension speculators. If these gamblers lose faith in housing,at a minimum, profits will collapse and if repossessions really take hold, the very existence of Nationwide is called into question.

The fate of the Nationwide is now trapped in the circular reasoning that sustains the housing market. Prices keep on rising, because people believe they keep on rising. People believe they keep on rising, because they keep on rising. Once this circle of lunacy is broken, housing market fundamentals re-assert themselves. Ratios return to long run equilibria, and this all points in one direction - downward.

Earley's role here is clear - her forecasts must keep the circle of speculative reasoning intact. So her forecast must always show positive growth. However, any attempt at inflating the growth rate threatens the credibility of the message. It would be counterproductive, for example, if the Nationwide were to suggest 10 percent growth. People are beginning to sense that something is going seriously wrong with the housing market, and these cracks can not be pasted over with a rosy press release announcing 10 percent housing inflation next year.

The three percent number wasn't plucked out of nowhere. It is, in fact, one percent above anticipated CPI inflation. In other words, it is the absolute minimum figure that Earley could present that would be acceptable to her employers while retaining a semblance of credibility. The public message is "don't worry, folks, prices are still going to rise". Nevertheless, the decoded message is stark; in reality housing prices will first decelerate rapidly, and then begin to fall.

So what about re-calibrating this 3 percent forecast; can we infer anything about what Earley and her ilk really think about house prices next year? Privately, Earley would probably admit that a crash is immanent, and the Nationwide should begin to prepare for some stormy and difficult market conditions. In other words, this 3 percent forecast should be re-calibrated into a significantly negative number.

Economic forecasting is a dubious business, where self interest and feigned optimism often plays a crucial role. Nevertheless, the message from Earley isn't hard to read; prepare for the worst. This week's disintegration of Northern Rock is but a prologue for an all-encompassing and comprehensive housing market crash. Any home owners ignoring Earley's message, do so at their own peril.

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