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Fannie Mae and Freddie Mac nationalised

It is curious how people with an absolute faith in the free market have suddenly turned into socialists now that things have turned nasty. But the market points to a reality – that US housing values (in reality, the price of the land that houses stand on), was just a bubble value. Either the price must adjust to reality or the currency must be debased to the point that inflation has the same effect. Nationalisation is just delaying the inevitable for a while.

What is reality when house prices are concerned?

The purchase of land is the purchase of an income stream – its rental value. Rental values are fairly stable, though of course subject to long term trends. The relationship between the rental values and capital values depends in the first instance on interest rates, which of course are variable over time and extremely difficult to forecast reliably. But to this capitalisation of income must be added a second factor, the expectation of future higher income. A third factor then comes into play – expectations of rises in capital values. There are further speculative factors too. There are expectations of inflation (debasement of the currency) and the prospects of changes in planning allocations to permit “higher” land use? All these factors piled on top of each other encourage borrowing and lending for land purchase, on the security of land prices already pumped up by expectations. The borrowing/lending cycle grows at an accelerating pace into a classic bubble, to the point that actual rental incomes are far short of the cost of servicing the debt, which people have taken on in the hope of unending growth. Of course, in the end the bubble bursts.

House prices can be considered as realistic when the speculative froth has been blown away. If interest rates are five percent, then a realistic price would be 20 times this amount. This is known as the years’ purchase (YP). Some expectation value on top is reasonable, but what is not realistic is when expection of capital value is built into present prices.

The house two doors away from me in the middle of Brighton illustrates the problem perfectly. It is let to four young people for £1500 a month, which represents income of £15,000 a year, net of expenses but before tax. With interest rates at 5%, then one would need to invest £300,000 in a savings account to achieve this return. It would be reasonable to pay a little more than £300,000 for the house because rents can be raised a little to keep pace with inflation. But not much more – certainly not more than £350,000. But at the top of the boom neighbouring properties were changing hands at £390,000 and they needed to fall by at least 10% and possibly as much as 20% before they are at a realis. The Halifax survey shows that the fall has been 12% over the past 12 months, which in itself would mean that the fall may not have much further to go.

But there are now other factors to be taken into account, such as the number of recently completed properties that have come onto the market. Some people have bought purely for the prospect of a profit and left the properties vacant. When these have to be brought onto them market, prices will be further depressed. Then there is the shortage of finance itself, which will exert further pressure on prices.

Until the mid-1960s, housing finance was restricted to the amount that building societies had available to lend, which depended on savers’ deposits. A further restriction was that the amount that could be lent was about 2.5 times one salary. When wive’s incomes began to be taken into account in the mid-1960s, the predictable effect was to create the first of the post-war housing (land price!) bubbles which ended in 1974. With the banks having caught a cold, it will be a while before they abandon their present attitude of extreme caution, so that too will keep a cap on things – so much so, possibly, that there may be good bargains available to be snapped up by cash purchasers.

Of course I am speculating, which I have put this in the blog section.