Credit Crunch and Its Impact on Real Estate Market of the UK - Dissertation Example

? Credit Crunch and Its impact on UK's Real E Market Definitions Credit crunch is a term that de s a situation where there is a tightened regulation from banks which makes lending of loans and credit, to customers, difficult. This means that the financial institutions or banks and credit card companies are not giving loans and if they are giving the loans -it is at much higher interest rates. The loans are being given to customers and businesses- who have both excellent credit report and have lots of assets for the collateral. So during credit crunch the bank is giving loans to the people who basically doesn’t need loan. Credit crunch is also being termed as the cyclical decline in credit demand and it is often suggested that the cycling swing is reinforced by the structural changes in the demand for the credit but fundamentally credit crunch is related to supply of credit, as opposed to the demand for it. Bernanke and Lown (1991) define a credit crunch as a decline in the supply of credit that is abnormally large for a given stage of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch. The credit crunch is the result of multiple factors. These multiple factors adversely affect the ability of the banks to supply credit at a time when banks’ ability to adjust to these factors was unusually limited. A credit crunch that continues for a long time is actually opposite of easily available and plentiful lending practices .These cheap lending practices are sometimes called “Easy Money” or “Loose Credit” .As it been stated earlier that credit crunch is a cyclic process . During the upward phase in the credit cycle it is seen that the prices of the assets undergo lot of fervent competitions .Upward credit cycle is also marked by the presence of leveraged bidding with inflation in a particular asset market. These all situation can then lead to formation of a speculative price bubble. During the upswing of the cycle increase in the money supply happens because of new large debt creation. This in turn stimulates the economic activities. Finally there is also chances of temporarily raise in economic growth and development.(Cooper,2008) The reason of credit crunch can be diverse. Few of the reasons are given below: 1. If there is an anticipation about the decline in the value of the collateral. The collateral is used by the banks to secure the loans that are taken. If the decline in value continues then it will lead to credit crunch.(Bizer ,1993) 2. If there is perception in the market about the risk of insolvency of other banks in the banking system. In this situation the traditional financial institutes will tighten the credit lending regulations (Kleege and Stephen,1992) 3. When the central government is imposing direct credit controls or are implementing monetary changes then lending of the loans will be done very warily by the goverment. (Grant,1993) 4. When there is a prolonged carelessness in lending the loans. The process of lending the loans is inappropriate and doesn’t take into account the intricacies of market and interest rate. This leads to losses to the lending institutions. The debtor is not able to pay the debt and finally the financial institutions will reduce the availability of credit. The prolonged defaults by the debtors leads to credit crunch.(Peek ,Joe and Eric,1993). 5.When the assets which were overpriced, before ,suddenly sees a sharp fall in their prices then it leads to financial crisis because of price collapse. If this price collapse continues then many banks and investors will face insolvency and bankruptcy. The financial institutions will become more alert .As the result the financial institution restore to restrict the regulations for lending the loan and as a result the market will face the credit crunch.( Rosenblum.1991) The last two points were the main reason for the recent credit crunch that struck the world’s economy. This was caused due to the bursting of housing bubble in United States of America which soon engulfed the whole world into its crunches. When finally struck by the credit crunch Jim Slater , British business executive and author, said “ A crash does not come knocking at the front door by appointment." which was quoted in Treasury of investment wisdom . Hence this recent financial crisis and credit crunch took many people by surprise. Ben Bernanke, United States economist and chairman of the United States Federal Reserve , confessed "I and others were mistaken early on in saying that the subprime crisis would be contained.".(Bernanke ,2008) The term subprime actually refers to situation where the subprime borrowers because of their poor credit qualities and abilities has led to weakened credit histories .This leads to greater risk of loan default. This global financial crisis has hit the world so hard that On November 3, 2008, the European Commission at Brussels predicted for 2009 an extremely weak growth of GDP, by 0.1%, for the countries of the Eurozone (France, Germany, Italy, Belgium etc.) and even negative number for the UK (-1.0%), Ireland and Spain. United Kingdom had to struggle a lot to get out of this financial crisis and is still struggling. Especially the real estate market of United Kingdom suffered a lot. Introduction It's a crisis if everybody calls it a crisis. Yes indeed! Many economists did agree that the financial meltdown that struck the world during onset of 20th century was a “ Crisis “ .They also pointed out that this crisis is as grave as the “Great Depression” of 1930 (Reuter,2009) . Alan Greenspan, US economist and former chairman of Federal Reserve , quoted that "The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the Second World War."(Greenspan, 2008). The whole story begun in United States of America and was basically triggered by the liquidity shortfall that happened in United States banking system. (Bloomberg , 2008). This had a huge ripple effect in financial and economical situation of each and every country. This Crisis resulted in crumbling down of huge financial institutions. Because of poor state of other financial institutions national governments of different nations had to come forward to bailout the banks. The stock market around the world saw a big downturn .These all circumstances contributed to the failure of the key businesses along with the significant decline in the economic activities .The final result of all these series of events was “The global economic recession 2008”.(Baily and Elliot ,2009). During the global economic recession the securities in the global stock market suffered great losses during 2008 and early 2009 .This happened because the credit availability had declined. The highly tightened situation damaged investor’s confidence and resulted in decline of international trade. The real estate market suffered a lot which resulted in evictions, foreclosures, prolonged vacancies and increased real estate prices.(World economic outlook, 2009). The bursting of the United State housing bubble peaked in approximately 2005-2006 and after this the already rising “subprime” and ” adjustable rate mortgages” began to increase rapidly .The banks started giving more loans to the potential home owners. The housing prices also began to rise rapidly and bank encouraged the home owners to take up considerably high loans with a trust that they would be able to pay it back quickly. The banks overlooked the interest rates. In 2007 when the interest rates started to rise the housing price started to drop drastically. The interest rate steadily decreased and this was backed by the United States Federal Reserve. The large inflows of foreign funds led to easy credit conditions for a number of year, prior to the crisis. This fueled a housing boom and encouraged debt-financed consumption in the market. Because of easy availability of loans investors around the world started investing in the United State Housing market. Slowly the housing prices started declining and the major global financial institutions that had borrowed and heavily invested in subprime mortgage-backed securities reported heavy losses. The prices of the houses fell down compared to the mortgage loans and this led to the foreclosure. This foreclosure began in 2006 and led to the erosion of wealth from the customers and it sapped the strength of financial banking institutions. While the housing bubble was building the financial system expanded and became fragile, a process called financialization. Investment banks , commercial banks as well as regulated banks had accumulated significant debt burdens while providing the loans to the house owners .These institutions were not cushioned enough to bear the loan defaults(Greenspan,2009).These losses affected the lending ability of financial institutions , all around the world-a situation which is called credit crunch. This credit crunch in turn slowed down the economic activities. On 24th September 2008 George W Bush, United States former President, said "These are not normal circumstances. The market is not functioning properly.” Every sector was affected by this global economic crisis. Every country faced the consequences and underwent the slowed economic situations. One of the first victims was Northern Rock, a medium sized British bank. Northern rock was the first bank in 150 years to suffer a bank run. Bank run is situation where a huge number of bank customers withdraw their deposit because they believe the bank is , or might become, insolvent. This withdrawing trend continues and can destabilize the bank to the point where it becomes bankrupt. (Diamond, 2007) In February 2008 the British government, having failed to find a private sector buyer, made the bank go into public hands. Northern rock’s problem was a sign that foretold the trouble. This indicated the situation that would become the fate of other British banks and financial institutions. Initially the companies affected were those involved in real estate business, home construction and mortgage lending. Due to credit crunch no credit was available for them in credit market to finance them. Slowly this credit crunch penetrated every stratum of economy especially United States, Europe, United Kingdom. On October 20th 2008 George W Bush, United States former President, referring to the frozen credit markets said “This thaw took a while to thaw, it's going to take a while to unthaw." Everyone around the world was astonished and flabbergasted on the impact of this global financial crisis. Queen Elizabeth II during a visit to London School of Economics in October 2008 said “Why did not anyone see it coming?”. In United Kingdom after the nationalization of Northern Rock in February 2008, there was a prize squeeze. This prize squeeze started building since 2007 and during the first six months of 2008 this rose because of driven demand from booming China and India .This led to pushing up prices of petrol, food and other basic costs.(Oxlade ,2011).The real estate of United kingdom came to sticky ends in 2008 . Market activity hit lows in late 2008 and early 2009 as well. Critical Analysis Credit crunch, as been discussed before, has crippled every sector of the world’s economy. Many people were in huge debt all over the world. According to United Kingdom Official figures in the first three months of 2005 nearly 26,000 property repossession orders were granted. This is highest number of property repossession since 1995. (Knight,2005). As time went by the financial crisis in United Kingdom started deteriorating .Britain’s Great Recession started in the spring of 2008.The size of the economy shrunk, as measured by GDP. In 2008 the United Kingdom real estate market was struck by a perfect storm. The property prices rose by 200% in the ten years to December 2007, according to the Land Registry. This led to the building the Property bubble. Many economists had predicted that this bubble was ripe for bursting, but after showing signs of a slowdown in 2005 , the market sped up again and the average price peaked between August 2007 (Halifax:?199,612) and January 2008 (Land Registry: ?184,784). The pin that burst the bubble was the credit crunch. The sub-prime crisis that had been brewing in the United States erupted in the summer of 2007, and as the year continued, the residential mortgage-backed securities market that had driven massive growth in credit for home loans essentially ceased to exist.(Waugh and Pyrnn 2011). During this scenario what lenders did was selling of packaged residential mortgages to a special purpose vehicle .These allowed debt to the investors who were lured by the strong returns from a supposedly liquid and low risk investment. According to the interim report by Sir James Crosby, commissioned by the Treasury, between 2000 and 2007, the total amount outstanding of UK residential mortgage backed securities and covered bonds rose from ?13bn to ?257bn. The report said that by 2006 mortgage-backed security funding accounted for two-thirds of new net mortgage lending in the UK. In July 2007 this market came to an 'abrupt halt', according to Crosby. This brought about the collapse of Northern Rock in the UK, problems for banks such as Bradford & Bingley that had fuelled the buy-to-let boom and major issues for all mortgage players. In February 2008, Northern Rock was nationalised and American bank Bear Stearns, which had specialised in the fancy finance that fuelled the mortgage boom, collapsed. It was the final sign that the party was over.(Waugh and Pyrnn, 2011) Banks fearful of huge losses began to dramatically cut back on mortgage lending and a vicious circle began. The more banks cut back on lending and raised deposits, the fewer homebuyers could secure finance, the more property prices fell and banks became more fearful and cut back further on lending. Francis Walker, spokesman of debt charity the Consumer Credit Counseling Service, said that “We are seeing lot of younger people coming to us for help”. This points out at the fact that unlike the credit crunch of 1990s, when the house owners had their lives squeezed out because of high interest rates and unemployment, this credit crunch squeezed the lives of younger people. This is far more dangerous because the young people don’t have assets to fall back on. The CCCS reports that calls from people worried about debt are up 50% year-on-year.(Knight,2005). But according to the Credit Service Association (CSR) they dealt with debt cases from High Street bank, credit card and utilities. This indicated that in United Kingdom the credit crunch did not just affect the young people. The credit crunch this time is wider one and affected every social strata of United Kingdom. Kurt Obermaier ,executive director of the Credit Services Association (CSA),said “"I think many people have spent too much on their homes and if something goes wrong in their lives, such as they lose their job, they can find themselves in problems very quickly," (Knight,2005) High Street sales were poor- which pointed out that people are reining in spending .This was a sure sign of slowing of real estate or housing market. Richard Gale, spokesman for debt charity National Debtline , "Interest rates have obviously had an effect in pushing up mortgage repayments but things in general just seem to be a little tighter for people.”(Knight,2005) The figure shown below shows GDP growth of United Kingdom .As we can see that the great recession in 2008 was marked by a negative GDP for the country. The GDP kept falling .The negative GDP continued but after 2009 things started getting back on track and the GDP starting increasing. The National Institute of Economic and Social Research estimated that UK gross domestic product increased by 0.3% in the third quarter of 2009.But gain GDP fell 0.5%; a fall for the first quarter of 2011 .(Jan to March 2011). If United Kingdom doesn’t brace itself then there are chances of recession again. This data points out that the situation in United Kingdom is still critical. The credit crunch is very much present and if not- taken care, the situations might deteriorate. The full year of 2009 saw an economic shrink of 6% as seen in the figure, the biggest calendar year fall since 1930.(Lambert,2011) Fig1.GDP Growth Of United Kingdom .(Lambert 2011) The Current worry that has engulfed United Kingdom is whether rising global inflation will force the Bank of England into raising rates, which is likely to derail the recovery. Another worry is Stagflation. Stagflation is a situation where the inflations is very dangerously high and the growth has been stalled. The output of Stagflation can be really lethal because it leads to erosion of real wealth .Stagflation results in hiked interest rates to control the inflation. These all things finally produces nasty side-effects where the economic growth is hampered because of higher borrowing cost.(Monk 2011) The current situation of United Kingdom is still grim. This year United Kingdom has the worst budget deficit in European Union Basically that means it will spend ?149bn of money it hasn't got and keep increasing the pile of debt already owed by taxpayers. We owed ??867.2bn in January, according to the ONS, up from ?720.9bn a year earlier. It will hit ?1 trillion by the summer.(Lambert 2011) As the whole financial crisis started from real estate fiasco hence the credit crunch has affected the real estate market of United Kingdom thoroughly. The prices in the real estate market trembled after the market peak that happened in summer/autumn 2007. The Prices decreased because of credit crunch. House price falls accelerated through 2008 and property market activity hit record lows in late 2008 and early 2009. The property market's performance in 2008 was worse than almost all of the gloomiest predictions made for the year. Halifax painted the gloomiest picture about the real estate situation in United Kingdom. Halifax’s index showed the average property losing a greater percentage of its value in just 12 months than during the whole peak to trough period of the 1990s crash. (Lambert,2011) The figure below shows the Long term real house price trend in United Kingdom. The X-axis denotes the years starting from 1984 to 2010. Fig 2. Long term real house price trend in United Kingdom (Halifax’s figure) According to the above figure in May 1989, before the crash, Halifax’s figures showed the cost of average home as ?70,247.But six years later the property prices again declined and in July 1995 the average home was worth ?60,965.This was a peak to trough loss of 13.2%.The Halifax index, in December 2007, pointed that the cost of average home was ?197,074. A year later there, in 2008, there was sharp decrease of 18.9% and the cost of the average home fell to ?159,896. The Land Registry's report showed property prices falling by 13.5% over the year, with the average home in England and Wales worth ?158,946 ' a similar value to October 2005. Even in the supposedly robust London market, the average home lost 12.9%, or ?45,585, to end 2008 worth ?307,071 ' a similar value to November/December 2006. (Halifax 2011) In 2011 House prices rose 0.5% in March, according to Nationwide, the third time in four months that the building society has reported price rises. Royal Institute of Chartered Surveyors indicated that London had benefitted from a 5% stamp duty beating the rush for ?1m-plus homes. But the overall picture is not so colorful. Austerity cuts are supposed to be arriving , with inflation still hampering the wages and savings. Tax rises are hitting people’s pockets with high rise in petrol and other daily required amenities.(Nationwide ,2011) There is a continued shortage of new homes coming for sale .This shortage allows the sellers to raise their initial expectations bid .On a monthly basis, house prices are falling across the UK, except in London, according to the latest RICS report – as the North South divide widens once more. The Royal Institute Of Chartered Surveyors report on different regions is given below. Source: Source: RICS February 2011 house price report The figure above gives the regional breakdown of the housing pricing of last three months. RICS said that there is a slight improvement .The turnaround in London saw 17% more surveyors report prices rising than falling. The above figure shows that the gap between the southern regions of England and elsewhere was indicated by strong negative balances in Wales, the North, Northern Ireland and Yorkshire and Humberside-compared to lower negative balances in the South and London’s positive recording(RICS,2011) RICS also said brighter points included the negative balance up from -31% the previous month, new buyer enquiries had stabilised after falling throughout the second half of last year and newly agreed sales had also steadied. RICS housing spokesman Jeremy Leaf added: 'Despite the more positive picture for some parts of the UK, the general mood is still a little flat. Broad trends in the survey indicate an increasing variation in the housing market across the UK, with London - and to a lesser extent the South East - operating in a very different orbit.'(RISC,2011) This is being believed that when the new homes coming up for sales will support prices. The RCIS report also pointed out that the demand and supply balance is tipping in favour of buyers. RCIS also showed that there were -1% reading on new buyer enquiries , compared to 5% more agents reporting new instructions to sell. Agents price expectations also declined with a 28% more forecasting a fall over the next three months, compared to 26% in January. This could boost sales, however, with 12% more suggesting more sold signs going up over the next three months, compared to 10% in January.(RSIC 2011). There is a scarce supply of new properties in the market. Meanwhile the properties that have ended up sat on the shelves at estate agents are not seeing big price cuts, because low rates mean sellers are not forced to lower their price expectations. The Land Registry shows transactions down almost 50% on their pre-credit crunch levels. This lack of turnover and low interest rates means a lack of forced sellers is supporting prices and keeping them relatively high against wages [See the chart below].(Waugh and Pyrnn ,2011) ROUND-UP: LATEST HOUSE PRICES INDICES AND PREDICTIONS Index Most recent Average House Price Monthly change Annual Change Link to report Peak Halifax Feb 11 ?162,657 -0.9% -2.8% Full report ?199,612 (Aug 07) Nationwide Mar 11 ?164,751 +0.5% +0.1% Full report ?186,044 (Oct 07) Land Registry Feb 11 ?162,215 -0.8% -1.7% Full report ?184,493 (Jan 08) Hometrack Mar 11 n/a -0.1% -3.2%% Full report n/a Rightmove (asking prices) Mar-11 ?231,790 +0.8% +0.9% Full report ?241,642 (Oct 07) Department of Communities Jan-11 ?208,552 -1.4% +0.5% Full report ?220,291 (Oct 07) LSL Acadametrics (formerly FT) Feb-11 ?222,456 +0.3% -0.5% Full report ?231,804(Feb 08) Figure above shows the latest prices indices and predictions (Lambert 2011) Share traders are always wary of the market where there are very few transactions. House prices are stuck in the doldrums and that should make it a buyer's market - the problem is many of those buyers are struggling to find anything decent to buy. Mortgage Scenario: The vast majority of buyers cannot purchase a property without a home loan. Therefore Mortgages play an important role in the property market. The availability and the restrictions that are imposed on these mortgages have a vital role and impact on ability of buying home. In 2008 and early 2009 when there was a sudden slump in the property rates at that time the lender turned off the mortgage taps. The mortgage backed securities market that accounted for the two thirds of new lending suddenly seizing up caused the lender to suffer a lack of funding. In the same time , banks were very confident about themselves and they overlooked the Atlantic and saw the nightmare that was taking place in America .This devastation was soon heading towards United Kingdom. Because of credit crunch the mortgage rates rose, deposits were hiked. There were many reports showing that many lenders had pulled mortgages at the last moment. Mortgages for home purchases dived by 49% in 2008, to just 516,000, according to the Council of Mortgage Lenders. This was the smallest number since 1974 and represented a third less than the 723,000 approved in 1991 ' the lowest level of the 1990s slump.(Monk, 2011). The figure shown below is from Bank of England’s Home buyer mortgage approvals. Fig 4:- Homebuyer mortgage Approvals Source :- Bank of England In the figure above the mortgage approvals fell acutely during 2008 to 2009 . And the fall was the grimiest and the worst since 1999. The number of mortgages for homebuyers hit a record low of 27,000 in November 2008, rising to around 31,000 to 32,000 in December and January 2009.But as seen from the graph above in September 2007 , just before the downward fall began Bank of England showed mortgage approvals for homebuyers of 102000 and this was significant at that time because this value was the lowest level for the two years. The level of mortgage activity for home purchases in the first half of 2009, was about 60% below that figure and economists say approvals need to be at at least 70,000 to 80,000 per month for prices to stabilise.(Oxlade, 2011) The average UK property cost ?30,898 in 1983, according to Halifax, and ?198,500 in September 2007 ' an increase of 542%. Even allowing for the current slump that property was worth ?160,327 in February 2009, an increase of 419%. For a similar effect to be delivered to a modern day homebuyer, the cost of the average property would need to stand at ?832,097 in 2035.(Halifax,2011). In 1983 the average wage according to the Office of National Statistics was ?7,700, today the most comparable measure stands at ?24,900, an increase of 223%. If both property and salary inflation are sustained at the same long-term rate, the average wage by 2031 will be ?80,500 and the home will cost 10.3 times more.This compares to the average home costing four times the average wage in 1983 and 8.5 times the average wage (?23,300) at the peak of the Halifax index in August 2007.(Halifax 2011). The main problem in United Kingdon since 2000 is stagnation when it comes to increase in wages. Unemployment is another bane that has engulfed United Kingdom . since 2000 wages have not risen anywhere near as fast as property prices or general prices in the economy.Inflation is present with its full swing with no sign in increased wages. Inflation helps only when the wages rise is in line with the prices otherwise Inflations becomes draconian and sucks life out every person. Owning a home is an emotional desire, a must-have aspiration for most Britons, and the demand for property in Britain remains high.. According to BBC the shortage of supply of property in the UK compared to demand has arguably been exaggerated by developers and the Government, but decent sized family homes in popular areas are typically in short supply.(BBC 2011) Government is trying their level best to provide people with their dream houses. They are coming up with many policies and programs to fulfill the demand at very affordable rates. Government development targets and planning guidelines have focused on quantity rather than quality. Target-led development has encouraged major scheme developers to concentrate on flats and small properties in order to deliver the most homes at the cheapest price. According to a report of National Housing and Planning Advice Unit the government's independent housing experts said that an undersupply of larger homes pushes up the cost of all properties and affects the house price inflation problems negatively.(Lambert 2011). The United Kingdom's high house prices are a drag on its economy. These high house prices are hampering economy movement. These real estate problems are making the condition of the country vulnerable to shocks. The only solution right now is to focus on real estate problem by trying to narrow the gap between property prices and wages .The government should try making buying a home less of a gamble. Conclusion There are hopes and fears for United Kingdom’s real estate market. Hopes: 1. The weak pound rates recently have made the products cheaper, that has made exporter way towards United Kingdom. This export will surely boost the economy of United Kingdom. 2. The recent strong and healthy stock market has helped in gaining confidence. 3. The Government is fighting the unemployment slowly. 4. Coalition is welcomed by the government to deal with the deficit. But the fears are far deep and monstrous and if government and authorities doesn’t do anything then United Kingdom will fall into more bad credit crunch and economy will suffer terribly. Fears : 1. The Government is has started doing huge public spending cuts. These spending cuts will in turn dent the demands. 2. United Kingdom’s house –prices are still over-prices. For example In London a property that would have cost 100000 pounds about thirty years ago would today cost 3473 million pounds. This indicates a growth of 3,437%. Renting a six square meter apartment in Notting Hill costs about 800 Euros per month. The prices are skyrocketing. Not just in London but in every part of United Kingdom.(Schmitt) 3.People still have large debt so pay . People don’t have assets to back on. It has been predicted that it will take next decade to clear all these debts. 4. The slower than expected recovery has hit the public finances. Borrowing will be a shade lower than anticipated this year at ?145.9bn but it will exceed expectations over the next five years by a total of nearly ?50bn.(Duncan ,2011). 5. With the oil conflict going on in the Middle East and there is a high demand of oil in the developing countries. Hence the prices of crude will a play a crucial role in economy of United Kingdom. 6. No rise in wages in line with prices has created a darker picture of inflation. The highly respected Institute for Fiscal Studies was typically cautious about the outlook, warning that spending cuts will be deeper and thousands more jobs are on the line because of runaway inflation.(Duncan,2011). The spending power crunch on British households intensified with figures showing the rate of inflation has jumped to its highest level since October 2008. The Office for National Statistics reported that the consumer prices index measure of inflation rose to a 28-month high of 4.4% in February, up from 4.0% in January – and significantly higher than the 4.2% economists had expected. The retail prices index measure, which includes mortgage payments, rose to 5.5% from 5.1% in January, its highest level for 20 years, and also ahead of expectations of 5.3%.The high CPI rate, which is more than double the Bank of England's 2% target, will add pressure on rate setters at the Bank to consider raising interest rates. All in all the picture of real estate market in United Kingdom is really sad and grim. Government has to take necessary steps now otherwise it would be too late. References 1. Baily,M.N. and Elliot D.J,2009,The US Financial and Economic Crisis :Where does it stand and where do we go from here?,Intiative On Business and Public policy :Brooking 2.Bernanke, B. 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