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A house price nightmare

Published in The Guardian – Comment is free, 14 August 2007

The current mortgage crisis in the US was exacerbated – and at least partly caused – by restrictive town planning policies.

Much has been written about the current crisis on the world’s financial markets, and there seems to be some agreement about the causes of it.

The story goes something like this. The US economy had become so accustomed (or should one say, addicted?) to cheap credit that more and more money was pumped into the housing market. People who previously could not have applied for mortgages were suddenly given mortgages beyond their financial capabilities, the so-called subprime segment of the mortgage market. When interest rates then went up, these homeowners were unable to keep up with their repayments and defaulted. But as house prices went down, the banks could not recoup them. As the original lenders had sold on their subprime mortgages to international investors, the crisis spread far beyond the US. And finally, the ratings agencies did a bad job at assessing the risks involved in these transactions.

How often have we read this account of the crisis over the past couple of weeks? And of course, much of this is true. Unfortunately, however, it’s not the full story. The roots of the current crisis lie much deeper than what can be seen in today’s extremely volatile financial markets. What usually goes unreported is why an increasing number of people had to take on ever riskier mortgages. Where only five years ago fewer than one in 10 US mortgages was in the subprime category, last year it was every third mortgage. So what drove these families to borrow more and more?

To answer this question, one has to talk about house prices. Wendell Cox and Hugh Pavletich have analysed developments in the American housing markets for their annual Demographia Studies. Their method is called the median-multiple affordability index. This sounds complicated, but it is actually a very simple way of looking at how affordable or unaffordable housing has become across the US. The median house price is compared to the local median household salary. The lower the multiple, the more affordable the housing market. So if, for example, the median household in Little Rock had an annual income $43,400 and the median house in this city cost $128,900, this equalled a median-multiple of 3.

Cox and Pavletich compiled data for 107 local housing markets in the US and discovered some remarkable differences. Housing affordability in the most affordable markets had an index of just 2.0 (Youngstown, Ohio), while in other parts of the country it could reach scores of 11.4 (Los Angeles, California). While some variation can be explained by the relative attractiveness of cities, these differences should have been moderated by the corresponding salary levels.

But the most interesting finding of the Cox/Pavletich study was something else: they could show that in those local markets which were most heavily regulated by town planners, housing tended to be the least affordable. Where, however, fewer planning controls were in place, affordability tended not only to be better, but house prices also remained stable over time.

As US town planners followed policies of restricting so-called “urban sprawl”, they drove up land and house prices. Only 10 years ago, the average median-multiple in the least affordable parts of the US stood at little more than 3, but last year it was more than 6 on average. For American homebuyers this meant that they had to stretch more financially to be able to afford their steps on to the property ladder. But thanks to a lax monetary policy they were still given substantial mortgages, sometimes even interest-only – the birth of the subprime market.

While some lending practices of American mortgagors may now seem to be naïve or even irresponsible, they were often the only way for many Americans to fulfil their dream of becoming homeowners. But with rising interest rates, their dreams turned into nightmares – first for them, and now for financial markets around the world.

So at the root of the current financial crisis are the restrictive planning policies of many American town planners. But this is no reason to be smug from a British point of view. Britain’s housing market poses a comparable risk to this country’s economic stability.

In Britain, too, house prices have been artificially inflated, thanks to an inadequate land supply. In many ways, there are disturbing parallels between the US and the UK. Housing affordability has worsened dramatically over the past decade: people are now offered mortgages of five or even six times income, sometimes stretching over 50 years. And UK interest rates are on the rise as well. All of this could eventually become a deadly cocktail.

The current subprime mortgage crisis in the US was at least partly caused – and definitely exacerbated – by restrictive town planning policies. This has negatively affected affordability and led to a debt bubble which now spectacularly burst. If there is one lesson to learn from this, we have to make sure that house prices are not artificially inflated by planning policies.

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