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The Standard Crash Argument

The “how big will the crash be” question is essentially this: we are sitting at the top of a peak with a p/e of 5.7, and it’s going to fall to something much less over about 5 to 7 years. We pick this exit p/e out of a hat, say the historical long term trend at about 3.5x, reduce it a bit to allow for an overshoot, and then work out the nominal crash by running it through the HPC equation

(1-C/100)=(3.5/5.7)*(1+E/100)^Y

where C is nominal percentage fall peak-trough, E is earnings growth (say 4% pa), and (3.5/5.7) is the unwinding of the p/e over Y years. Note that the nominal minimum occurs slightly before the p/e minimum, so we use 5 rather than 7 years, and raise the p/e slightly.

Here are some numbers (with E = 4% and 3.5%)

Exit-p/e unwind% over-value% C(4%) C(3.5%)

4.00 .... -30% .... +42% .... 14% ... 16%

3.50 .... -38% .... +62% .... 25% ... 27%

3.25 .... -43% .... +75% .... 30% ... 32%

3.00 .... -47% .... +90% .... 35% ... 37%

So, if we fall to 3.25x, the same as last time after the 1989 peak, then the crash will be about 30-32% depending on how hard earnings are hit (down from 4.5% at present).

So far to good, *but* the lenders are always going on about ‘affordability’, saying that it’s different this time, and pointing to the current low IRs. This probably *is* significant and might well change the numbers above, especially the estimates of the exit p/e – so exploring this idea is what this thread is about. In other words, adjusting the exit p/e estimates to account for the effect that low IRs might have, and to adjust the crash estimates accordingly. :)

Edit: Price and Earnings are defined as those published by HBOS.

Earnings are the same as ONS average.

Edited by spline

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Can you be so sure that earnings will rise during the recession caused by a HPC?

By price/earnings do you mean earnings as average salaries? If so is the ratio not higher than this? This board shows average prices are somewhere up at 180 or 190K, that is way more than 5.7 times average salary surely? But it occurs to me that it is not average salary so much as average household income.

But if more folk band together to buy houses with joint incomes that will reduce demand for houses....

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The Argument including Affordability

A starting point is the ODPM table 539

odpm_afford.gif

which shows that the mortgage repayments as a fraction of gross income of both FTBs and OOs is constant at about 19%, except, that is, when it is stretched in a bubble. The stretch is not surprising, but the constancy of the 19% baseline *is* surprising - during this period IRs have varied between nearly 15% and 3.5%, yet the curve remains essentially a constant plus a pair of localised bumps. Notice that the 1990 bump is bigger, more on this later. The bumps clearly represent the affordability stretches required during a bubble.

Suppose we take the historical earnings E(t) and rates R(t), then work out the loan L(t) that would eat 19% of earnings, so L = annuity(0.19*E, R, 25years). Now from this ODPM figure

odpm_ratios.gif

showing ‘All-types’ loan to earnings (L/E) and price to earnings (P/E) ratios we can gauge that average house prices are about 1.5-1.6 times the average loan – this completes the calibration, call this P*=1.5*L. It reflects the price as determined by a ‘normal’ level of affordability based on average earnings E and interest rates R.

This P*/E is plotted (green line) below, alongside the historical HBOS data (blue line) and the agreement between 1992 and 2003 is surprisingly good – when there is no bubble it looks as if prices are in fact set by the 19% earnings rule. This is a direct consequence of people spending a fixed fraction of their earnings on housing. Prices before 1986 follow the same trend but are boosted by MIRAS and other tax advantages – I’m not too worried about precisely accounting of this, but it enters the argument later in that the 1989 bubble is effectively pre-inflated by the removal of this boost around 1989.

dqrofc.jpg

Note that the dips in the P*/E exactly mirror the peaks in the HBOS P/E – the gaps are actually the bubbles – and these can be patched in by adding suitably scaled Gaussian hills. Doing this produces the purple line, and P/P* = 1 + B gives the bubble ratio B or excess that reflects the market ‘exuberance’ and models the stretch (above baseline) in the ODPM repayment/earnings curves above.

The model can be extended out to 2010 by continuing earnings at 4% pa and interest rates on hold.

Also YoY can be extracted

dqsq6o.jpg

Discussion Points:

1. The P* price based on traditional affordability of 19% gross earnings does a good job of tracking the inter-bubble period, but it obviously ignores the bubbles

2. Adding the pair of bubbles produces a good fit to the HBOS P/E data

3. The 1989 bubble is larger than the 2004 bubble – it appears that this is because the boost from the pre-1990 tax advantage, on it’s removal, is directly converted into further inflating the bubble.

4. The 1989 bubble subsides under the weight of IR increases, but is caught by lower IRs (meets green line) in 1993.

5. Gradually lower IRs raises prices (but without a bubble) up to 2002 when a new one starts.

6. The 2004 bubble grows, is limited by raised IRs in 2004, and begins to deflate – continues out to 2009. This bubble, even though the peak p/e exceeds the 1989 one, is actually smaller (about 60%) because the p/e is supported by the low IRs.

7. Using an exit p/e of 4 in 1989 gives (see first post) a nominal crash of around 15% by 2009.

8. Tweaking the 4% earnings and future IRs will shift the exit p/e up/down slightly.

9. estimated exit p/e is much larger than 3.25 trough of the last bubble.

Conclusion:

On this model, the new low IR climate supports the 2004 bubble, so that although the bubble has a higher p/e than the 1989 one, it is partly 'bubble' and partly IR lfted. Because only the bubble component will deflate, the crash will be less, 15-20%

Health Warning - this is a deliberately *simple* model to explore what follows logically from the observation that people usually (except in a bubble) spend a fixed percentage of income on housing, and to use this idea explore what impact affordability and low IRs might have. :)

Additional technical details posted here

post-2887-1127245078_thumb.jpg

Edited by spline

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Durch – Yes, accept that this is in no way a detailed prediction – as you say that would be far too complex and have a very short shelt life – it's really a simple framework for thinking about the problem, warts and all, but I was surprised how such a simple idea could unfold into something seemed to capture the flavour of the problem quite well. It's back of the envelope stuff with some arithmetic + graphs from Excel. Of course, it could all be wrong and a fluke! :)

Edited by spline

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The Argument including Affordability

That's a really nice piece of analysis. The only thing I might add is that if there really is a trend towards interest only mortgages, then the market can support a rather higher p/e ratio while meeting the 19% of earnings rule, so the exit p/e might be a bit higher than your 4x average earnings.

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Durch and zorn – thanks for the positive comments. :)

Yes, the forward assumptions are just plain vanilla ‘business as usual’ – and, as Durch says, any attempt to predict the future is likely to be screwed up by the unexpected. Still, they only have to work for a couple years or so …

IO mortgages – if people use them to handle the affordability stretching during a bubble, then I suppose this is part of the bubble argument, but, yes I agree, certainly any long term trend towards IO mortgages would lift the exit p/e further.

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Fascinating. Well done.

I agree with you regarding the 19%, but does this only apply to the interest repayments on the mortgage?

ie we have the case now where many people are ignoring capital repayments in the hope that the house will pay for itself (endowment mortgage scandal II anyone ?)

One of the troubles of these models (and the housing market) is the sensitivity to future interest rates.

What happens if rates revert to a more natural level, ie the exit pe remains 4 but rates move up to 6%.

How hard is this market going to come down?

Edited by BandWagon

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Bandwagon – Thanks, the 19% pays the repayment mortgage, and so (without any bubble) the exit p/e is independent of earnings and given by

p*/e = 1.5*annuity(0.19, M.Rate, 25years)

M.Rate P*/E

--------------

3% 4.9

4% 4.5

5% 4.0

6% 3.6

7% 3.3

8% 3.0

then convert the exit p*/E into a crash % using the appropriate earnings growth E (see first post). So if base rates go back up the crash will probably be hard.

M.Rate = mortgage rate, BoE base + offset

Edited by spline

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Many thanks to Spline for a first class piece of research and for

the detailed work.

The figures produced agree with observation and experience -

namely that there was a correction from 1998 to 2002/3 or

thereabouts, then an overshoot or bubble, particularly in 2004.

Because of circumstances, I distinctly remember the gradual

hiatus of mid 2003 as FTBs stopped buying and sellers held

the price.... this I believe was the end of the genuine correction

from the previous slump and the "new plateau" due to lower IR

and cheaper credit.

What followed was an unsupportable further burst in late 2003

and then the wholly unsustainable 2004 spring bounce until increased

IRs brought a halt in August 2004.

My own expectation is that prices will correct back to mid-2003,

which agress with Spline's figure of about 20-25% drop, rather

than a 33% drop which would take us back to 2002.

** Note: of course, there may be an overshoot - a market over-

correction, depending on economic circumstances and consumer

confidence, which could drive prices even further down.... no-one

can calculate such a dip **

Again, thanks to Spline and those who do such excellent figures

for those of us who do not have the ability or time.

Edited by justanewbie

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- Global warming break-out as massive methane releases destroy vast areas of frozen Siberian tundra.  Sea levels rising cause massive destruction on Eastern US seaboard...

You've seen the day after tommorrow. The super-hurricanes, and overnight cooling scenarios were completely unrealistic, what isn't though is the fact that in the past 200,000 years the gulf stream has switched on and off on numerous occassions, causing Britain's climate to change within 18 months from maritime temperate to something closer to that experienced in Labrador (the same lattitude as us). Salinty rates in the North Atlantic have been dropping rapidly over the past decade as the Greenland Ice sheet and Siberian tundra have been melting due to global warming. The Gulf stream relies on high salinity levels as the water cools and plunges off the tip of Greenland. This could literally stop overnight. If it did, the waters around Britain would cool by ten degrees over a period of 18 months, making our winters much longer and harsher (we're talking frozen ground and snow cover from mid-November to mid-April). Our economy would collapse and there would be mass starvation. You wouldn't be able to give away a house in Edingburgh!

Conservative scientific estimates place the chance of this happening in the next thirty years at 50%. This could be higher and sooner if global warming continues to accelerate.

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Humans are so tiny and insignificant when you look at the earth's history (4,000 years of civilisation versus 500 million years of walking and swimming life, and ovr 4 billion years of the planet's existance), yet we have had such an incredibly large effect on the planet. But then if you look at us like a mosquito. For one night, one mosquito can seem like the mother of all monsters as it whines above your head, and covers you in red bites, but with one well aimed swat it no longer exists, and in the many years you have to live, you will not remember it ever existed, and the bite will be forgotten in hours. So it is with mankind. The harm we have done to this planet may prove to be a self-inflicting blow that results in our exstinction. The planet's ecosystem will adapt and settle down, new life forms will appear to rule the land mass and man's short, grubby and selfish reign will be fogotten.

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Humans are so tiny and insignificant when you look at the earth's history (4,000 years of civilisation versus 500 million years of walking and swimming life, and ovr 4 billion years of the planet's existance), yet we have had such an incredibly large effect on the planet. But then if you look at us like a mosquito. For one night, one mosquito can seem like the mother of all monsters as it whines above your head, and covers you in red bites, but with one well aimed swat it no longer exists, and in the many years you have to live, you will not remember it ever existed, and the bite will be forgotten in hours. So it is with mankind. The harm we have done to this planet may prove to be a self-inflicting blow that results in our exstinction. The planet's ecosystem will adapt and settle down, new life forms will appear to rule the land mass and man's short, grubby and selfish reign will be fogotten.

The arrogance of the Human species is to believe that, unlike previous dominant species, it will continue forever.

Just because we can think about our behaviour and perhaps try to modify it, to attempt to limit our effects on the planet, imho, isn't going to change much.

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The Standard Crash Argument

The “how big will the crash be” question is essentially this: we are sitting at the top of a peak with a p/e of 5.7, and it’s going to fall to something much less over about 5 to 7 years. We pick this exit p/e out of a hat, say the historical long term trend at about 3.5x, reduce it a bit to allow for an overshoot, and then work out the nominal crash by running it through the HPC equation

(1-C/100)=(3.5/5.7)*(1+E/100)^Y

where C is nominal percentage fall peak-trough, E is earnings growth (say 4% pa), and (3.5/5.7) is the unwinding of the p/e over Y years. Note that the nominal minimum occurs slightly before the p/e minimum, so we use 5 rather than 7 years, and raise the p/e slightly.

Here are some numbers (with E = 4% and 3.5%)

Exit-p/e  unwind%  over-value%  C(4%)  C(3.5%)

  4.00 .... -30% .... +42% .... 14% ... 16%

  3.50 .... -38% .... +62% .... 25% ... 27%

  3.25 .... -43% .... +75% .... 30% ... 32%

  3.00 .... -47% .... +90% .... 35% ... 37%

So, if we fall to 3.25x, the same as last time after the 1989 peak, then the crash will be about 30-32% depending on how hard earnings are hit (down from 4.5% at present).

So far to good, *but* the lenders are always going on about ‘affordability’, saying that it’s different this time, and pointing to the current low IRs. This probably *is* significant and might well change the numbers above, especially the estimates of the exit p/e – so exploring this idea is what this thread is about.  In other words, adjusting the exit p/e estimates to account for the effect that low IRs might have, and  to adjust the crash estimates accordingly.  :)

Edit: Price and Earnings are defined as those published by HBOS.

Earnings are the same as ONS average.

Great bit of work spline but too much for my little brain !!

The only comment I would make on the affordability issue is, that IR's will almost certainly have to rise eventually, and this time even 1 or 2% would be disasterous for alot of people.

If it went back to the long term average I hate to think what would happen.

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FaTB - Yes, it's a bit awkward to work the numbers out by hand, so this graph might be useful - it summarises how the crash is predicted to vary with interest rates B) .

It shows the estimated crash % (nominal, peak to trough, 5 years) according to the model for earnings growth at both 3.5% (red line) and 4.0% (green line) as it depends on mortgage interest rates. Note that close to 3.5% is true stagnation territory, but the more typical 5-6% gives 15-20%, and 8-9% a really hard 35-40% crash.

dwx5wl.jpg

The ideas underpinning these results almost exactly parallel the view put forward by Stephen Nickell to argue that any bubble would be small or non-existent if the IRs were reduced enough - in other words, how improved affordability from low IRs can reduce the size of the required correction, or alternatively, why in a low IR environment a higher p/e can be sustained.

Edited by spline

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Hi Spline,

I am fascinated by this "affordability" argument for the current level of house prices being sustainable. I don't believe it myself but it is fascinating.

I think the whole repayment v interest-only issue really skews this argument.

For example, someone who takes a £100k mortgage (25 years at 5% - fixed, to keep the argument simple):

Interest only - £5k mortgage payments per year. At 19% of gross income that means they have a salary of just over £26k (roughly the UK's official national average, I think).

Repayment - £7,015 mortgage payments per year (according to Charcol's calculator). This leaps to almost 27% of the same person's gross income.

My point is that the increase in IO mortgages (hopefully we all agree they are more popular today that in 1989) can make it SEEM like there is no "affordability" problem while the fact that people feel they need to take IO mortgages rather than repayments suggests to me that there absolute IS an affordability issue.

I can understand that this "affordability" measure is of extreme interest to mortgage lenders, since it tells them how able people are to repay their mortgages (a crucial factor for their business model... they don't actually care though whether the borrower "owns" the property or merely "rents it from the bank").

I'm not really sure it tells the rest of us THAT much. In the above example, knowing that this guy's mortgage costs are 19% of his salary is not entirely helpful without knowing that it is IO now while it would have been repayment in 1985. The two are not comparable and the lenders help to confuse the market by suggesting things are OK on this basis.

I also think the affordability, since it is based on AVERAGE mortgages and AVERAGE wages, confuses the issue in other ways. I think how affordable property is to RECENT purchases gives us much more information than this generalisation.

For example, someone who took out a £20k mortgage 20 years ago is probably sitting pretty with some nominal fraction of their current salary going towards mortgage payments (assuming they haven't re-geared, MEW-ed etc). However, the guy who bought the identical place next door last summer is in a much tougher position.

I would say this last guy tells us much more about the sustainability of current house prices (since nobody is buying at the prices of 20 years ago that guy's mortgage repayments tell us about his ability to consume, the security of the lender's loan and other issues but not much about whether house prices are sustainable).

Similarly, the guy who bought 20 years ago can trade up without a major affordability issue even when house prices are at bubble levels. As he can trade bubble equity for bubble equity (say he sells for £100k and buys another place at £150k) his affordability is still OK... but a new buyer (FTB) taking that £150k place? His affordability will tell us something very different.

Also, the fact that FTBs are being priced out of the market tells us a lot about "affordability" even though it is not reflected in these "official" affordability numbers.

All-in-all, I think it is an interesting thing to look at but I thikn the lenders are using it hoodwink people into believing there isn't a problem.

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House Price Predictions of the HBOS index - Monthly Roadmap.

This is the first time I've compared the model against the HBOS monthly data - much more relevant to track the falls month by month ...

Running the model out to 2010 with IR=4.5% and earnings growth reduced to 3.5% from Jan-05 gives the following monthly projections – this is just using the original quarterly calibration and without any special tweaking to fit the monthly data. Suggests YoY negative in November, and a trough at about £140k around 2009 but this will shift up/down depending on the IRs at the time. It's going to be interesting to track this as the new monthly data comes in. In the meantime, I think it's a reasonable roadmap. :)

Price to Earnings

e5jq5x.jpg

Price

e5jp7a.jpg

YoY

e5jp7s.jpg

(includes HBOS Sept YoY)

Edited by spline

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House Price Predictions of the HBOS index - Monthly Roadmap.

What you have described is basically the soft-landing scenario, IMO. I'd say that you're assuming a benign world economic picture for the next five years, which is anything but guaranteed.

But good work anyway.

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What you have described is basically the soft-landing scenario, IMO. I'd say that you're assuming a benign world economic picture for the next five years, which is anything but guaranteed.

I think I’m putting it the category of ~20% falls (although the projection a slightly less than this) – so definitely more than a ‘soft landing’ but not a full-blown crash of the 30-40% type. The lower economic growth is reflected in the lowered earnings growth at 3.5% and the flat IRs projections are plain vanilla - if these go up again the price predictions will go down. But the roadmap will get better as we move further along … :)

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  • 302 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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