Source: Economics Observatory —
The global financial crisis of 2007-09 highlighted how housing markets can create massive financial and economic instability. Similarly, recent high inflation and economic uncertainty have had a big impact on house prices, rents and mortgage costs. Policy needs to deal with these interactions.
The global financial crisis of 2007-09, which began in the US market for ‘subprime’ mortgage lending, was a stark reminder of how housing systems can bring economic instability (Jordà et al, 2015; Gertler and Gilchrist, 2018).
That experience exemplified that while the housing market is a critical component of the economy, it can also be a source of vulnerability and crises. In turn, a boom or a bust in the housing market can profoundly affect an economy’s business cycle and contribute to systemic financial crises (Barwell, 2017; Hartmann, 2015).
Indeed, more than two-thirds of the almost 50 systemic banking crises in recent decades were preceded by boom-bust trends in house prices, according to the Global Financial Stability Report (International Monetary Fund, IMF, 2019).
Once housing crises occur, dealing with them can have enormous financial repercussions. In the case of Ireland, government bailouts of banks from the housing collapse consumed 40% of the country’s GDP during the global financial crisis (Zhu, 2014).
In many economies, the early 2020s were marked by significant increases in housing output and price booms but rising interest rates through to 2023 have led to growing concerns that significant downward ‘corrections’ in house prices have already begun or are imminent.
Further, over two million fixed-rate mortgages are due to expire this year, which means that housing costs for many households are likely to increase at the same time as fuel, heating and food prices have risen.
It is essential to understand the processes and risks involved, to monitor developments carefully, and to consider policy actions for housing markets in downturns.
What has happened to the housing market since the global financial crisis?
Since the global financial crisis of 2007-09, UK house prices have risen consistently. There have been even more pronounced periods of growth since the Covid-19 pandemic (see Figure 1).
Consequently, home ownership has long appeared to be a safe bet. During the pandemic, interest rates and the costs associated with servicing mortgage debt were at historic lows, spurring further price rises.
After only a brief dip in 2020, rents also took off as the initial Covid-19 crisis subsided, rising ahead of wages (Pawson and Gibb, 2022). Not only did sustained increases in house prices and rents contradict expectations of a downturn post-pandemic, they exacerbated already unaffordable markets.
The UK housing market is currently in the middle of a shift, as the era of ultra-low borrowing costs is ending. The Bank of England’s base rate has increased through ten successive rises – from 0.25% at the start of 2022 to 4% in early 2023 – in the most aggressive tightening of monetary policy in almost a decade.
This mirrors trends in the United States and the eurozone (see Figure 2), where rates are forecast to remain elevated in the coming years (Bank of England, 2022). Households in the UK are experiencing an unprecedented cost of living crisis, which is being exacerbated as mortgage interest rates continue to rise in line with monetary policy.
Overall, the economic outlook for the UK has worsened, and financial conditions have tightened dramatically over 2022. Combining these factors, we get a prescription for a grim future for the housing market and can expect further price drops.
The rapid transition in monetary policy from non-conventional to more conventional approaches (higher interest rates), together with increased household leverage, have increased macroeconomic and financial stability risks for the UK economy.
What might this instability mean for the UK economy?
In the UK, approximately 36% of wealth is held in property (Office for National Statistics, ONS, 2022). Consequently, changes in property markets are consequential for the economy’s overall health and stability.
Since the early 1990s, economic downturns in the UK have been accompanied by declines in housing wealth and spending, as the rising cost of mortgage payments constrain household budgets. The probability that indebted households may default on their debts or drastically cut their spending has also increased (Bank of England, 2022).
The global financial crisis was characterised by a close association between mortgage debt and financial stability. It was foreshadowed by debt-financed housing spending that was underpinned by financial institutions holding extensive stocks of mortgage-backed securities based on underlying mortgages that were risky (Mian and Sufi, 2010).
The sharp decline in the value of these mortgage-backed securities in the asset base of banks meant that the US housing market downturn quickly became a global financial crisis. Millions of leveraged homeowners lost trillions of dollars of wealth.
In the UK, the near collapse of major banks with substantial assets of this kind – most notably the Royal Bank of Scotland – had ripple effects on the housing market, where loans had been based on loose underwriting standards. As a result, in the UK too, substantial mortgage debt contributed to financial instability and aggravated the crisis.
Historically, unsustainably high mortgage debt has affected the UK’s financial stability in two ways (Bowe, 2022).
The first is through its effect on borrower resilience. When highly indebted households face a drop in real income or a rise in mortgage rates, they tend to cut back on spending quickly. This can exacerbate a slump and have systemic consequences for financial stability.
Second, shocks can affect financial stability via lender resilience. Lenders suffer losses when heavily leveraged households face repayment issues. These losses can reduce credit availability to consumers, businesses and the wider economy, thus risking financial instability.
How might mortgage rates affect the economy?
While housing is the largest asset of most households, mortgages tend to be their biggest financial liability. They have one of the most extended terms of loans in the economy and their repayments are sizable – equivalent to around 15-30% of households’ disposable income (Garriga et al, 2021).
Mortgage lending has significant consequences for financial instability and, consequently, macroeconomic policies (Maclennan et al, 2021). Over time, mortgages – with their riskier loan features – have become a more significant part of total financial sector activity, shifting the focus of systemic crisis risk to mortgage lending booms (Jordà et al, 2016).
