Housing pessimists have got it all wrong

A 40 percent fall in house prices? No way, says Yolande Barnes of the Times:

"To predict that the UK housing market will fall by 40 per cent and remain at these new, corrected levels is to ignore the role of finite supply and the use of equity.

The most frequently used indicator of property market overheating is the house price to income ratio. In the 1970s and 1980s loans averaged around three to four times earnings, causing the pessimists to argue that the recent levels of six or seven times are unsustainable.

What the pessimists ignore is the increased use of equity in the housing market. Mortgage lending in the 1960s and 1970s facilitated a huge transfer of property ownership from landlords to owner-occupiers. Those home-buying pioneers have been paying off their mortgages and house-price inflation has increased their purchasing power in competition with new entrants.

So it has always been inevitable that, in the face of finite land and property supply, the relationship between incomes and value (the basis of having a mortgage) would become disconnected as owners became less mortgage-reliant."

The problem with this story is that it works the other way too. As house prices fall, equity shrinks, meaning that existing home owners have less purchasing power to buy high priced homes. The housing market can enter into a death spiral with evaporating equity pushing prices down further.