SO, it looks like we might be heading for another EU referendum. But what happens if we, the electorate, call their bluff and a No Deal Brexit is on the cards? (Specifically in relation to our financial system, that is.)
Well, other than having to start boiling stones for soup – two things are likely, both of which I think are reasonable predictions: the first is that there’ll be a run on the pound, and secondly, interest rates will have to go up to defend the currency. Based on historical precedent, by about 3% seems likely.
How will this impact on the housing market and our financial system generally?
This is what my model is trying to war-game. The outputs of my little model, simplified, are below.
By the way, all these figures are approximate, and gathered largely from the ONS or figures put out by the banks themselves.
To start, total housing stock at the moment is £7.14 trillion. Total bank assets are £8 trillion, with UK bank assets at £4.2 trillion. Despite what you may have been told, nothing has fundamentally changed with regards to our financial system since the last financial crisis, which came within hours of ending Western Capitalism: no UK bank has enough reserves to fund itself for very long, they are still entirely reliant on wholesale markets for day to day funding: UK bank’s capital reserves now stand at a meagre £450 billion.
The total mortgage market is £1.3 trillion, roughly a quarter of total UK bank assets. This is based on an average house price of £226k, with 1.18 million houses changing hands every year. Of these, 40% are bought with cash – about 700k being bought with a mortgage. There are 27 million houses forming part of our housing stock in total, so just over 4% change hands annually.
Non sequitor: this is what makes the idea that building more houses will make houses affordable such a bizarre idea – even an extra 100k houses a year only increases supply by a maximum of 6-8% – and average house values are valued at over 8 times average incomes. To make houses affordable, ceteris paribus, you’d have to build well over a million houses a year. But I digress.
If rates go up to historical norms – ie to, say, 4.5% – then in our scenario this will more than double interest repayments in aggregate, and arrears will roughly double, as a rule of thumb.
House price values are driven by transaction prices, and transaction prices are the product of loan affordability – which is driven by average salaries, leveraged against interest rates. If rates go up in this way, affordability is likely to drop back to approx. 6.7 times income multiples, again based on historical precedent. This would cause a 32% drop in market valuations for new transactions.
The very big mistake people make here is to think that this will only apply to houses coming onto the market: this is a fundamental error. As a Chartered Surveyor, I am more aware than most that values are based entirely on comparables – ie houses that have sold recently. If ten identical houses are in a row, and one sells at a 10% haircut, then every house in the row is suddenly worth 10% less in terms of our current housing market’s financial ecosystem.
If new transactions, based on what becomes affordable with rates more than 3% higher than they were, transact at approx.. two thirds of their values prior to a rate increase, this will force banks to re-value their entire loan portfolios. Based on current aggregate asset values of housing stock, this would mean a total loan book write down to, at least, £860 billion, more or less.
This would mean that if house prices start changing hands for a third less than they are now, which would be likely if a no deal Brexit happens, banks would have £438 billion wiped off their balance sheets, within a few months. This is not taking into account any potential panic taking hold in the market – and also the completely unprecedented fact that 5 million houses are now held on short term ASTs, which can come on to the market in a matter of months – previous significant house price corrections have always been tempered by illiquidity.
Given that total UK bank assets stand at £450 billion, as noted above, even the optimistic scenario would more or less render our entire banking system bank-rupt.
Given our banks barely have enough funding to cover day to day activity as it is, I think I might start planting vegetables.