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.
Figure 1: Average UK house prices
Source: Office for National Statistics (ONS), 2023
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.
Figure 2: Policy rates in the UK, the United States and the eurozone
Source: Bank of England, Monetary Policy Report, November 2022
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).
Until the global financial crisis, UK housing markets operated within a highly leveraged financial system, with the major banking institutions heavily dependent on mortgage intermediation (see Table 1).
Table 1: Bank lending to GDP ratios, 1960-2010
| Country | Total lending | Mortgage | Non-mortgage | Households | Business |
| Australia | 1.13 | 0.70 | 0.42 | 0.77 | 0.36 |
| Great Britain | 0.82 | 0.55 | 0.27 | 0.67 | 0.16 |
| USA* | 0.88 | 0.54 | 0.34 | 0.48 | 0.39 |
| Canada | 0.62 | 0.35 | 0.27 | 0.55 | – |
Source: Jordà et al, 2016
Note: The first column reports the change in the ratio of total lending to GDP expressed as a multiple of the initial value between 1960 and 2013 ordered from largest to smallest change. The second and third columns report the change due to real estate versus non-real estate lending. The fourth and fifth columns report the change due to lending to households versus lending to businesses. The starred USA entry includes credit market debt.
While mortgage lending has kept increasing, households’ debt vulnerability has been exacerbated as mortgage rates have risen substantially with the changed monetary policy regime.
There are around eight and a half million owner-occupier mortgages in the UK, which represents around 30% of households. Approximately 20% of borrowers have variable-rate mortgages, so their costs have already increased (prior to 1990, variable-rate mortgages would have comprised 90% of mortgages).
About 6.3 million UK mortgages are fixed-rate home loans, and these debtors are protected from rising interest rates until their contracts expire. More than two million fixed-rate mortgages will expire by the end of 2023 (Bank of England, 2022). These households may face a significant increase in their mortgage repayment costs.
While this may result in higher demand for mortgage refinancing, prospective new borrowers – especially those in lower-income groups and with limited buffers – will confront rising affordability barriers.
These circumstances for UK households have become a major obstacle to economic resilience. UK mortgage approvals fell to the lowest level in more than two years in November 2022 (Matthews, 2023). Approvals for house purchases fell to 46,100 in November, down from 57,900 the previous month, according to the money and credit statistical release from the Bank of England. This was the lowest level since June 2020.
The share of UK households with high cost of living-adjusted mortgage debt servicing ratios (COLA-DSR) will rise to 2.4% in 2023 (Bank of England Financial Stability Report). The number of mortgages in arrears is projected to increase by 23% to 98,500 in 2023 and to 110,300 in 2024 (UK Finance, 2022).
Any increase in unemployment will affect households further. In addition, higher mortgage rates may affect rental markets because, with escalating mortgage costs, landlords may increase rents or stop renting out properties, thus reducing supply.
How might house prices affect the economy?
Both housing development activity and home ownership are contingent on the availability and cost of capital. These help to predict the behaviour of household spending and debt, as well as house prices.
Changes in house prices are affected by national and global capital markets, the regulation and structure of national housing credit institutions, and the monetary policies that affect these factors.
The transition from unconventional to conventional monetary policies has increased lenders’ caution and reduced household demand for credit (mortgages/loans), leading to a slowdown in housing markets. If assets begin to decline in value, the economy will face a negative wealth effect, which is detrimental to financial stability.
This is because house price declines are an intrinsic aspect of the broader financial stability framework in which macro-financial imbalances have an adverse impact on the real economy. Financial stability risks represent the relationship between macro-financial imbalances, often known as vulnerabilities, and unforeseen adverse shocks. These vulnerabilities develop because lenders and borrowers take excessive risks during economic booms.
In the housing market, this process links favourable financial conditions and consequently easy credit – reflecting a low-risk premium – to vulnerabilities in the form of household overborrowing (high household leverage) and overpriced house prices (which deviate from fundamentals).
With increased vulnerabilities, adverse shocks can be amplified by credit cutbacks or rising prices (reflecting binding borrowing constraints), resulting in a feedback loop of large house price declines, weakened household balance sheets, declines in real activity, increases in credit risk, and declines in the value of collateral in the banking sector, as well as tightening financial conditions that reinforce one another (IMF, 2019).
House prices in the UK have already started falling, and similar patterns (with different degrees of severity) are apparent in Australia and Canada. According to the Office for Budget Responsibility (OBR), home values are expected to drop by 9% between the fourth quarter of 2022 and the third quarter of 2024. At the same time, the average interest rate on mortgage debt would peak at 5% in the second half of 2024, the highest since 2008 (see Figures 3a and 3b).
As a result, money will be squeezed from household balance sheets, making many homeowners feel poorer. There are possible implications for non-housing spending via a behavioural effect stemming from a reduction in perceived wealth.
Figure 3a: House price forecast
Figure 3b: Mortgage rate forecast
Source: OBR
How resilient are households and the UK economy to these trends?
With increased pressure on household finances, servicing household debt will become more difficult. But several factors are likely to mitigate the effects of the current economic downturn on households and lenders.
Debt-to-income ratio
The Financial Policy Committee (FPC) of the Bank of England judges that households are more resilient now than in the run-up to the global financial crisis (Bank of England, 2022). Households are, on the whole, less indebted than the peak that preceded the crash at that time.
As per the House of Commons Library economic indicators, household debt peaked in the third quarter of 2008 at 155.6% of household disposable income. It then declined to 132.4% by late 2015. Growth in household debt levels accelerated from early 2016, so the debt-to-income ratio rose again to 136.3% by mid-2017.
In the third quarter of 2022, it was 133.8% (Francis-Devine, 2023) (see Figure 4). Although high compared with historical standards, this is materially below its 2008 peak.
Figure 4: UK household debt-to-income ratio
Source: ONS, 2022
Nevertheless, high levels of household debt can damage the financial system, either directly through loan losses and bank capital or indirectly through a decline in household spending, exacerbating periods of recession. Given the quick evolution of housing market conditions, this requires close monitoring.
Disposable income spent on mortgage payments
The proportion of disposable income spent on mortgage payments (DSR) is projected to rise but remain below the peak levels during the 1990s recession and the global financial crisis (Bank of England, 2022).
This currently sits at 5.4%, compared with just below 9% and 10% in the periods preceding the 1990s recession and the global financial crisis, respectively (see Figure 5).
Figure 5: Aggregate UK household mortgage DSR with illustrative projection to end-2025
Source: Bank of England, Financial Stability Report, December 2022
Policy interventions
Housing market booms and busts have a profound impact on the business cycle (Funke et al, 2021; Leamer, 2007). Given the role of housing in systemic financial crises, it is crucial to have ‘macroprudential’ interventions to protect banks and the wider financial system from potential threats to resilience. This is in addition to protecting the housing market itself, and the individuals within it.
Before the global financial crisis, mortgage measures that mitigated systemic risk were not widely used, but the UK was one of several countries to implement them after the crisis. By managing the accumulation of vulnerabilities and bolstering buffers, policy-makers can decrease the downside risks to house prices.
These macroprudential policies can lower systemic risks by controlling the build-up of vulnerabilities stemming from housing market valuation risks or households’ financial vulnerabilities (Galati and Moessner, 2013, 2018; Lubis et al, 2019). They can also reinforce financial intermediaries with buffers to absorb initial shocks and break negative feedback loops (Adrian et al, 2019).
There were three policy interventions in the UK housing market shortly after the global financial crisis: the Financial Conduct Authority’s (FCA) Mortgage Market Review (MMR); the Financial Policy Committee’s (FPC) intervention on high loan-to-income (LTI) mortgages; and the Chancellor’s Help to Buy programme.
The motivation for these varied, but they were all macroprudential in the broadest sense. They were designed to reduce a perceived structural threat to financial stability (MMR), to manage a cyclical threat to economic stability (LTI caps) or to improve access to a core financial service (Help to Buy) (Barwell, 2017).
Following a review in 2014, the FCA introduced stricter requirements for lenders to ensure that prospective borrowers could afford their mortgages. This included requiring income verification, and consideration of other debt and spending commitments.
Importantly, where the interest rate is variable or fixed for under five years, a test to ascertain if households would be able to accommodate possible interest rates rises in the first five years of a loan was put in place (Bowe, 2022). The Australian Prudential Regulation Authority (APRA) and Canada’s Office of the Superintendent of Financial Institutions (OFSI) have implemented similar, significant measures.
What issues may these policies raise?
While macroprudential initiatives are best viewed as precautionary policy interventions, the housing market remains one of the most significant potential threats to financial stability in the UK.
The regulation of mortgages has transformed risks and behaviour in the housing system, giving wealth-based leverage a more significant role in shaping housing booms after the global financial crisis.
Since 2008, it appears that mortgage arrears, defaults and the possibility for significant negative equity have been mitigated, and there are recommendations for further stricter mortgage stress testing (for example, by the OFSI in Canada in January 2023).
Yet as prudential regulators are not obliged to consider broader or longer-term housing market outcomes, they appear to have neglected the immediate consequences. For example, tighter mortgage rationing shifts significant volumes of middle-income households into rental accommodation, which can lead to rental shortages and rapid rent increases. This can also increase the role of ‘family’ equity in home purchase, reducing social mobility.
The longer-term implications for asset accumulation of households during their lifetimes – as home ownership both declines overall and is pushed into later years – do not appear to have been a factor in policy deliberation.
A restricted supply of mortgage financing necessitated the implementation of programmes such as Help to Buy. While these plans intended to stimulate demand, they did not trigger a rise in supply. As a result, they led to price increases and amplified the affordability concerns that underpinned the scheme’s motivation.
This highlights the redistributive character of rising house prices: those near the top of the housing ladder gain, at the expense of those at the bottom and future generations yet to join.
The country’s core banking system remains resilient (Bank of England, 2022). It is not thought that the rising pressures on households will immediately endanger the UK’s banking system’s stability, although some indebted households (especially younger generations and lower-income groups) are more vulnerable than others. In other words, while resilience across the whole economy is the focus, resilience at the household level is also important.
To prevent the build-up of imbalance in the economy, macroprudential policies must not only serve as an insurance policy but also address vulnerabilities both at micro and macro levels by complementing the Bank of England’s monetary policy.
There must be a shift in policy thinking that incorporates empirical evidence and enhances the control of housing market outcomes (and macroeconomic performance) in connection with monetary and prudential policies. The solution might not be house price targeting but rather a more integrated housing system perspective in macro-level policy-making.
Conclusions
The housing sector plays a transformative role rather than a passive role in shaping national economic outcomes as it continues to affect business cycles and growth paths. Yet it is often missing in macroeconomic and monetary analysis, or represented simplistically.
Housing policy is governed inadequately, and weaknesses in monetary policy understanding of housing systems are still part of the problem. These failures may obscure important economic dynamics and lead to misleading policy prescriptions.
Housing research and policies need to be reoriented to address the processes that contributed to the global financial crisis and to current economic conditions. The decade or so leading up to 2007 may have been ‘the most stable macroeconomic environment in recorded UK history’ as far as the UK was concerned (Benati, 2006). But the housing market was anything but stable.
The Bank of England’s Monetary Policy Committee’s (MPC) summary of its first decade documented that a housing boom had been a near-permanent feature of the years from 1997. Indeed, house prices tripled between 1997 and 2006, the ratio of house prices to household income was around two-thirds higher than its historical average, and mortgage debt had risen as a proportion of annual post-tax household income from 75% in 1996 to 120% in 2006 (MPC, 2007).
That trend continued until recently. Notably, the current difficulties do not simply reflect cyclical activity and shocks related to the war in Ukraine, but a regime shift from non-conventional to more conventional monetary policies.
It is time to reflect on how monetary and macroprudential policies previously failed to consider the housing market. Not only has this failure affected house prices, rents and affordability, but it has also made the conduct of monetary policy more challenging.
Even if inflation subsides and central banks conclude their cycles of rate hikes, household debt servicing costs are likely to remain elevated. As central banks worked to restore market confidence and justify the fast withdrawal of hyper-stimulative monetary policies (such as low interest rates), it made sense for them to concentrate on observable inflation statistics.
Central banks now face difficult challenges as they try to address multiple goals with few levers. As policy rates have climbed at the quickest speed in decades, we are again in uncharted territory.
Even if house prices return to pre-pandemic levels, the UK economy will be severely hit because many interconnected industries (such as finance, construction and furnishing) rely on a buoyant housing market. Higher mortgage payments, falling property values and a drop in construction will all contribute to an economic slowdown.
While certain indications imply aggregate resilience, we are currently dealing with a housing emergency and a cost of living crisis. This volatile environment poses significant risks to the UK’s property markets and financial stability. Poor economic prospects exacerbate these threats. Regulators must adapt to an ever-changing economic environment to protect the UK’s financial system.
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- John Muellbauer
- Will Hutton
- Yavuz Arslan
- Satyam Goel
- Chris Leishman
- Duncan Maclennan
- Ken Gibb
