Chris Hamnett: Can Bank win a game of Reverse Monopoly?

Many British home owning consumers have been living on thin air

The past five years have been something of a golden era for homeowners. After the grim years of the early Nineties, when house prices fell sharply, particularly in London and the South-east, prices began to recover in 1995. Since 1995, aided by a very low interest rate regime, national average house prices have risen 150 per cent, from £66,000 to £166,000, and mortgage lending and house price affordability ratios have soared to an all-time high.

The past five years have been something of a golden era for homeowners. After the grim years of the early Nineties, when house prices fell sharply, particularly in London and the South-east, prices began to recover in 1995. Since 1995, aided by a very low interest rate regime, national average house prices have risen 150 per cent, from £66,000 to £166,000, and mortgage lending and house price affordability ratios have soared to an all-time high.

The overheated housing market has prompted concern from the Bank of England. The Governor, Mervyn King, has recently made it clear that prices are now above a sustainable long-term level and that they are more likely to fall than to continue rising.

One of the Bank's main concerns is the soaring level of mortgage equity withdrawal (MEW) and its impact on consumer spending and the wider economy. MEW has risen dramatically, from £600m in the first quarter of 1999 to an all-time high of £17.5bn in the final quarter of 2003. MEW now accounts for more than 8 per cent of post-tax income.

Most home owners know instinctively what MEW is, and many will have engaged in it, but the Bank of England defines it as "new borrowing secured on housing which is not invested in the housing stock". In other words, it is the difference between private sector housing investment in buying new houses, purchases of existing houses such as council houses from other sectors, and the cost of home improvements and changes in the stock of housing finance. The latter includes new mortgages, increases in existing mortgages and capital grants minus repayments and redemptions.

What this means in practice is that if existing owners re-mortgage or if they increase their existing mortgage but spend all or part of the proceeds on a new car, a holiday abroad, or use it for current spending, they are engaged in MEW. It also includes owners who move down market to a less expensive house and use some of the surplus to fund their retirement, go on a cruise or to give to their children.

While MEW has always taken place through owners moving down market, it was relatively small scale until 1979 because of a memorandum of agreement between the government and the building societies which in effect restricted them to lending only for house purchase or bona fide improvements. In those days, if you wanted to borrow money for improvements you had to provide estimates and receipts of costs.

But when the Conservatives were elected in 1979 they allowed the agreement to lapse and in 1980 the "corset", which had restricted the development of bank lending and borrowing, was terminated. Finally, the 1986 Building Society Act allowed societies to obtain access to wholesale funding and effectively ended mortgage rationing.

The result was predictable. MEW rose from about £1bn in 1979 to £4bn in 1981, reaching a peak of £16bn in 1990 when mortgage interest rates rose sharply and the housing market slumped (see chart one). MEW fell sharply between 1993 and 1998 to a low in 1997 of about £800m a year. It seems that MEW is related to the state of the housing market. When prices are rising strongly, so does MEW, and when prices fall MEW shrinks.

But since the late 1990s MEW has risen ever more rapidly, reaching the astonishing figure of £57bn in 2003, although the figure for the first quarter of 2004 indicates a slight slowing, probably reflecting the increase in interest rates and greater caution. The likelihood is that MEW has now reached a peak and will fall back.

Why is MEW significant, and does it matter? The short answer is that it provides a considerable boost to current consumer spending financed by taking on greater long-term debt. When MEW is fairly small this is of no great consequence but, as the second chart shows, MEW reached a peak of almost 8 per cent of total post-tax income in late 1989, just before mortgage rates were raised sharply, and it reached this level again in late 2003.

This represents a very considerable addition to consumer spending, which is not paid for out of income, but by borrowing. As such, it represents a potentially destabilising force. The personal sector has become much more indebted. The household sector debt-to-income ratio has risen sharply from 100 per cent in 1998 to 135 per cent in 2004, increasing the vulnerability of households to rises in interest rates or falls in income.

Twenty years ago, Martin Pawley suggested that equity extraction was becoming a major motor of the British economy. He argued that homeowners have begun to play what he termed "Reverse Monopoly". Unlike the traditional board game, in which players start off with property and try to turn it into cash, the aim now is to increase the share of annual expenditure that is drawn from long-term housing credit at the expense of the share from earnings.

Pawley may have exaggerated, but his point is real. One consequence of the increase in MEW is that households spend more, borrow more and save less. This is shown in chart three, which plots MEW as a percentage of post-tax income against the saving ratio (the proportion of income that is saved rather than spent). Crudely speaking, the two are counter cyclical: when MEW goes up, the savings ratio goes down.

There is an argument that many British home owning consumers have been living on thin air, taking out larger mortgages to fund their current spending. This is fine as long as interest rates stay low and they can afford the repayments. But when interest rates begin to rise so will the pain of mortgage and credit card repayments.

When repayments begin to rise as a percentage of income, and house prices begin to slow or fall, so consumer spending will begin to slow down as individuals face the reality of a squeeze on their disposable income and a reduction in their net wealth.

The Bank of England admits there is enormous uncertainty about the impact of a fall in house prices on consumer spending, but its forecast is that house price inflation will slow rapidly in the next two years, leading to a slowdown in consumer spending. It is precisely to avoid the possibility of a hard landing for the economy that the Governor is trying to take the heat out of the housing market sooner rather than later.

Chris Hamnett is professor of geography at King's College London and the author of "Winners and Losers: Home Ownership in Modern Britain"