Houses down, shares up

Housing market crashes cause a huge amount of economic pain. They hurt building and construction, as well as many related businesses including home furnishings and DIY. And they make it much harder for consumers to borrow money against their homes to spend on other things such as cars and holidays.

It's no surprise, then, that housing recessions here in the UK have been associated with recessions in the wider economy (see 'Crashes and recessions' chart below). The last three major slumps in residential property have all coincided with a shrinking overall economy.

A horrendous bubble

The latest outbreak of bricks-and-mortar mania had all the hallmarks of a classic bubble. Just like in the dot-com era, property groupies told us that "the rules of the game had changed" and that "this time would be different".

They delighted in telling us how the unprecedented immigration of the last decade would keep the market propped up. Russian billionaires would snap up every Mayfair penthouse and Surrey manor house, while Polish plumbers would be queuing up around the block for two-up two-downs.

At the same time, Britain's fiddly planning laws and the limited land supply prevent enough new homes from being built. In 2002, new housing completions actually hit their lowest level since the 1920s. Together with the new demand from migrants, the optimists could make a seductive case why there would be no repeat of past upsets.

Unfortunately, their reasoning totally ignored the experiences of Tokyo and Hong Kong. Both are more densely populated than anywhere in the UK and are also places that attract new residents. Nevertheless, each has suffered a catastrophic house-price collapse in recent memory, the Hong Kong market having shed two-thirds of its value between 1997 and 2003.

As well as a compelling story, every bubble requires a gushing supply of cheap credit to keep it going. And that's exactly what we've had since 2000, with interest rates in 2003 dropping to lows not seen in decades. Also, the banks and building societies lent more and more carelessly. As prices soared, many people borrowed high multiples of their income and offered little or no deposits. Lenders frequently demanded no proper evidence of borrowers' ability to repay their mortgages.

The latest bubble was far bigger than anything that went before it, as our 'Crash history' shows (see below). The average ratio of UK house prices to incomes has been about 3.1 since 1930. At the height of the recent madness, that ratio hit a record of six times average earnings. Whichever data series you use, the story is the same: house prices became more overvalued than at any other time on record.

Unlike in the 1980s, the recent bubble was a truly nationwide phenomenon. House prices went through the roof not just in London and the south-east, but right across the country. During the last bubble, the party was confined to the more prosperous areas, with London achieving double the increase seen in the north between 1983 and 1989. The pain today is likely to be much more widely shared.

Blueprints of a demolition job

• This is the fifth crash since 1945.

• House prices fall an average of 28 per cent in real terms during crashes.

• The three biggest crashes have lasted on average 66 months.

• At the end of crashes, the average house price/income ratio is 2.8 times, compared with a recent level of more than 5.

• The biggest quarterly drop in house prices was between March and June 1975 when the market fell 5.5 per cent in real terms.

• The biggest real monthly drop actually occurred during a boom: -4.2 per cent in December 2002.

• A bottom could occur in early 2013

House-price boom and bust is as familiar a feature of the British landscape as thatched cottages and pebble-dashed semis. There have been four bubbles since the second world war, each followed by a crash. This gives us a gorily graphic guidebook of what we might expect from the latest installment of housing horrors.

In the four post-war crashes, house prices fell on average by 27.7 per cent in real terms (see chart, below). If we exclude the mini-crash of 1979-82 – which followed hotly on the heels of the 1973-77 meltdown – then the average sell-off has been 31 per cent. The three most serious episodes have all been pretty similar in duration, averaging 66 months – or just under six years. The most severe was the last collapse in the early 1990s, although this record could easily be broken.

Whether you adjust for inflation or not, the Halifax index has fallen even further this time than at the equivalent point in that last crash. But just how far might house prices fall and over how long a period?

In inflation-adjusted terms, UK house price crashes have tended to last for about five years. If history repeats itself, the market might hit rock bottom in late 2012 or early 2013. The overvaluation of the market also points to big falls. According to Halifax, the average house cost 5.43 times average wages in April. Over the long term, the average has been about 3.97, around a third of where it is now. However, prices tend to overshoot in a crash – by 1995, the ratio had fallen to just 3.09 times.

Let's imagine that house prices continue to fall at their recent monthly rate. At the same time, let's say that average wages continue to grow at the pace they have for the past 10 years. Under this scenario, the Halifax house price/wages ratio would return to its long-run average in January 2011, with house prices having fallen some 17 per cent from current levels, or 25 per cent from peak to trough.

A 25 per cent drop in nominal house prices would easily qualify as the biggest crash yet in UK house prices. During the last housing bust, the Halifax index fell by 'only' 15 per cent. However, it's quite possible that the crash will be even worse still. Both the Halifax index and my longer-term UK housing series suggest that the price-to-wages ratio tends to fall below historic average levels during a slump.

How long could it last?

At the bottom of the last slump, the average UK house was priced at 3.09 times the median annual wage. If prices keep falling at the rapid rate they have lately, it would still take until April 2013 for the the price/wages ratio to return to 3.09 times. However, this still optimistically assumes that wages will keep growing at their 10-year average rate, when lately they’ve actually been slowing sharply.

The worst could well be to come for another reason. In the last three crashes, the steepest falls in prices tended to occur when the economy was in recession. This is most likely because recessions involve some people losing their jobs and a lot more people worrying that they'll be next out of the door. As yet, the UK hasn't officially entered a period of negative growth and unemployment is relatively low. If things get worse – as seems likely – the housing crash will accelerate.

There will be lots of false dawns along the way. Property cheerleaders will seize on any slight upturn in the data and tell us that the "worst is over". However, it's worth remembering that, during the last slump, the Halifax index actually went up in nominal terms about 40 per cent of the time. Even during 1991 – when the country was mired in recession and home repossessions hit an all-time high – there were two months when prices rose by around 1 per cent, month on month.