The purchase of a house is the largest single purchase most of us will make. To buy a house most people will need to take out a mortgage. The mortgage lender will normally gear the size of the mortgage to the person’s likely income because this is what the borrower will use to repay the interest on the mortgage and the principal. The ratio of house prices to income is therefore a rough indicator of how easy it is likely to be to buy a house.
House prices in most countries have generally risen over the last half century – and generally by more than other prices, making them not only useful in themselves but also an apparently good hedge against inflation. However, the view that house prices always rise can be dangerous. First, it can encourage potential buyers to borrow too heavily against their income: for example, if they originally borrow £100,000 to buy a house and find later that that they have no prospect of paying the interest or repaying the principal, then if the price of the house has risen to £150,000 they can sell it and repay the loan with £50,000 to spare. It may have the same effect on lenders: if the price of houses rises then if borrowers default the houses revert to the lenders who then have assets worth more than their original loans. So the prospect of continually rising prices can lead both sides astray. If house prices unexpectedly drop and the borrower defaults the lenders may well then find themselves with houses that are worth less than the value of the loans originally made. The value of the asset side of their balance sheet will have fallen and the lenders may be technically bankrupt.
This is essentially what happened in the US in the housing crisis that began in 2006. House prices had risen sharply in the previous few years and had encouraged unwise lending. This tendency had been exacerbated by the development of complex financial instruments which broke any personal link between the ultimate lender and the borrower. Rather than lending to a known person whose financial circumstances they had checked out lenders now in effect bought assets which represented a share in loans to many borrowers whose personal circumstances they had no knowledge of whatsoever – a sort of financial beefburger. For the safety of their loan they now relied not on their knowledge of the particular person they had lent to but on the “law of large numbers” i.e. that they could accurately assess the average probability of default by a large number of borrowers and not need to know that of a particular individual. When prices began to drop, many more people defaulted than expected. Financial institutions found themselves holding assets – the beefburgers – whose value had become highly suspect or “toxic”, and many of these institutions faced bankruptcy.