How to respond to falling house prices

10.10.32am BST (GMT +0100) Sun 13th Apr 2008

Vincent Cable: 'Talk of large-scale repossessions and negative equity is sending shivers down ministerial spines (and, no doubt, those of many homebuyers).

We have already seen house prices fall faster than at any time since the early 1990s. Serious commentators expect a 25-30 % price fall to return an overvalued housing market to its long-term trend. Neither panic nor complacency is appropriate; what is needed is clarity as to what policymakers should do.

There are some obvious differences from the past housing crash. Unemployment is 1m as against 3m. Nominal interest rates, which then reached 15 %, are much lower and falling - though real interest rates, then about 5 %, are not markedly lower and borrowers are not getting the benefit of cuts since lenders are not passing them on. In some ways the position is potentially worse. Since 1995, benefit entitlements have been curbed for mortgage payers, while fewer than one in four have payments protection insurance.

So far, distress levels are less than in the last crash. Repossessions are less than half of earlier peak levels. But repossession orders, the first stage of the legal process, are comparable (95,000 last year; 103,000 in 1990), which suggests that distress is being delayed, not averted.

The 1990s crisis was caused by recession hitting an unaffordable housing market. We do not have a recession - at least not yet. We have a global credit crunch. The government claims that Britain is uniquely well placed to weather this new storm. How can it know that? The UK financial sector is relatively large, open and, therefore, more exposed to financial shocks. Britain's home-grown problems of a house price bubble and associated personal debt are relatively extreme. When the bubble bursts, the effect on wealth and other real economic impacts will be disproportionately large.

The policy response involves different degrees of urgency. Banks are demanding extra liquidity to maintain lending flows with the Bank of England buying up, or accepting as collateral, mortgages of variable quality. Crudely, they want the state to underwrite their risks and losses. The US authorities have gone further. But the Bank governor is right to say that a balance needs to be struck between helping the banks and not rewarding reckless, irresponsible lending.

A large injection of liquidity is necessary. But help should be conditional. Banks have to come clean about their losses. Bank shareholders, not the taxpayer, should foot the bill for writing down bad debts. There may well have to be rights issues and a cessation of dividends to restore bank balance sheets. The process must be carefully managed by the Bank of England.

These urgent, but technically difficult, problems do not really register on political radar screens. What does register is fear of constituents sliding into negative equity and mortgage arrears. It is not the job of government to prop up an overheated housing market. But there is a public interest in averting a wave of repossessions that would lead to local and national taxpayers shouldering the cost of housing the homeless. Mortgage lenders want the government to restore benefit entitlements - in other words, the taxpayer pays. No. Responsibility lies with lenders, as well as borrowers. Responsibility should be enforced by a statutory obligation on both parties to submit to an independent financial assessment by an agency such as the Citizens Advice Bureau and for lenders to offer payment alternatives so as to keep families in their homes - involving shared ownership and rental arrangements - with an equitable sharing of losses. There is also a good argument for social (state subsidised) landlords to act as a buyer of last resort, to prevent a fire sale of repossessed property and to rebuild the depleted stock of social housing.

The longer-term issue is what kind of regulatory regime should succeed the current discredited arrangements. We need a commitment to active management of cycles in asset markets, notably housing. Charles Goodhart and Avinash Persaud have described how adjusting statutory capital requirements could reflect cycles, restraining lending excesses and easing liquidity shortages. The anti-inflation mandate of the Bank of England would also have to incorporate asset inflation and deflation. Sensible and prudent bankers should welcome a shift from a culture of binge lending and painful hangovers to stability and responsibility. Back to basics was a poor political slogan. But back to basics for bankers is the right message now.