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A helping hand?

Scott Philipson

June 24, 2006

Background

The present government believes there are about a million people in the UK who would like to own their own home but cannot afford to do so. This affordability crunch shows no sign of abating with the Council of Mortgage Lenders (CML) now forecasting a UK house price inflation rate of 7 per cent during 2006 – way ahead of earnings growth. Five years ago, first-time buyers (FTBs) accounted for 43 per cent of all house purchases in the UK. By the end of 2005, this number had fallen to 37 per cent.

In April 2005 the Office of the Deputy Prime Minister (ODPM), now the Department for Communities and Local Government (DCLG) launched a consultation paper entitled Homebuy – expanding the opportunity to own. Within this the government outlined its plans to enable an additional 100,000 people to purchase at least part of their own home with help from a mixture of public and private sector sources.

There are three products within the proposed scheme:

Social HomeBuy – aims to help existing social housing tenants to purchase at least 25 per cent of their home’s discounted value with the local authority or housing association holding the balance of the equity and receiving rent on this share.

New-Build HomeBuy – specifically aimed at key workers, those on the housing register and other FTBs identified as a priority for assistance through Regional Housing Boards. Again, the minimum proportion to be funded by the individual is 25 per cent. Again, the balance of the equity stake stays with the product provider on which rent has to be paid by the occupant. As in the case of Social HomeBuy, the purchasers have the opportunity to increase their stake over time.

Open Market HomeBuy – aimed at the same groups as New-Build, but most properties qualify. The minimum participation required from the purchaser is 75 per cent of the value of the property with 25 per cent being provided in the form of an interest-free so-called “equity loan”.

After the consultation period expired, it became apparent that most lenders had serious doubts about the economic viability of the concept of equity loans in Open Market HomeBuy. The government nevertheless pressed on regardless and has already opened up all three schemes.

Open Market HomeBuy

Equity loans are only applicable to Open Market HomeBuy. In this scheme it is proposed that the government and lender should both act as providers of that part of the equity which is not purchased by the borrower. Since the scheme was originally proposed, most major lenders have declined to participate with only three institutions remaining in place for the pilot due to launch in October 2006 – Nationwide Building Society, HBOS and Yorkshire Building Society.

Under discussion

The actual terms and conditions of the equity loans are fundamental to the success of the scheme and are still under discussion, but it has been agreed that:

the proportion of the loan provided by the government will be subordinated to the lender’s tranche with the government thus taking the riskiest position. The government will not levy an annual charge to the borrower.

the lender cannot charge interest on its equity loan during the first five years but thereafter a small levy of around 3 per cent per annum will be permissible.

if a person who purchases a property as a Key Worker ceases to be classed as such, they will no longer be entitled to an equity loan from the government and it will need to be repaid within two years. It is not yet clear what the government would or could do if its loan was not repaid under these circumstances.

the lender will have recourse to the buyer for repayment of the original cash value of the equity loan in the event that the proceeds of sale are insufficient to reimburse the lender despite the government’s cushion. This had to be agreed because lenders cannot take a true equity position in a property investment without allocating vast amounts of scarce capital in the process.

In effect, therefore, the borrower has to share any appreciation in the property’s value with the lender and the government, but if the value of the property falls and a loss is realised, the borrower is on his own – he still has to repay the original amount of the equity loan to the lender. On the face of it, that might still be a good deal for the borrower on the basis that he is getting the use of the 25 per cent equity tranche without charge for at least five years – after all, both the lender and the government are giving up the rental yield on their share of the equity which they should be receiving.

Sting in the tail

But there’s a really nasty sting in the tail. The participating lenders are talking about charging around 1 per cent above Base Rate for the conventional mortgage element on the buyer’s 75 per cent share. That could be as much as 1.5 per cent per annum above the cost of the best mortgage rates in the market. Without paying this high mortgage rate, the borrower can’t get the ‘cheap’ equity loan to go with it.

In effect, therefore, the borrower is paying a massive annual premium for the equity loan and will end up with a larger monthly mortgage payment than would be produced by taking a conventional 87.5 per cent mortgage – which most lenders would happily grant at market competitive rates. The remaining 12.5 per cent could still be provided by the government as proposed.

Even assuming that the Open Market scheme is a success, the government’s own projections make it look virtually irrelevant. Its latest forecast of between 9,200 and 15,300 additional purchases by FTBs during the 18 months of the Open Market HomeBuy pilot is dwarfed by the 364,300 FTB sales which took place in 2005 alone.

In order to attain the 43 per cent FTB share of purchases seen in 2001 an additional 66,904 FTBs would have needed to purchase property in 2005 alone. Clearly, the Open Market initiative is hopelessly sub-scale.

WSUB

With the average price now paid by FTBs in the UK more than £140,000, the potential benefit of an increase in the Stamp Duty threshold is far greater. The Royal Institution of Chartered Surveyors (RICS) has calculated that if the threshold was raised to £150,000 from £125,000, this would bring an additional 35-40,000 FTBs into the market every year.

Exposure

Perhaps more fundamental from the tax payer’s perspective are the risks to be assumed by the government. If the scheme were to grow to any significant degree, HM Treasury would accumulate a big exposure to house price inflation/deflation. Is this kind of speculation an appropriate activity for government? Could it create conflicts of interest for future governments in the management of fiscal and monetary policy?

The fundamental difficulty with the thinking behind Open Market HomeBuy is that it seeks to treat the symptoms rather than the cause of the problem. The causal link is clear – there isn’t enough housing of the right type located in the right places to meet rising demand. Making soft loans isn’t going to increase the available stock of property and may simply serve to push prices up further.

In 2004, the Barker Review pointed out that over the last 30 years the UK experienced a long-term upward trend in real house prices – an average of 2.4 per cent per annum. To improve macro-economic stability and deliver greater affordability for individuals, the report observed, a lower trend in house prices is desirable. To bring the real price trend in line with the EU average of 1.1 per cent, an extra 120,000 new homes are required each year.

The government needs to address these key, structural issues and concentrate its efforts on easing the demand/supply imbalance in the housing market while lightening the burden of taxation (starting with Stamp Duty) on the interest groups it is trying to help.

For example, if he can’t afford a significant increase in the threshold for Stamp Duty Land Tax, the Chancellor should levy the tax on sales proceeds received, not purchase prices paid. This would have the effect of transferring the burden from FTBs to those established homeowners who are trading down or out, most of whom will have accumulated big chunks of tax exempt capital gains.

In conclusion, the obstacle of affordability will only be overcome by reducing state intervention in the operation of normal market forces rather than by launching ill-considered tactical initiatives which have little or no prospect of success.


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