April 21, 2008

Financial Insecurity

The current money market and housing market problems are underpinned via a common root problem, so I will treat them together. Government plans to solve the woes of the money markets and housing market are short term tactics, probably designed largely to get the government past the next general election. These plans don’t recognise the underlying problem and its causes. Also late in arriving, they instead treat some of the obvious symptoms. So, as it is unlikely that the government will do what is needed, we must recognise how best we might adapt our plans. Although the root problem for both market systems is the same, the symptoms are different.

The Symptoms

The housing market symptoms have increasingly been affordability issues for first time buyers and recently price falls leading to the infamous negative equity trap for some. Government plans to tackle affordability for first time buyers by allowing them to own a fraction of a property exasperate rather than alleviate their problem. People will commit what they can to get a house, so enabling fractional ownership simply allows the same financial commitment for a fraction of a house. Obviously, this in turn increases the price for the whole house. No one wants to spend any money on buying a house, prices are dictated by how much people are allowed to spend by lenders. Fractional ownership simply increases that allowance. There are no direct plans to help those in the negative equity trap, which reduces the mobility of the workforce and so is bad for the economy.
The financial services industry has a crisis in confidence that has stifled the free flow of money. Money is a vector for the flexibility and growth of an economy, so this impediment will have far reaching implications for the UK and is the biggest single problem we face now. Government plans to restore confidence to the money markets using bonds in exchange for property backed debt are not solving the root problem. Instead this tactic dilutes the problem by spreading it over time and distributing losses to the public purse. Another possible tactic seeks a quick correction of the problem by compressing the problem in time and localising its effects. The latter tactic, although less intuitive, has a number of advantages, prime among them is returning the economy more rapidly to a better state. As a result, even those most impacted have time to recover and more obvious measures can be enacted to restore confidence, which is certainly one of the most important qualities of a market based system. Now the problem exists one of these tactics must be employed, as the over valuation of property has to be normalised, implying losses for those that bought in late. The only question is how much to dissipate and slow those losses. It should also be noted that as the government does not in fact have money reserves to back these bonds, so their effect is ultimately inflationary. Also the drawn out tactic using bonds disengages the debtor from the consequences of their poor judgment, which has obvious negative effects.

The Root Problem

The use of residential property as an investment vehicle is at the root of both the money markets and the housing market problems. There is a complex interplay of many causes, but the two most prominent are: Firstly, pension savings are inflexible, not protected and are subject to means-testing. The lack of confidence people have in pensions has encouraged them to find alternative savings vehicles. Secondly, poor understanding of investment markets by amateurs who have access to them with residential property. Profiteering using markets is as old as humanity, but amateurs using them with residential property is a bad idea. Stability of residential property supply is too important to allow it to be used as a tool for speculation which inevitably leads to the decoupling of prices from earnings.
So how should the government tackle this twin causes. Firstly, they must introduce a government backed flexible pension scheme linked to contributions that is not means tested. Importantly, these savings must be ring-fenced and protected in law to prevent misuse. This will provide a safe haven for people with savings and reduce the tendency to use inappropriate savings vehicles as pensions. Secondly, the residential property market is too important to be used as a speculative investment tool by people with a poor grasp of its consequences. Strong controls need to be applied to the total percentage of income and its sources used to repay residential mortgage debt. Naturally, to discourage the inevitable attempts to circumvent these controls significant penalties need to applied to transgressors. It will be difficult to fabricate this control and it will need continual tinkering with to perfect, but it is essential. The ideal time to apply these controls is approaching when we reach the bottom of a property price dip. This root problem will keep recurring until it is addressed by providing a sensible pension scheme and controls designed to strongly correlate residential housing prices with earnings.

What Can We Do

Given that the government is unlikely to see the light and tackle this problem correctly as I outlined above, what can we do for ourselves.
On housing, timing is important. There will be a bottom to the housing market price falls. If you are planning to get into the property market or move, the best time to do so is at the bottom a price slump. In the end it is not the relative price of a house that matters to you, it is the amount you borrow to pay for it. That amount is always going to be lowest at the bottom of a price dip. If you want a house that costs twice as much as your current house is worth, that is easier to fund if for example your house is worth £100,000 rather than £200,000. Naturally as we get further from the bottom the less good a deal we get, but caution need only be exercised where there have been years of house price rises above wage growth. This is very difficult to do when prices are rising rapidly, but that is the time to save until the inevitable price crash. Those who are brave enough, or have no choice can get in and try to get out when they feel a good profit has been made. However, this is a very risky venture because typically the sums of money involved are large relative to income. If you do try this approach, a mercurial nature is essential. On sensing the market is topping out, sell fast and strongly discount your price to ensure a quick sale. If the price is not good enough and you are left holding the property too long you will have to discount even further later.
The financial sector has experts that understand their problems well enough. Unfortunately, those experts are not directing the businesses and so short-term and badly formed strategies still get used. It is in the interests of their directorships to ensure that directors and senior management making strategic and significant tactical decisions are well enough educated in the fundamentals of their business. General businessperson and salesperson types without the correct background simply do not have the depth of understanding required. In addition the board should sponsor multiple technical reports on the viability of any significant shift in strategy. They should also have clauses in the contracts of the most senior figures that prevent severance payments in situations where it is considered a poor strategy has lead directly to losses. This will not discourage good people from competing for these positions, in part because nobody takes one with the expectation of failure.

October 9, 2007

Confidence Needed

A vital element of any market based system, especially those trading nonessential items, is confidence. Firstly, confidence in the reliable operation of the market place and secondly that the items traded have some stability in value. Lower confidence and fewer people will be prepared to use the market. It seems the significance of this axiom has been lost on the various interested and influential parties in the Northern Rock debacle. They need to refocus on this fundamental. Further, I suggest that reviews and action should be proactive rather than reactive.

Blog at