We owe it all to UK banks

Today, the Office of National Statistics reported November trade data. The mainstream media were not tripping over each other to report the latest export and import numbers. The latest numbers were, truth be told, quite unremarkable.

Debt problems worse now than in 2008

Credit rating agencies sow more havoc

Its those credit rating agencies again; with their recent downgrades of UK buildings socieites, they have thrown a spanner into the Bank of England's Special Liquidity Scheme. From today's Times:

THE Bank of England is locked in talks with seven British building societies to renegotiate crisis funding measures introduced at the height of the credit crunch. A slew of credit-rating downgrades for building societies last week threatens to breach the terms of the government’s Special Liquidity Scheme and force the societies to hand back cash to the Bank of England.

Such a move would reduce the amount of new lending they could make, dealing a blow to Whitehall plans to kick-start the housing market. Chelsea, Yorkshire, Skipton, Coventry, Newcastle, Norwich & Peterborough and Principality are the societies affected. All have recently passed stress tests imposed by the Financial Services Authority (FSA) and are not considered in danger of collapse. Nonetheless, they will now be charged more to use the emergency funding.

The Dunfermline - What happened?

We are becoming numb to financial scandals. We have seen far too many. So when a mid-sized regional bank fails, it barely registers.

However, the failure of the Dunfermline building society is scandalous. Yet again, the FSA failed to properly supervise an institution that was taking unacceptably dangerous risks. It was also an institution that had a highly paid but basically incompetent management team. The FSA missed it all. Yet again, the taxpayer has been lumbered with a huge bill to clean up yet another FSA supervisory disaster.

The FSA had a opportunity to step in when the Dunfermline building society prepared their Basel II Pillar 3 Disclosures 2007 document. This submission is supposed to outline the institution's exposure to various kinds of risk. This is what the Dunfermline management said about their commercial property risk profile.

Our commercial risk appetite is confined to loans secured on property where the Society is able to achieve an adequate return for that risk, where the commercial investment is in lower risk areas, and where the Society is able to take advantage of risk mitigation such as guarantees to limit its risk.

The Society seeks to limit its risk to any one area of commercial lending by imposing sector limits.

This wasn't a terribly accurate representation of the magnitude of their commercial property exposure. The Chancellor - Alistair Darling - picked up on this point on Monday when he was forced to explain why the Dunfermline failed.

"This is a building society that, unfortunately, took out over £650million in loans in commercial property. In the last couple of years, it bought some mortgages from an American company that had gone bad. It's had to write off some of its IT systems because of difficulties it's had and it needed between £60 million and £100 million to keep it going. When you bear in mind that the society has never made more than about £5 million or £6 million a year in the recent past, it couldn't even service that sort of loan, let alone repay it.”

Presumably, someone at the FSA took a look at the Basel II document and concluded that everything was fine. Yet if someone had bothered to look at the loan portfolio, they would have quickly realized that the Dunfermline was far too exposed to a commercial property downturn.

After all, as the 2007 annual report pointed out, the institution had assets amounting to ₤3.3 billion. It had ₤117 million in capital, giving it a leverage ratio of 28. Holding a £650million exposure to commercial property was a very precarious position for a bank like the Dunfermline. The FSA should have picked this up.

The Dunfermline debacle sadly reveals that the FSA continues to incompetently supervise the financial sector. In fact, it is worse than that. The institution is dangerous. With each bank failure, it pushes huge clean up costs onto the taxpayer. In summary, it has wrecked the financial viability of UK public finances. It has to be stopped before it does any more damage.

The silent property crash

(Click on the chart for a sharper image)

The commercial property crash is rarely mentioned, but it is just as vicious as the one currently raging in the residential market. UK Banks are dangerously exposed to commercial real estate. Declining rental values and property prices threaten to weaken already battered bank balance sheets.

Prices are already down over 40 percent since the peak in early 2007. They could fall further and easily outstrip the fall in residential prices.

Even the Duke of Westminster?

This is a crisis that has hit the rich the hardest. It might go south and ruin the rest of us, but at the moment, the big wealth wipeouts are happening at the very top of society.

Even the Duke of Westminister is having to talk nicely to this bankers.....

Britain's wealthiest landowner, the Duke of Westminster, is in advanced talks with his bankers to prevent his £2bn property fund business breaching bank covenants. Pressure on the multibillionaire duke has intensified with investors in his funds suggesting that his property managers failed to heed advice to reduce borrowings 18 months ago, ahead of the collapse in property values.

The developments mark a serious threat to the duke's private investment company, Grosvenor, and underline how the property downturn is embroiling the country's wealthiest aristocrats.

UK commercial-property firms need to raise $20 billion this year

Meanwhile, back in the UK property market.....

Jan. 14 (Bloomberg) -- U.K. real-estate companies may need to be rescued by shareholders this year to stay afloat. The largest commercial-property firms need to raise as much as $20 billion this year to restore their balance sheets at a time when financing is scarce, according to estimates by Bernd Stahli, an analyst at Merrill Lynch & Co. in London. The FTSE 350 Real Estate Index fell 7.3 percent, the biggest slide since 1987.

The five largest real estate investment trusts -- Land Securities Plc, British Land Co., Hammerson Plc, Liberty International Plc and Segro -- have combined debt of 19 billion pounds ($28 billion), according to their latest reports. About 700 million pounds of loans are due this year, research by Nomura International Plc shows. The banks that granted those loans may now be reluctant to provide more credit.

That could spur another year of losses for REIT investors. The FTSE 350 Real Estate Index of 18 stocks fell 46 percent last year, the most since the index was created in 1986. The worst performer was Liberty, which declined 56 percent.

UK commercial property - it is the crash that rarely gets a mention in the regular media.

Rent crash continues

Mayfair rents; the top of the market on the monopoly board. Now they are crashing.

For a decade it was the preferred location for hundreds of hedge fund managers as they deserted the City and set up shop nearer to their well-heeled clients. Making the move to Mayfair and St James’s, they would think nothing of paying more than £100 a square foot for a few floors inside a Georgian townhouse, driving rents ever higher as they bid against each other.

Property experts described the rents as “eye-popping”, but investors’ money was flooding in and fee structures were designed to capture 20 per cent of the profits, so managers believed that the bills could be shouldered easily.

(from today's Times)

Darling - VAT cut from 17.5 percent to 15 percent

Just checked the BBC website; fiscal irresponsibility is the order of the day. Darling is up on this feet delivering this pre-budget statement.

So far, Darling has:

Reduced VAT from 17.5 percent to 15 percent:

Raised the government deficit to £78 billion this year and £118 billion next year.

Working on the assumption that this year's GDP is about £1.4 trillion, and assuming that it does not increase next year, this means that these deficits are about 5.5 percent and 8.5 percent of GDP respectively.

Do New Labour really think that they are going to get away with deficits of that magnitude?

Dream on....

Riot in Iceland

The BBC reports that the Icelandic masses are on the move. Several hundred stroppy protesters gathered outside the city's main police station to shout and stomp at the injustices perpetrated upon them by the world financial system.

Lets be honest, Icelanders don't have much experience at rioting. These demonstrations are going nowhere. Brits, on te other hand, have centuries of accumulated know how of street protests and anarchy.

Can you imagine what is going to happen when Reykjavik-on-the-Thames finally blows up.

UK property - another 15 percent fall next year?

Two stories today that illustrate just how precarious the UK housing market is right now. The market may have slipped 16 percent relative to the peak. However, here are two stories that suggest that things are about to get much worse.

The first, from the Telegraph, highlights the huge number of empty homes in the UK. When prices were going up, it made sense for speculators to buy and hold properties rather than rent them out. It was supposedly much easier to time the market with a vacant house whereas a rental property would contain those awkward renters with their six month contracts.

"Almost 1 million homes are standing empty across the United Kingdom, and the vast majority – more than four out of every five – are believed to be owned by private landlords.

Some landlords might be actively trying to sell, or planning refurbishment, while many have simply given up on their empty properties. Whatever the reason, the Empty Homes Agency (EHA) believes that a staggering 85pc of empty homes in this country belong to landlords.

The EHA claims that there are more than 762,000 empty residential properties in England. Based on earlier figures, about 650,000 of these are believed to be owned by private landlords, and almost half of these are thought to have been empty for more than six months. Almost 1m homes are standing empty across the United Kingdom, and the vast majority – more than four out of every five – are believed to be owned by private landlords. The charity estimates that there are at least another 77,000 empty residential properties in Scotland, plus 50,000 each in Wales and Northern Ireland."

Meanwhile, the Financial Times reports an increase in voluntary repossessions in the UK:

"Banks are seeing an increase in the numbers of homeowners deciding voluntarily to hand back their properties because they cannot afford to keep up mortgage payments. Voluntary repossessions involve the bank selling the property at auction but this will not show up in official figures as a repossession because there has been no court order.

The phenomenon is widespread in the US, where it has been nicknamed jingle mail because homeowners often post their keys to lenders if they cannot make the payments and no longer have any equity in their homes. It was also common in the UK recession of the early 1990s when homeowners were in negative equity."

With huge supply and rising repossessions, it isn't too hard to imagine a surge in supply which will quickly lead to outright panic amongst speculative investors.

A further 15 percent fall in prices next year looks very likely.

Falling flat prices in the North West

Penny, who writes the wonderful rentergirl blog, asked me to post a few regional house price charts.

Here is the first of what I hope will be a series. Today, we are looking at flat prices in the North West of England, which includes Penny's home town of Manchester.

According to the data, average flat prices in the region peaked in the first quarter of 2007 at ₤111,000. Since then prices have fallen by about 19 percent. The latest data puts the average price at about ₤89,000.

As Penny's blog illustrates, the North West is the epicentre of the UK's buy-to-let inner city two bedroom new build speculative bubble. It will also be the epicentre of its crash.

I just wish Penny would post more often.

The end of mortgage securitization

Housing bubbles across the world were built on securitization. Banks bundled their high risk mortgages into bonds and sold them onto unwary investors. In return, banks received cash that allowed them to issue more mortgages. This recycling of loans created unprecedented levels of credit and fueled the extraordinary run up in house prices.

With the onset of the credit crunch, mortgage securitization has all but died. In October this year, residential mortgage backed securities issuance was just $10 billion; barely 5 percent of the March 2007 peak.

Without securitization, it will be impossible for housing prices to stabilize and recover. Without credit, there can be no housing bubble.

Alice's bubble wrap

Too Late For Me

Renter girl is moving out and moving on.

"My landlord is going bankrupt, and so I must leave. Somehow, he’s accumulated twelve buy-to-let mortgages, you see, and nine are in negative equity.Good job I packed, really."

Twelve buy-to-lets, with nine underwater? Who gave him the credit to create such a mess?

Do Fannie and Freddie hold the key to UK’s housing crisis?

First prize for dumbest question of the day.

UK going into recession, says EC

The Eurocrats must have enjoyed making this forecast.

Housing slide hits Barratt profit

Profit warning? I'm amazed that Barratt is still around.

Stagnation in Welsh economy continues

I haven't heard much about the Welsh property bubble.

Lehman shake-up as losses mount

"Troubled US bank Lehman Brothers has reported a massive third quarter net loss and outlined radical plans to strengthen its finances. Lehman said it made a loss of of $3.9bn (£2.2bn) between June and August, taking its losses this year to $6.6bn. To shore up its weak financial position, it has slashed its dividend and will sell a stake in its lucrative fund management arm. "

It doesn't look like a long term growth strategy; it is more like "can we last till the weekend" strategy.

Lehman Death Watch: Will Paulson Let Lehman Fail?

Naked capitalism thinks that the Fed and the Treasury might let Lehman sink. Not so about this one.

Lehman Brothers: Wall Street atom smasher set in motion

"The world’s most powerful balance sheet smasher was set in motion for the first time Wednesday morning at the start of an experiment designed to unlock the secrets of the investment bank accounting universe."

Lehman losses hit world stocks

Al-Jazeera's take on the Lehman crash.

Irish Nationwide disagrees with downgrades

"Irish Nationwide Building Society says it 'fundamentally disagrees' with recent rating downgrades from credit rating agencies Fitch and Moody's. Fitch said today that the downgrade reflects concerns about the uncertain outlook for commercial and residential property lending in Ireland and the UK. It said this has deteriorated further and faster than was anticipated in early 2008."

Pimco fund makes $1.7 billion in a day after bailout

The real reason behind the Freddie and Fannie nationalization.

Bill Gross Finds Communism

It is as if the Berlin Wall had never fallen.

Spanish PM unveils housing credit to combat slump

More state aid for the housing market.

Economic Breakdown: Result of Moral Breakdown?

"Today, people don’t seem to care so much about things like their reputation, honesty and character. The pursuit of money reigns supreme."

Judgement day is upon us; we had it coming.

Bernanke and the power of central banks

Back in 2002, Fed Chairman Ben Bernanke gave a speech entitled “Deflation: making sure it won’t happen here. It was a year after 911 and the US economy was dealing with the aftermath of the dot.com crash. Taken together, the two events pushed the US economy into a recession. With asset prices crashing, the Fed feared that the US might slip into a Japan-like deflation.

Here is what the man said about deflation back then:

“(The) US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, the US government can also reduce the value of a dollar in terms of goods and services, which is the equivalent of raising the prices in dollars of those goods and services. We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.”

Taking quotes out of context is often a dangerous thing. It is tempting to use this particular comment to label Bernanke as an irredeemable inflator. The quote, coupled with the drastic cuts in US interest rates provides a strong case against the Fed chairman.

However, a quick attack on the Fed’s irresponsible monetary stance is not the immediate objective here. Instead, we have a simpler purpose. Bernanke’s 2002 statement is one of the clearest statements of the power of central banks. Although talking directly about the Fed, Bernanke offered a telling description about the capacity of all central banks, including the Bank of England, to affect the price level.

As Bernanke points out, when a country has a government-controlled paper money system, then it can use the printing press to increase the relative supply of domestic currency. As the printing presses crank up, the price of money relative to goods and services falls. In other words, the domestic currency loses value as inflation takes hold.

Bernanke’s last sentence is positively chilling; “under a paper money system, a determined government can always generate higher spending and hence positive inflation.” His words are extremely precise, and worth close examination. The qualification “paper money system” is crucial. There are plenty of monetary regimes where the government could not devalue the currency; for example; a gold standard, a silver standard; a fixed change rate; or a currency board. Unfortunately, a paper money system is exactly what we have here in the UK and in the US.

The phrase “a determined government” is also significant. Inflation is a policy choice not an accident. Even under a paper money system, avoiding inflation is a straightforward matter; just keep the printing presses under control. If a central bank keeps control of the money supply then inflation will not be a problem.

Bernanke then offers a strong clue why a “determined government” might want to debase the national currency. Such a government “can always generate higher expenditure.” Inflation allows higher government expenditure. Inflation is often a symptom of fiscal difficulties; when a government would like to spend more than it receives in taxes.

Higher inflation erodes the real value of government debt and makes borrowing very attractive. Inflation also directly works as a tax. Governments pay their workers and suppliers in pieces of paper that are costless to produce and in return, it receives labour services and goods. If someone holds a note issued by the government, in an inflationary environment, over time the value of the note falls. That loss of value accrues to the government. If the government ever had to redeem those notes, in real terms it would return less once inflation has done its work.

However, Bernanke’s most important words are in the last sentence – “can always generate…higher inflation”. It the “can always” part that needs emphasizing; a determined government can always generate inflation. If a government finds itself in a deflationary cycle, it is because it has chosen to be there. It can always find the exit door; it is marked “print more cash.” In other words, deflation is an extremely unlikely occurrence.

This recent fear of deflation is actually a cover for inflation. Greenspan used it during the post dot.com bubble as an excuse to cut interest rates to 1 percent and inflate the real estate bubble. At the time, Greenspan used monetary policy to dodge a deep post-911 recession. He succeeded but at the expense of creating a huge real estate bubble that is now crashing with terrible consequences.

So long as he does not look too far into the future, a little inflation would help Bernanke right now. Higher prices and negative interest rates would rob savers and relieve the debt burden on irresponsible borrowers. Since defaulting borrowers threaten to bring down the US financial system, a little debt relief via some inflation would be most welcome.

The benefits would not stop there. The biggest and most irresponsible borrower has been the US government. With debt levels rising, higher inflation would also rip off US government bondholders, and would deflate the real value of government debt. Higher inflation would reduce the value of the dollar, giving US workers a pay cut in terms of import prices.

For banker or politicians who are unwilling to tell the US taxpayer that government liabilities are unsustainable and that expenditure must fall or taxes must rise, then the case for inflation is a compelling one. If, on the other hand, you are a worker or a saver, then the Fed is about to roll you over.

What is true for the Fed, is also true for the Bank of England. Our banks are in trouble; government indebtedness is rising; and sterling is overvalued. A little inflation here might help enormously with some short run difficulties.

However, there is nothing short-run about the impact of inflation. Once it takes off, people quickly begin to expect it. Savers demand higher interest rates to compensate for potential inflation. Workers demand inflation indexation. Long-term contracts become untenable, while investment is discouraged. Inflation quickly destabilizes economies, and impoverishes anyone living on a fixed income.

The 1970s was the last time determined governments took the inflationary option, with 1975 being the high point. It took about 20 years before central banks brought inflation back down to the levels experienced in the mid-1960s. While inflation may offer a few quick fixes, in the end it is a disaster. However, today central banks today seem willing to trade off some short run convenience for long run pain.

Collapse

Here is another word I am using too much - collapse. Unfortunately, everything is collapsing; growth, banks, property speculators, and confidence. Everything is indeed falling apart, except inflation. That number is surging northwards.

Here is today's dollop of misery.

The UK needs a plan

You know we are in trouble when politicians start calling for a rescue plan. It will take more than a cut in stamp duty and liberal bankruptcy protection laws to save the UK economy from its day of reckoning. Personally, I think there is nothing that can be done other than sit back and suck it up.

Spain's largest property developer collapses

We covered this story yesterday, but repetition is the mother of learning. There is much instruction to be had from Martinsa-Fadesa. The property developer was unable to secure a €150 million (£119 million) loan from the banks and creditors. These speculators were already holding €5 billion of debt.

Panic is now gripping Spanish financial markets. If Martina-Fadesa could fail, all Spanish property developers could fail. Perhaps, they will and if they do, they will take the Spanish banking system down as well.

£30 billion is wiped off the FTSE

Like everything that goes wrong with the UK financial system, it is all the fault of Americans.

Bernanke sees downside risks

Those desperate interest rate cuts haven't worked; the US economy is still slowing and the financial system is still imploding. In fact, Bernanke's mad dash to cut rates provoked a screaming rise in commodity prices and led to the highest level of producer price inflation since 1981.

So what is next? The interest rate option is closed off. The fiscal stimulus package temporarily kept consumers spending, but the impact is quickly tailing off. Undeterred, there is talk of a second package of tax cuts. Meanwhile, US public sector indebtedness keeps on rising, and the taxpayer is firmly on the hook for a massive bank bailout.

Bernanke is in a hole, and he helped to dig it.

Bush - no bailout

According to Bush, the Treasury's frantic weekend attempts to shore up confidence in the GSE's in "no bailout". Whatever......

Economists say UK economy in trouble

Inflation is soaring (and surging); the economy is slowing; and the financial system is imploding. Businessweek thinks we might be in trouble.

Commercial property down 2 percent in June.

Commercial property values sank by a bigger-than-expected 2 percent in June. The market is down more than 19 percent since it peaked a year ago.

Equitable life - more delays

Here is the FT's take on the crisis:

"Equitable Life policyholders will have to wait at least until the autumn to find out if the government will bow to calls from the parliamentary ombudsman to compensate more than 1m policyholders who lost billions of pounds in the mutual’s crisis. Alistair Darling, chancellor, has ordered lawyers to pore over the ombudsman’s report and is expected to wait until the House of Commons returns from its summer break before giving any view on compensation claims."

Bad news round-up

The jig is up. The UK is hurtling towards meltdown. The bubble is so, so over, and now it is payback time.

Bovis and Redrow fire 1,000

The two homebuilders are downsizing. Remind me again, didn't Mr. Broooon have some kind of socialistic target on homebuilding? No workers, no homes methinks.

High street banks save the B&B

And about time too. With the B&B sinking 19 percent a day, someone needed to step in and sort things out. Someone, somewhere must have been screaming at the FSA "do something, pleeeeezzzze before the B&B thing brings the show crashing down." So the FSA leaned on the high street banks. who are going to pony up the cash to recapitalize Britain's busted buy-to-let bank. A nice touch; the FSA forces other banks to cover up its regulatory failures.

Is the B&B saga over? Perhaps it is time to move onto HBOS.

UK breaks EU budget ceiling

Darling, you naughty boy, you have been breaking the EU's fiscal deficit ceilings and they have caught you out. The deficit is above 3 percent and EU finance ministers want you to reduce it.

Barclays dives out of the secured lending business

There will be no more homeowner loans from the UK's fourth largest bank. What does this mean for Carol Vorderman?

US pending home sales down almost 5 percent

What, you call this news?

Taylor Wimpey crash

Yesterday, Taylor Wimpey shares were worth just 9 percent of their value a year earlier.

An early warning of things go come?

How far will UK property prices crash?

It is everyone's favourite parlour game - guess the price drop in the UK property market. What is it going to be? Will the market be down 10, 20 or 30 percent? Does a 50 percent drop seem realistic?

Over the the last week or so, I tried to formulate my own answer. As I started to think about it, I realized that the answer might reveal a lot more than the amount of negative equity that recent home buyers might face. It may also tell us something about recent monetary policy and the Bank of England's growing tolerance of inflation.

Most answers to the "price drop" question begin by looking at past experience. I will be no different. When it comes to generating unsustainable bubbles, the UK housing market is repeat offender. In many respects, today's housing bubble looks a lot like previous ones; too much credit fueling unsustainable house price inflation, followed by a painful crash.

Long term data emphasizes the repetitive nature of housing bubbles. Over the last 56 years, the UK market divides into two periods; the stable years of 1952-70, and the bubble years that started in 1971 and continues to this day. During this latter period, the UK went through four housing bubbles.

During the first period, the years of stability between 1952-1960, house prices increased, in real terms, at a steady rate. During those 18 years, property values, adjusted for RPI inflation, increased by about 28 percent, or about 2.4 percent a year. This 2.4 percent growth rate is remarkably similar to the annual real GDP growth rate.

This similarity should be no surprise; GDP growth reflects increasing labour and non labour income. Therefore, this period was marked by a close correlation between house prices and total income growth. In other words, during these two decades, house prices were largely determined by good old fashioned fundamentals.

The second period started in 1971, when the UK experienced the first of four property bubbles in 36 years. The first bubble occurred in 1971, when the Heath government liberalized banking regulation. The reform led to an explosion of credit which fueled a housing bubble. By 1973, the UK had double-digit inflation, increased rates were up, which killed off the bubble, and prices crashed.

The crash was only temporary dip. A second more muted bubble quickly followed under the Callaghan government. At the time, houses became a hedge against inflation. The government kept interest rates low and negative, which further encouraged price increases. However, the appalling policy choices caught up with Callaghan and by the end of the old Labour government, inflation was high, forcing the inevitable hike in interest rates. As usual, higher rates burst the bubble, and prices in real terms came crashing down.

The third and fourth bubbles are much more familiar; the Thatcher bubble (1985-91) and the New Labour bubble (2001-2007). There is no need to go through the causes and consequences; the facts are well known and I won't repeat them. Suffice to say, that during the early years, both bubbles enjoyed copious credit. Inflation increased, followed by higher rates and a crash.

The trend growth of house prices during the stable period (i.e. 1952-71) offers a good guide as to how far prices are likely to fall once a housing bubble bursts. I estimated the trend growth of prices during these 18 years and then forecasted house prices for the period 1971-2008. The forecast is illustrated below as the pink smooth line. (The sharp eyed reader will notice that the trend is not a straight line. It is, in fact, an exponential trend.)

During the three previous bubbles, once the party was over and the market crashed, house prices returned to my forecasted long run trend growth. Typically, prices did more than return to long run trend. In every one of the last three corrections, prices fell slightly below their long run trend.

What would it take for prices today to return to my forecasted long run house price trend? First, we need to recognize that prices can return to trend via a combination of three factors; a) a nominal price drop, b) increasing inflation (other prices catch up with house prices), or c) rising real incomes.

Let us start with an extreme case - a pure nominal price adjustment that occurs immediately. As the chart suggests, prices today are a long way from long run trend growth. As of March 2008, it would take a nominal drop of 44 percent for prices to return to long run trend.

Of course, this type of adjustment is too extreme; prices will not adjust immediately. Sellers will go through a prolonged and agonizing period of denial before expectations adjust downwards. Inflation will erode the real value of house prices and wages will gradually increase. Nevertheless, the extreme case tells us the rough order of magnitude of the required change. It tells us that our three adjustment factors; nominal prices, inflation and growth, taken together, must adjust together by around 40 percent to bring prices back to trend.

Now let us assume a more gradual adjustment, say, around six years up to December 2013. During that period, we will assume that economy will grow at its normal rate 2.4 percent. If it maintains this growth rate, the economy will be about 15 percent larger in five years. Allowing for this rate of economic growth, real house prices would need to adjust a further 27 percent.

We will consider two possible adjustment scenarios to get this 27 percent real adjustment; a) no fall in nominal prices, and an average economic growth rate 2.4 percent, with all the adjustment occurring through inflation ; b) inflation increases at 2 percent a year, again the economy grows at 2.4 percent, and nominal house prices adjusts to get us back to the long run trend.

In the first scenario, inflation does all the work. Therefore, the key question is what inflation rate gets us back to long run trend. The answer? It turns out to be 4.2 percent, which is more or less the inflation rate we have today.

In the second scenario, nominal prices do all the work in terms of adjustment, while inflation grows at 2 percent and the economy at 2.4 percent. The answer here is that prices have to fall 11.5 percent between now and 2013.

If you were sitting in the Bank of England and these two scenarios were placed before you, which would you choose? Meet the inflation target with tight monetary policy and see real house price reductions, or have a higher inflation rate, with a more relaxed monetary policy, and stabilise nominal house prices at their current level. Recent RPI data tells us what choice the MPC made.

The MPC appears to have gone for the inflation option. Since 2006, the RPI inflation rate increasd from just over 2 percent and it has been consistently above 4 percent.

The timing of this higher inflation rate is very compelling. Back in 2005, the MPC tried to stabilize housing prices by raising interest rates. For a short period, prices stopped growing, and even began to fall. However, higher rates began to reduce economic growth. The MPC didn't like the slow growth, falling house price mix, and began to cut rates again. Once the MPC went back to loose monetary policy, house price inflation took off again, and inflation crept up to 4 percent.

Sadly for the inflationist MPC, this benign inflation-led adjustment has fallen apart. It disintegrated last summer when Northern Rock went under. The vision of a UK bank beign ripped apart by a deposit run frightened other banks. They woke up and realized that lending, even mortgage lending, contains risks. They took a long hard look at their lending portfolios and saw that the UK personal sector was carrying huge amounts of debt.

All the banks came to the same conclusion, it was time to pull the plug on the housing market. Mortgage approvals tanked and prices are now in free fall. The five year adjustment scenario is out. Prices could be hitting their long run trend level within 24 months or less.

What kind of price fall would return the housing market to trend growth by December 2009? With 4 percent inflation, and 2.4 percent economic growth, it would need a nominal fall of 25 percent. So, there you have it, my answer - 25 percent.

(Thank you, Brian from Canterbury for the articles and suggestions, they were very useful).

Fools rush in

Although house prices began to weaken last summer, the BTL brigade didn't get the message. In the last six months, landlords have taken out over 94,000 new loans - 49,000 since the beginning of the year.

This was not the only number going up; BTL mortgages in arrears is also rising. Currently, almost one BTL mortgage in 100 is at least three months in arrears.