Bank may yet need to go nuclear to burst the housing bubble

London Terraces

The Bank of England did not need the Organisation for Economic Cooperation and Development to point out the risks of a property bubble in the UK.

They were spelled out by Sir Jon Cunliffe, the Bank's deputy governor, who said in a speech last week that it would be unwise to rule out the possibility of a hard landing for the housing market.

Threadneedle Street's response to this threat is following the graduated approach used by the US military to prepare for a nuclear conflict. The Pentagon has a series of defence readiness conditions (defcons), which start with the lowest state of alert (defcon 5) and end with war only minutes away (defcon 1). Similarly, the response to a real estate boom-bust in the UK is being progressively toughened up as more and more evidence emerges – from mortgage approvals and house prices – of history repeating itself.

Defcon 5 has already been and gone. At this point, the Bank began to worry that the housing market was getting a bit hot. As a result, it made sure that lenders were not being tempted to relax mortgage underwriting standards so that people who were poor credit risks could jump on the property ladder.

The Bank's hope is that lenders will get the message. If they don't, the option is there to tighten up the capital requirements for banks and building societies. This means that lenders have to hold more capital to safeguard themselves against potential future losses, and limits the amount of money they can parcel out in mortgages. When this happens, defcon 4 becomes defcon 3.

But there is plenty of cash floating around the UK financial system, courtesy of the Bank's own quantitative easing and funding-for-lending programmes. The unleashing of several years of pent-up demand, coupled with an inadequate supply of new homes, means the property market has plenty of momentum. Tighter capital requirements might not be sufficient, so the next step would be to tell George Osborne that it is time to wind up, or heavily scale back, his Help to Buy scheme. Telling the chancellor that his beloved mortgage subsidy plan was part of the problem rather than part of the solution would be a sign that Mark Carney, the Bank's governor, was starting to run out of options. In Threadneedle Street, defcon 3 would have become defcon 2.

By this point, the discussion inside the Bank would be about how to bring down house-price inflation with the minimum collateral damage. Rising house prices have forced many borrowers to stretch themselves to the limit. In the past five years, the number of people taking out mortgages with a loan to income ratio of more than 4.5 has doubled to 8%. Half of all new mortgages are for more than 25 years. The Bank could impose loan to value or loan to income curbs as a way of bringing prices down.

Finally, there is the nuclear option. The Bank's financial policy committee was designed to provide a range of custom-made tools for preventing the UK housing market from running out of control.

Knowledge that innocent people will be hurt means policymakers are reluctant to go to defcon 1. But ultimately, they will need to be prepared to press the button and push up the cost of borrowing.

Powered by Guardian.co.ukThis article was written by Larry Elliott, for The Guardian on Tuesday 6th May 2014 23.12 Europe/London

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