Trillion-pound trapeze act for house market

Mortgage borrowing smashed through the trillion pound mark last week (yes, that's 12 noughts), a landmark in Britain's love affair with bricks and mortar. With house price rises now bubbling along at 5 per cent a year, dire warnings of a property crash seem long forgotten; but some experts still believe the worst may not be over.

Since the Bank of England stepped in with a confidence-boosting cut in interest rates last August to steady a rapid decline in consumer spending, the housing market has surprised many observers by bouncing back - though not to the gravity-defying double-digit price increases of the past five years.

Twelve months ago, anxious homebuyers were holding back from entering the market and prices were treading water amid fears that the long-predicted crash had finally begun. When borrowing costs were cut, the nervous mood appeared to change, and by the beginning of this year the market was ticking over again. Estate agents, especially in London, were even talking of a spring boom. Instead of sliding into a 1990s-style crash, with negative equity and repossessions, the housing market had once again escaped.

'There was an awful lot of nervousness in early 2005 about the extent of the slowdown that was coming through,' says Ed Stansfield, property market economist at Capital Economics, which has long predicted a fall in house prices. 'When the Bank cut rates, it released a huge pent-up demand. People thought, "this is as bad as it's going to get".

'Most people have been pretty surprised at the strength of the rebound. There has been a recovery in overall levels of activity and interest. Strong mortgage approvals figures for May - up to 81,300, from 64,700 in April, according to the British Bankers' Association - suggested there's still plenty of house-hunting going on.

However, analysts warn that despite the market's impressive performance since the turn of the year, many of the same factors which made house prices vulnerable 12 months ago are still in place - and it's only a matter of time before they take their toll.

'There are a lot of headwinds facing consumers at the moment, which makes me surprised that we have seen such a rebound, and sceptical about whether it can continue,' says George Buckley, chief UK economist at Deutsche Bank. 'The fundamentals are not really in place to sustain a significant further boom. Real income growth hasn't been that strong, inflation is rising for non-discretionary items like energy bills, taxes are increasing and there's a greater need for people to save for their pensions.'

John Butler, chief UK economist at HSBC, agrees. 'I think the fact that it has rebounded over the past six to nine months doesn't mean we're past the worst: a lot of issues could weigh down on the housing market. House-price-to-income ratios are very high, the debt-servicing burden is high, and banks are suffering a pick-up in arrears. We are still where we were a year ago.'

With interest rates tightening across the world, led by the Federal Reserve in the US, the cost of servicing a mortgage has been rising, even without the Bank of England changing its policy rate. The Bank is expected to leave interest rates unchanged when it meets next week but the markets are betting on a rate rise by the end of the year.

'There is a bigger group of people who are very vulnerable to a 1 or 1.5 per cent rise in interest rates than there would have been five or 10 years ago,' says Stansfield. Also unclear are the consequences of the rapid expansion in so-called 'sub prime' lending, often to borrowers with shaky credit records.

Not everyone agrees about the risks. Housing market economists Gavin Cameron and John Muellbauer at Oxford University produced an influential paper earlier this year reassessing the state of the market, and suggesting that there had been no bubble after all. Instead of an outbreak of irrational exuberance, their analysis suggested that factors such as strong income growth, population expansion, low interest rates and the slow pace of house building have explained almost all of the rapid price rises between 1997 and 2003.

Even those who still believe the market is overvalued are now more cautious about how dramatic any slowdown will be. 'We're still expecting the market to undergo a period of correction,' says Stansfield, 'but I expect things to be pretty dull for the next couple of years.'

Butler says that, although houses still look too expensive relative to incomes, a prolonged period of sluggish growth in prices - the economists' 'soft landing' - may be the most likely outcome, unless there is a trigger. 'If interest rates don't rise, and unemployment stays fairly low, it's hard to see what would drive a hard landing,' he says.

Although activity in the market remains strong, there are already some signs that the upturn is running out of steam, and the soft landing has begun. June's Nationwide index showed that prices were almost flat in June, growing by just 0.3 per cent, and taking the three-monthly growth rate to a steady 1 per cent, half as fast as the 2.1 per cent pace seen in the first three months of the year.

Fionnuala Earley, the Nationwide's chief economist, who has been predicting a slowdown in the second half of 2006 for some time, said the figures suggested the high cost of servicing a mortgage may be putting a dampener on the market. 'While demand seems fairly stable, the deterioration in affordability and its likely impact cannot be ignored. Mortgage payments for someone on average earnings now take up around 42 per cent of takehome pay compared with around 32 per cent three years ago,' she said.

As the steam comes out of the market, analysts and homeowners will once again be asking themselves whether they face a flat few months, or the beginning of a much trickier 'hard landing'. That has now become a trillion-pound question.