Fears that negative equity could affect up to three million homeowners

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by Lin Freestone

The Bank of England’s warning that the number of homeowners caught in negative equity could rise from about half a million at present to 1.2 million by 2011, has been considered to be too optimistic.

Michael Saunders, a Citigroup economist, has pointed out that the Bank of England bases its figures on a survey of households where homeowners are asked for details of their own debts, financial assets and property value. Previous research has shown that people tend to overstate the value of their homes by up to 20%. They also undervalue their debt status by between 10% and 15%.

Bearing this in mind, Michael Saunders has calculated that up to three million households could be at risk of negative equity. This figure is based on the assumption that house prices will fall by 30%, by adding an anticipated further drop of 15% to the 15% drop in prices already experienced over the past 12 months.

Michael Saunders notes that the calculations are uncertain, but the key point is that, with house prices plunging, the numbers of households in negative equity will probably match or exceed the early 1990s peak of 1.8m. In turn such negative equity is likely to exert a lasting drag on spending as households save more.

It will also hit the credit quality of lenders’ assets and add to the caution over high debt levels among both lenders and borrowers.

In the recently issued Stability Report, which is the Bank of England’s six-monthly assessment of the health of the financial system, there was a warning that a vicious circle has developed, in which the financial crisis is causing banks to cut the amount they are lending, which in turn is pushing house prices lower still, which is then causing the financial crisis to intensify.

There is pressure on the Bank of England’s monetary policy committee to deliver an aggressive rate cut when it meets tomorrow. Many economists expect a further half-point reduction in interest rates to take the rate to 4%.