UK housing : firm foundations, or a rally built on sand?

Recent data releases in the UK have been interpreted as suggesting that the housing market may be showing signs of some form of recovery. Our interpretation, though, would be that the releases suggest merely that the pace of decline is slowing. On top of this important difference in interpretation, we would like to highlight the risk of a potential further turn down in housing market data.

In the event that current data do sustain and we are on a trajectory back to house price appreciation, we should see consumer and bank balance sheet repair, an increased willingness of banks to lend, and an improvement in profitability and general economic activity.

In the event that they do not, we will continue in the current situation in which banks are reluctant to lend even to those who view property as sufficiently affordable to be attractive, and the number of people in negative equity will continue to rise. Interest rates will have to remain low for some time, in this latter case, especially given the largely variable rate nature of UK mortgage loans.

The Nationwide House Price index today reported a 0.9% month-on-month increase in house prices in June, following a 1.2% increase in May, and a 1% rise in March, punctuated by only a very small drop in April. Continuing this positive, or better-than-expected, theme, the Hometrack Housing Survey published yesterday, reported that June prices remained stable versus May, after May also showed no deterioration when compared to April. So might current data be taken as evidence that house prices have found a floor? Mortgage approval data has been supportive of this, rising every month this year since January, from around 32,000 approvals to 43,400 in May.

Year-on-year comparisons, unsurprisingly, tell a different story: Nationwide house prices are down 9.3% versus June 2008, and mortgage approvals at the end of 2008 were 57% lower than at the end of 2007. The question is, then, can the monthly figures sustain their current and short-lived trajectory enough to start improving the longer term trends?

This morning we have seen the release of consumer lending in the UK, and particularly the net lending figures secured on dwellings. The market had expected to see a figure of £1 billion of new credit secured on property, and today’s figure disappointed at £324 million. This represents a staggering 64% decline in credit extended to mortgage borrowers in the month of May compared to April. The May number is also the lowest figure of new mortgage credit on property since the index began in 1993. It is data of this type that frames our conservative view on the housing market in the UK. The credit mechanism in the UK is broken. Banks are only willing to lend at their terms, and these terms are drastically tighter than they were between 2003 and 2007 (inclusive). The lending on 10% or even 0% deposits at very low margins that characterised banks’ willingness to lend in 2006 and 2007 is now a distant memory.

A cursory glance at major UK mortgage lenders’ websites reveals some dramatic changes: let’s look at the widespread and popular 2 year fixed rate mortgage (which then turns to standard variable rates). 2 year gilt yields are at 1.15%, and 2 year swap rates, the rate at which banks should be able to borrow, are at 2.21%. So let’s say you are a customer who’s looking to refinance and either have 15% equity remaining in your property after recent falls, or you are a new buyer with a 15% deposit: such clients can probably take a 2 year fixed mortgage at 5.5% to 5.75%. So the banks are taking at least 3% in margin on a mortgage loan (assuming banks can fund at or near swaps). What if you only have a 10% deposit, one of the most popular products in the UK in recent years? You will probably have to pay between 6.5% and 7%. This means banks are charging between 4% and 4.5% of margin for these mortgages with less equity in them. BUT: if you are someone with a healthy balance sheet and a good deposit of 25%, then you can get the above mortgage for between 3.5% and 4%, at an affordable margin of 1% to 1.5%.

This differentiation by the banks in terms of pricing risk, and their unwillingness to lend, leads us to believe that there is a possibility that recent housing market data is benefiting from a wave of buying interest from those with large deposits of 20% or 25%. These investors have seen properties fall by 15% to 20%, and have decided that in the long term, and with attractive financing still available to them, now represents an attractive entry point into the market.

Those without such cash cannot get attractive financing, as shown above. And moreover, there is the small issue of those that bought with 15% or less deposits in the last two years or so. Many of these people will find themselves in a position of negative equity, when the value of the loan they took on their mortgage is greater than the value of the property. For many of (most of?) these people, the deposit on their property will have been their biggest investment. The majority of these people probably won’t have enough resources to stump up the additional amount needed to refinance their current deals at attractive rates. So the majority will have to accept the standard variable rate route at the end of their 2 year term.

These issues highlight two major factors that we believe will be detrimental to UK housing: firstly, there is a large proportion of the UK housing market that is ‘stuck’ in their current mortgage deals, unable to refinance, which will substantially reduce demand for housing and mortgages going forward (likewise, rates available to buy-to-let investors are highly punitive, and will only be made to those with 25% deposits, so this has removed another large source of demand for housing and mortgages). Secondly, if inflation rises and interest rates follow, there will be many SVR-borrowers who see their monthly payments rise, and who may find great difficulty in keeping up with payments (see previous blog here).

In terms of how drastic these influences could be, Fitch released a research report last week in which it estimates that 15% of UK mortgages are in negative equity at April 2009. The agency forecasts that this figure will rise to 34% based on its assumption of a 30% peak to trough decline in house prices. In terms of RMBS, the agency notes a huge disparity by issuer in the proportions of master trusts of mortgage loans that are in negative equity, so care must be taken here. Whilst being in negative equity is not a necessary and sufficient condition of entering default, it does increase the probability of default by a borrower, and it clearly directly influences the probability of a bond taking a loss on default.

As we’ve stressed over the past few years on this blog, the housing market is key to the strength of the UK and global economy.  A prolonged weak housing market makes it very difficult to have a sharp bounce in economic activity.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Ben Lord

Job Title: Fund Manager

Specialist Subjects: Corporate bonds, inflation markets, financial institutions and credit default swaps

Likes: Sport, weekends, cooking, countryside

Heroes: Ron Burgundy, Superman, P.G. Wodehouse

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