Northern Rock not so solid any more – question from a client

The following question was sent to us from a client last week:

The recent profits warning from Northern Rock has clearly taken the equity market by surprise in the short term, though equally many people will regard it as a victory for common sense that sooner or later they had to pay the price of such an aggressive strategy. But where does this leave sentiment in the mortgage-backed securities market and is it likely to add to difficulties in the already-spooked credit markets? Do you have any exposure to any of the higher-risk UK lenders, and why?

Over the past six months, our team (and myself in particular) have probably thought more about the UK and US housing markets than any other topic, as regular readers of this blog will probably have realised. Will the US sub prime crisis spread to the wider credit market, and if so, when (see Jim’s recent comment here)? How strong is the UK housing market and when will it start to slow?

Sentiment in the mortgage-backed securities market has weakened on the back of a sharp housing market slowdown in the US. The roots of this lie in the Federal Reserve’s decision to hold interest rates at just 1% in 2003-04 in an effort to encourage consumers to borrow and spend. The Fed’s policy initially succeeded, as the US consumer pulled the economy from the brink of recession. The US housing market was a great beneficiary as consumers took advantage of amazingly cheap credit to borrow like crazy, causing US house prices to shoot up. But the supply of new houses exploded as the construction industry adjusted to soaring demand by churning out a load of trailers and condos. So now that US interest rates stand at 5.25% and demand has started to dry up, suddenly the US economy is left with a huge overhang of inventory, and house prices are starting to fall and will continue to do so until the market returns to equilibrium.

The story is not the same in the UK, where there have been few signs of any slowdown in the UK housing market. The reason for this dichotomy lies in the very different dynamics of the US and UK housing markets. In the UK, the supply of land is limited, and a booming economy and low real interest rates simply encourage borrowing, forcing house prices up. Despite recent rate hikes, UK real interest rates are still very low, and the housing market is if anything accelerating. Northern Rock’s profit warning was not a function of a worsening UK housing market (there has been virtually no deterioration in asset quality), but was more to do with profit margins getting squeezed from rising competition (in January I discussed the changing dynamics of the UK housing market and its influence on UK interest rates here).

If the housing market meltdown is primarily a US phenomenon, why are we concerned? Just as the FTSE falters when the Dow Jones dips, UK corporate bond spreads will tend to follow the US market, which isn’t surprising given that the £1.5 trillion US corporate bond market is 50% bigger than the UK and European markets combined (and many of the issuers in the European markets are US companies).

I have therefore reflected my concerns about the US mortgage market by positioning my portfolios defensively, favouring higher rated corporate bonds. In keeping with this, I have tended to avoid the aggressive and smaller UK mortgage lenders and have no exposure to Northern Rock. Within the M&G Optimal Income Fund, I have gone the next step by buying protection on Wachovia, a bank heavily exposed to the US housing market (for more detail on what I’ve been up to in the fund and for more detail on my views, see a replay of my recent teleconference here [no longer available]).