Mortgage intervention – the UK government’s unconventional attempt to ease monetary policy

Since we started writing these blogs almost 7 years ago we have spent an understandably great deal of time discussing Bank of England monetary policy in the UK, initially with regard to conventional interest rate policy and now in the context of the unconventional policies we see today.

The most recent unconventional twist for monetary policy is not emanating from the Bank of England itself, but is effectively coming directly from the government. The Help to Buy home ownership scheme is a direct attempt to make the monetary transmission system more effective, with its supporters claiming it is a way to get free markets working so that good borrowers can access appropriate funding, while its detractors claim it’s stoking a housing boom and fuelling the next crisis.

One of the ways that monetary policy in the UK works is through the housing market. Interest rate changes reduce the cost of financing, which increases disposable income, or allows an individual to own a larger house for the same mortgage payments. This creates immediate wealth via higher disposable income, economic activity via the associated services and goods consumption that occurs with house moves, and a wealth effect as house prices rise.

It has been pretty plain that the connection between official interest rates and rates available in the real world has broken down during the financial crisis, as the banking system has been repressed from a capital, confidence, and regulatory point of view. The authorities have tried to counteract this by providing capital, encouraging the raising of capital, and providing huge amounts of liquidity. However, the traditional mechanism of rates feeding into the real economy in the UK via the housing channel was limited.

The Help to Buy and other schemes such as Funding for Lending are attempts to mend the disconnect between official rates, the banking system, and the real economy. Therefore they should be welcomed as an attempt to make monetary policy work again. This unconventional policy appears to be working. The UK housing market is strong. This week’s RICS survey showed that home sales in September reached a near four year high and the market is improving across the country, not just in London. As the chart below shows, there is potential for further strength in the future too, with sales expectations for the next three months reaching new highs.

RICS Sales Expectations at multi-year highs

My next chart shows 2 year fixed mortgage rates plotted against 2 year swap rates. As you can see, although swap rates plummeted from late 2008, when official interest rates were slashed in the height of the credit crisis, these falls were not passed on to the same degree in the real world through mortgage rates. But they are now becoming slowly more aligned, as swap rates have been gradually rising recently and mortgage rates continue to fall. This is obviously good for the housing market and the economy. This effect is about to get bigger as the availability of low deposit mortgages should provide a strong boost to all the activity associated with housing.

Mortgage rates are slowly reducing

Why has it taken so long to introduce this unconventional measure? It could have been a reluctance to stoke the housing market following the last crash, a belief that these kind of non-standard measures would not be needed, or it could be that it has been timed now in an attempt to push the economic cycle in line with the UK political cycle. The latter seems to be a consequence of the measures. They have been introduced in time to boost the housing market and the economy, and are set to expire before the election to encourage a rush of buying, as occurred with the removal of mortgage interest tax relief in the 1980s.

The UK economy looks set to be strong in the run up to the election as the disconnect between official rates and real activity gets resolved. The liquidity trap is being solved by government action. For better or worse, the UK housing market is going to be at the centre of UK economic activity once again.


Higher mortgage delinquencies not necessarily bad for all RMBS

Moody’s, the credit rating agency, published a report a few days ago on the asset backed securities market. One section of the report has attracted some media attention – it details the agency’s thoughts on UK interest-only residential mortgage-backed securities (RMBS).

Moody’s reaches the fairly unsurprising conclusion that when interest rates start rising in the UK delinquencies on interest-only mortgages will pick up. They go on to say that this effect will be greater in the non-conforming sector than in the prime segment of the market. This makes sense, as borrowers who have an impaired credit history usually fall into the non-conforming bucket and are therefore, on average, more likely to have trouble paying their mortgages than those who qualify as prime borrowers.

This isn’t as bad for RMBS deals that are backed by interest-only mortgages as one might think. A large proportion of RMBS deals are structured with features that protect investors in the more senior notes to the detriment of those who own the more junior ones. A variety of trigger levels are usually built into the deals which amongst other things reference delinquencies and credit enhancement. If these triggers are hit, cash flows are diverted to the most senior tranche of notes, bringing forward their maturity date and increasing their yield.

A deal I have been looking at recently is 95% backed by interest-only mortgages and has a trigger when 7.5% or more of the mortgages are more than three months in arrears. Delinquencies are currently much lower than that but if they did breach the 7.5% level the deal would switch from paying pro-rata to sequential. This means that any excess cash that is generated through repossessions or borrowers re-mortgaging will all be paid to the lenders at the top of the stack instead of being shared by all the note holders. An increase in interest rates and delinquencies would in this instance clearly be of benefit to the senior notes.

Another dynamic to be aware of is when the mortgages backing the deal were originated. Mortgages taken out closer to the peak of the credit bubble in 2007 are generally of a lower quality because lending standards were weaker and borrowers generally have less equity in their property. As a result, these mortgagees have less of an incentive to keep paying their mortgage each month.

Holders of junior notes in later vintage deals should definitely be worried by the prospect of higher interest rates in the future. Senior note holders – whilst remaining attentive to movements in the market – should be fairly comfortable with the credit quality of their bonds, even in a climate of higher interest rates.


First home owner grants – a gift to new home buyers, or existing?

We aren’t the first to have a look at George Osborne’s “Help to Buy” scheme. It has been met by warnings far and wide. Sir Mervyn King stated that “there is no place in the long run for a scheme of this kind”, whilst Albert Edwards from Societe Generale was a little more blunt when he wrote that it was “a moronic policy”. Even the IMF and the OBR are getting in on the act, warning that the scheme may have more of an impact on the demand side of the house price equation, rather than fix the real issue which is a lack of supply.

What alternatives does Osborne have? Seeing as rising house prices do almost nothing to help the UK’s biggest problem, the Government should target the bigger problem, which is the UK’s dearth of investment.  Construction is a very low productivity investment. The UK needs investment in infrastructure, education, plants and equipment.  Without this the UK has very weak long run growth potential.

Now don’t get us wrong. We can see what George Osborne is trying to do. By announcing the “Help to Buy” scheme in the latest budget, the Chancellor is doing his best to stimulate economic growth through construction which will hopefully encourage consumption through the multiplier effect in an economy that has been anaemic since the financial crisis. The Government coffers will start to look better too due to higher stamp duty and income tax receipts. Who knows, it might also help in the polls. And it will work. We know this because Australia and Canada – two of the most expensive countries for housing in the world – have been running schemes like this for years.

The UK’s Help to Buy scheme will take two forms. The first part will offer buyers that qualify an interest-free loan (up to £120,000) from the Government. The second part will see the Government act as guarantor for a proportion of the borrower’s debt. In Australia, the “First Home Owner Grant” has been in existence in some form or another since 2000 and is a one-off grant to first home owners. It is not means tested and differs from state to state (in Sydney, the most expensive city in Australia, first home owners are currently entitled to $15,000 under the scheme). And in Canada, those looking at getting on the property ladder are entitled to a $5,000 tax credit and under the “Home Buyers Plan” can also withdraw up to $25,000 tax free out of their retirement savings to buy or build a home.

The problem is, these schemes have generally caused housing affordability to worsen in Australia and Canada. The chart below (courtesy of Torsten Slok at Deutsche Bank) highlights just how overvalued house prices are in parts of Australia and Canada. The fact that Wollongong ranks higher than New York on a house price to house income ratio seems like madness to me.


Another interesting result of Torsten’s affordability chart is the prevalence of New Zealand cities like Auckland and Christchurch. And you guessed right, New Zealand also has a form of the Help to Buy scheme, called the Welcome Home Loan. And if you are a New Zealander with some pension savings, you could be allowed access to your retirement savings to get on the housing ladder.

Home buyer schemes push up prices primarily through the accumulation of mortgage debt. Arguably financial companies have done the correct thing in tightening lending standards and reducing loan-to-value ratios. With the UK government now guaranteeing up to 20% of a new mortgage, those “riskier” types of borrowers that previously wouldn’t have qualified for a mortgage now have the ability to enter into the housing market. Demand increases, supply may not respond to the same extent and prices rise. Additionally existing home owners may sell their home and acquire more debt in order to buy a more expensive home. Who knows, mortgage equity withdrawal levels might come back in a big way too. But sooner or later, the house of cards will come crashing down – as we are all very familiar with.

The charts below highlight the relationship between rising levels of mortgage debt and house prices in Australia, Canada and the UK. Australia is a very interesting example as the First Home Owners Grant has been increased and decreased over time with house prices suitably responding.

Australia relationship debt

Canada relationship debt
UK relationship debt

The UK’s Help to Buy scheme is most likely going to encourage a further accumulation of mortgage debt, leading to higher house prices, causing housing affordability to worsen from current levels for those who don’t have access to the scheme. Arguably, this scheme will also make income inequality much worse, so those who aren’t in a financial position to buy a property will fall even further behind.  It will also worsen the wealth age gap, i.e. it’s the older, existing homeowners who are most likely to benefit, to the detriment of younger people who don’t have a home and need somewhere to live.

We have already seen evidence of house prices increasing in the UK, with yesterday’s RICS house price balance at levels not seen since January 2010. This data is consistent with the stronger house price data we have seen recently from mortgage lenders Halifax and Nationwide indicating that we are back at pre-crisis highs. One has to wonder whether a scheme encouraging financial companies to lend and consumers to borrow is the brightest thing to do in an economy with £1.26 trillion (or 80% of GDP) mortgage debt outstanding. Especially as it is designed to make an already expensive asset even more expensive, which could lead to financial instability if the economy wobbles and ultimately cost the taxpayer big time.

With house prices set to rise further in the short term, the question has to be asked – is this a help to buy or help to sell scheme?


A look at housing affordability in the US and UK

In recent months we have blogged about the recovery in the US housing market that is currently underway. This is in contrast to the UK experience, where the housing market appears to be stuck in the mud. We thought a quick look under the bonnet could reveal the dynamics at play in both countries.

In order to do this, we have constructed a housing affordability index that captures the three main barometers of the health of the housing market; wages, house prices and mortgage rates. By combining average house prices and mortgage rates, we can estimate the typical payments facing a mortgage holder in either country. We have then divided the average wage in both countries by this number. We think that this enables us to get a pretty good read on how affordable housing is in the respective countries.


As the chart shows, owning a house has become considerably more affordable in the US relative to the UK since 2007. There are a number of reasons why this has occurred.

Firstly, US house buyers are feeling rate cuts to a greater extent than their UK counterparts. For example, at the end of 2012 30-year US fixed rate mortgages were 3.35% compared to an average UK fixed rate mortgage of 4.10%. As outlined earlier this month, UK building societies are finding it difficult to pass on any rate cuts because of the impact that such a move would have on their profits. Secondly, wage increases have also favoured potential American homeowners. In the US, wages have risen by nearly 16% compared to an increase of 12% in the UK.

The US has improved on two metrics relative to the UK, but the difference isn’t enough to explain the divergence in affordability between the two markets. The dominant affordability factor has been house prices.

US house prices saw a greater correction, falling by 30% from the peak to trough, while UK prices only fell by 18%. We have now seen US house prices generate solid returns for buyers, with prices now growing at over 10% year-on-year. This is likely to have a significant impact through the multiplier effect on consumption and GDP growth. In contrast, the UK housing market recovered relatively quickly, but since late 2010 house prices have been anaemic.


With the standard variable mortgage rate rising over the last 11 months, limited upward pressure on wages, and stable house prices it appears unlikely that the UK housing market is going to become more affordable for home buyers anytime soon. It is thus understandable that in order to assist potential homeowners, the government has launched its “Help-to-Buy” scheme (following the muted impact of its Funding for Lending scheme) which will come into effect in January next year.

Whether the scheme will work or not will continue to be debated amongst economists. The Help-to-Buy scheme should theoretically impact house prices in a positive way. But this could actually have a negative impact on those looking to buy and potential homeowners may end up borrowing more to purchase a house than they would if the scheme didn’t exist at all.


4 Housing Markets, One Country

The Eurozone has become a very extreme example of the dangers inherent of creating a single currency area populated with a myriad of different countries and regions. There is little doubt that the right monetary policy for Germany is not necessarily the correct one for Portugal given the underlying structural differences and lack of fiscal coordination.

However, closer to home, there could be an argument that the same (albeit in a less extreme form) is true of the UK. Looking through the prism of the UK housing market over the past 30 years, it’s possible to argue that there are 4 distinct regional markets within the UK. The UK is not an optimal currency area.

Using historical regional data from the Halifax house price index (see the chart below), there have been some very large and identifiable variations between different regions within the UK. Prices within Greater London have fared the best over the period, showing a strong bounce back from recent lows. Northern Ireland has suffered from an extreme boom and bust whereas the Scottish market has been the relative underperformer over the same period. In contrast, the other regions of the UK have, by and large, moved in lock step with each other.

Given the fact that Bank Rate is the same in Chelsea & Kensington as it is in Dundee, the potential to exacerbate structural imbalances between regions due to a common monetary policy is clear to see. Indeed there is a sense that as central London market prices rise to new highs in absolute and relative terms, we are witnessing a new liquidity fuelled bubble divorced from the economic fundamentals of the rest of the UK.

However, there are mitigating factors: existing within a single sovereign political entity, fiscal transfers and labour force mobility should all help redress these imbalances over time. The fact the London and the South East contribute a greater proportion in tax revenue is a case in point. However, due to the foibles of negative equity, labour mobility has been greatly constrained in recent years. Differences in regional unemployment bear witness to this fact. For example, the latest ONS data states that the unemployment rate in the North East is 12.0% compared to 6.4% in the South East.

Are we therefore condemned to a future of further economic stresses and strains within the UK? Maybe not. If the Scottish do eventually decide to leave the United Kingdom with their own central bank and currency, maybe the Northern Irish and Londoners should be given the same option too?


UK housing market flashing amber

The July RICS survey continued the worrying trend of weaker UK data that has been in evidence since the preliminary UK Q2 GDP data release on July 23rd.  It seems that the economic slowdown that has been evident in the US in the past few months is no longer contained to the US alone. The survey showed that UK surveyors are on balance seeing house price falls rather than rises, the first time this has been the case since July 2009, and signs of both weakening demand and greater supply meant that future price expectations turned more negative. 

We’ve focused on the UK and US housing markets on this blog a lot over the years, and forward looking indicators such as sales/stocks ratios or mortgage approvals played a primary role in shaping our exceptionally gloomy view on the UK and US housing markets (and hence financial markets) in 2008.  The correlations between the variables has changed, as correlations always do, but you can definitely get a feel for which way the UK housing market is headed by eyeballing this updated chart, which plots UK house prices against the RICS sales/stocks ratio (ie the number of sales that estate agents have made over a rolling 3 months divided by the total number of properties that estate agents have on their books).  A low ratio implies a glut of supply and/or poor demand, while a high number suggests houses are flying off estate agents’ books. 

The RICS sales/stocks ratio doesn’t suggest that the UK housing market is about to fall off a cliff, but it does suggest that the short term outlook is for flat or slightly negative prices.  This isn’t necessarily surprising considering that UK house prices moved sideways in the aftermath of the last housing crash in 1993-1995.  But the concern is that the enormous monetary and fiscal stimulus of the past two years has only served to temporarily halt the decline in house prices, and house prices in the UK in particular still look very overvalued relative to average earnings.  Another leg of house price declines will place significant strain on the already vulnerable banking sector, which would leave us looking more and more like Japan

Returning to the recent trends in global economic data, some of the US slowdown may simply be because the economic benefit of the huge monetary stimulus at the end of 2008 has now worked its way out of the system (monetary policy operates with about an 18 month lag, as suggested in last week’s blog).  The Bank of England didn’t move quite as rapidly as the Fed, with the final rate cut taking place in March 2009.  The UK is only now starting to face a slowdown, which will likely be highlighted in the Bank of England’s quarterly inflation report released tomorrow.  European data remains remarkably strong, although this may be partly because the ECB was slower and less forceful in implementing monetary policy (the final rate cut didn’t occur until May 2009).  There have of course been numerous additional monetary and fiscal responses around the world since May of last year, but the beneficial effect of the ECB’s rate cuts will cease to be felt over the next few months and I’d expect European economic data to begin to weaken.


Free falling

Today’s mortgage approvals numbers came out at a record low (see this comment for why we love mortgage approvals so much). Weakening mortgage approvals is no surprise – the housing psychology is moving to a bear market from a buyers perspective, and the mortgage lenders are strapped for cash so the number of willing providers of finance is collapsing. But it’s the pace of the decline that is startling. This free fall in lending creates a vicious spiral, with a subsequent free fall in house prices. Our adjusted mortgage approvals number now predicts that UK house prices will be dropping by at least 15% year-on year by December this year (see chart).

Like any free fall, the damage is a function of where you jump from. Sadly for the UK economy, we start from the highest point in the western world. Recent research from the Bank for International Settlements (BIS, see graph 3B) looked at the house price to income per capita ratio (this is the housing market equivalent of the P/E ratio) across a selection of economies. They then compared the ratio to the 1995-2005 trend to get an idea of how far each country’s housing market has deviated from its historical ratio. As at 2007, the UK housing market was the most overvalued, closely followed by Spain. The UK housing market was twice as overvalued as the US housing market, so we certainly shouldn’t rule out the possibility of the UK having a property meltdown worse than that in the US.

Housing market crashes historically take two to three years to work their way through, and given that the past decade has seen the biggest housing boom, there is every reason to expect that the following bust will be bigger and will take longer than has been the norm. If things continue deteriorating at the current pace, then pain in the financials and construction sectors will spread way beyond the likes of Bradford & Bingley or Taylor Wimpey.


US housing crash now worse than during the Great Depression

US data released last week showed that US house prices fell by 14.4% in the year to the end of March (this is the S&P/Case-Shiller Composite-20 Index, which the market tends to focus more on – the S&P/Case-Shiller Composite-10 Index was down 15.3%). The track record of these indices is not very long though – the composite-20 index goes back to 2000, while the composite-10 index began in 1987. So Robert Shiller, who is the cofounder of the index, has calculated the change in both nominal and real US house prices going back to 1890 (see the second bullet point in this link for the data). As shown on our chart and reported in this week’s Economist (see here), US house prices are now falling faster than the -10.5% rate witnessed in 1932. Given the month-on-month declines of more than 2% that we’re currently seeing, it should only be a few more months until the year-on-year record of -16.1% is broken, which dates back to 1901.

US nominal house price falls are bad enough, but the picture is even worse in real terms (ie adjusted for inflation). Real US house prices are currently falling by 16.6%, which is easily the worst figure on record. In 1932 for example, the US economy was experiencing deflation of 10.1%, so real house prices were only falling by 0.4%. The US housing market doesn’t appear to be anywhere nearer reaching the bottom either – the supply of houses on the market is very close to all time records, and house prices will have to continue falling until this is cleared.

The UK housing market looks like it is rapidly following the path set by the US. Nationwide have UK house prices falling by 4.4% in the year to the end of May, while HBOS today reported that house prices are down 3.8% over the same period. Taking the last three months of the Nationwide index and annualising it shows that UK house prices are dropping at an annual rate of 17.0%. HBOS’s index has registered monthly falls of -2.5% in March, -1.5% in April and -2.4% in May, which equates to an annualised rate of -25.1%. And unfortunately, UK house prices are set to fall a lot further. We’ve charted the progress of mortgage approvals over the past 18 months (see here for Richard’s comment at the end of April), and as you can see from our updated chart, our adjusted mortgage approvals number is predicting a year on year house price decline of 15% by the end of 2008.

The central banks’ inflationary concerns are preventing interest rates from coming down as fast as they otherwise would do. This, combined with banks’ unwillingness to lend, means that demand for houses continues to wane, and a rebound in house prices is exceptionally unlikely in the foreseeable future. A collapsing housing market will inevitably have a severe knock on effect for the wider economy.


Watch out below

One of our favourite economic lead indicators was released yesterday – the rate of new mortgage approvals in the UK. Readers will probably be familiar with this by now as we discussed mortgage approvals in October, November and January. Mortgage approvals are an excellent house price predictor because they show the amount of new money entering the housing market. Mortgage approvals drive the housing market with a lag, and the housing market drives the economy with a lag. Yesterday’s headline grabbing figure of 64,000 was a record low, pointing to a continued deterioration in the housing market (Nationwide announced today that house prices are now 1% down year on year). A weaker housing market will mean a weaker UK domestic economy.

We try to look beyond the headlines, and look at real numbers. As we have previously pointed out, it is not just the headline amount that matters but the ratio of new mortgage approvals relative to the available size of the UK housing stock. So comparing mortgage approvals last month to mortgage approvals in the early 1990s is wrong, because the UK’s housing stock has risen by about 0.8% per year. The headline unadjusted number is a record low, but adjusting for the growth in the housing stock makes this number even worse. The outlook for the housing market (and hence the economy) is therefore bleaker than headline figures suggest (click chart to enlarge).

The big question is are these approvals a momentary spike down, or are they going to get worse? The anecdotal evidence sadly points to ongoing falls in this number. This is due to the mortgage lenders’ decision to change their lending and business plans in the face of the credit crunch. Northern Rock typifies the change – this time last year they had the largest new market share, but they are now shrinking their total mortgage lending. The ongoing credit withdrawal is continuing. Nationwide yesterday announced that they won’t lend to a new buyers on their base mortgage rate without a deposit of at least 25%, and they’ve also decided to stop lending more than £500,000 per property. This will further hit buyer demand.

The foundation of the UK residential property market is the first time buyer and the availability of credit. If these impetuses disappear, then the credit drought could cause damage to the UK property market that will take years to repair.


How much do homeowners stand to lose on the UK housing market?

At the beginning of October last year, Richard asked “Is the UK housing market on the brink?” (read article here). Conclusion – little danger of collapse in the short term, but any dropping away of mortgage approvals would change this view. By the end of November, mortgage approvals had indeed started to fall sharply, and Richard said the UK housing market was “over the edge” (see article). Mortgage approvals continued collapsing, and in January we said that the mortgage approvals figures implied that the UK housing market would be falling 5% year-on-year by this summer (see article). This is now looking a little on the conservative side – Nationwide figures show UK house prices have fallen five months on the trot, while data from HBOS said the UK housing market fell 2.5% in March, the biggest monthly drop since 1992.

So how far could UK house prices fall? The IMF said last autumn that UK house prices were 50% above where their models suggested house prices should be, although this month they toned it down to 30%. The honest answer is that nobody knows how far prices could fall, as there is a huge margin for error on long term economic predictions. We tend to stick to shorter term projections, and look at things like mortgage approvals. Mortgage approvals are a reliable predictor of UK house prices six or seven months ahead, and current data implies year-on-year falls of between 5% and 10% by early autumn (and this projection is likely to worsen, because the banks are becoming increasingly reluctant to lend, which means that mortgage approvals and hence house prices could fall much further).

If we were to have a longer term guesstimate, history suggests that when the UK housing market crashes, it tends to fall about 25%-30% from peak to trough in real terms. But given that UK house prices rose about 270% from 1995 to the end of 2007, there’s a risk that this current crash (and it is a crash) could be worse.

Let’s assume, then, that UK house prices fall by 30%. How much do homeowners stand to lose? A lot of homeowners will think that they’ll lose 30%, but they’re wrong. It’s actually a lot more. Buying a house is a leveraged investment, and the degree of leverage depends upon how big your mortgage is in relation to the value of the house. Consider someone who has a house worth £400k, and whose charitable parents have coughed up £200k for a deposit. If house prices fall by 30% (so their house falls to £280k in value), they’ve lost £120k. Unfortunately house price falls don’t make mortgages smaller, so if they sold their house, they’d only get £80k of their £200k deposit back. This means that they’ve lost 60% of their money.

Then consider someone who put up a deposit of £80k to buy this hypothetical £400k house (so that’s an 80% mortgage). A 30% fall in the value of their house leaves them in negative equity – their £80k deposit is wiped out, and they owe £40k. Maybe this person is one of the 20,000 people in the City who are forecast to lose their jobs. This wouldn’t have been a big problem in the 1990s, when the government generously agreed to pay the interest on anyone’s mortgage if they were made unemployed (no matter how big your mortgage). Now, you can only receive assistance on the first £100,000, and you’re not eligible to mortgage relief if your partner works more than 24 hours per week or if you have more than £16k of savings.

You can see from the examples above how a house price crash would have severe consequences for the economy. Due to the leveraged nature of home buying, a housing crash can greatly reduce the spending power of consumers. It’s no coincidence that house price crashes result in (or occur at the same time as) recessions. The only way out is for central banks to slash interest rates in order to encourage borrowing again, which will eventually revive the housing market.

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