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Tuesday 19 March 2024

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.

Some interesting ideas about how Japan (and by extension the rest of us) can get out of the deflation trap in today’s Times.  The article, "To fight deflation, abolish cash", proposes that getting rid of physical money will allow policy makers to do something not possible in a world where the population can hoard bundles of bank notes in sock drawers – namely to set an effective negative nominal interest rate.  Many economists suggest that Japan needs interest rates of around -4% (and a similar number has been talked about for the Euro area).  Abolishing yen notes and moving fully to electronic payment systems would allow policy makers to apply negative interest payments to "hoarded" money, and thus encourage spending rather than saving.  Whether it would simply encourage spending on gold bullion and foreign banknotes is another question, but whether it’s spending on non yen financial assets or on domestic consumption, negative nominal rates should eventually generate inflation.  Such a radical measure in an economy where the amount of cash circulating is over 6 times higher than in most developed economies is unlikely to be implemented, despite some political support, which in part explains why the Japanese government bond market continues to expect  average deflation of -2% per year for the next decade.

Longevity risk and pension fund deficits aren’t exactly new topics – one of the first ever comments on this blog was on precisely this subject (see here).  But it’s going to become a bigger and bigger issue over the coming years, and this has huge implications for both bond investors and for the global economy as a whole.  Last week the IMF made an important contribution to the debate with this paper.  For a decent synopsis, the Economist reported on it in their most recent edition here.

Probably the most startling part of the IMF’s paper was this slightly understated passage – the “major threat to long-term fiscal solvency is still represented, at least in advanced countries, by unfavourable demographic trends. Net present value calculations illustrate the differential impact of the [current] crisis vis-à-vis ageing: in particular, for advanced countries, the fiscal burden of the crisis is about 11 percent of the aging-related costs”.  In other words, the long term cost to governments of an ageing population (eg government pensions, healthcare) is ten times larger than the amount that governments around the world have thrown at the current banking crisis.  TEN TIMES.

Yesterday I attended S&P’s European sovereign roadshow, and they referred to the IMF study above in conjunction with one of their own studies.  Their study was released in September 2007, which was a long time before the worst effects of this financial crisis were felt, and countries’ fiscal positions have obviously deteriorated rapidly in the past two years.  In 2007, S&P estimated that if governments didn’t do anything about the huge demographic time bomb (eg don’t sort out pension deficits, don’t raise retirement ages) then of the 32 countries sampled in their study (25 EU and 7 larger non-EU countries), spiralling debts and deficits would mean that half of the world’s richest countries would be junked within the next 20 years.  80% will be sub-investment grade in the next thirty years.  As S&P pointed out, the assumption that governments don’t do anything about the demographic time bomb is (hopefully) unrealistic because countries would be forced to eventually address these problems, not least by the electorate.  But if they didn’t take action, then Japan would be junked by 2020, and the US, UK, France would be rated sub-investment grade by 2040.

One of the long term implications of this is that investors will likely prefer lending to the world’s strongest corporates than to the world’s strongest governments.  Stefan mentioned in February here how 5 year euro denominated Greek government bonds had about the same yield as 5 year bonds issued by Vodafone, Carrefour, BHP Billiton, Deutsche Telekom and Diageo.  These corporates actually all now yield quite a bit less than Greek government bonds, which is a combination of a significant credit rally since February and continued deterioration in Greece’s finances (S&P mentioned yesterday that they see Ireland as a much stronger credit than Greece, which doesn’t say much about Greece), but it’s still relatively unusual for corporates to trade inside government bonds. In 2020, maybe it will be very common for a large number of investment grade corporates to yield less than government bonds, and people will get used to talking about negative credit spreads.

Today we saw the release of May’s inflation data, which came in a little higher than the market expected.  CPI is running at 2.2% on an annual basis, and RPI remains in deflation, at -1.1%.  Food and energy prices continue to be disinflationary factors, whilst the prices of DVDs, TVs, clothing and footwear rose.  There was a rise in average mortgage payments too, which impacted the RPI number, probably due to people coming off low fixed rate deals – not good news for consumer spending going forwards.

We’ve just seen the Bank of England’s Q2 Quarterly Bulletin, which contains a paper called Public Attitudes to Inflation and Monetary Policy.  Median perceptions of current UK inflation have fallen from over 5%  at their peak in August 2008 to 4% now, but they remain much higher than actual inflation.  The biggest cohort of respondents (about a third) thinks that inflation now is over 5%.  The Bank’s survey shows that people pay relatively little note of falls in their mortgage payments when they think about their own personal inflation rate, which explains why perceptions of inflation remain elevated at a time when RPI (which takes account of lower mortgage payments) has moved into deflation.  People are much more sensitive to household energy bills, food and drink, and transport costs (you go grocery shopping and fill up your car more often than you have a mortgage direct debit go out, and so inflation in food and petrol is much more noticeable).  This is a bit of a shame, for the Bank of England’s monetary policy can only really target (and then only indirectly) the mortgage rate.

The research paper also discusses the role of the media in setting price perceptions.  It’s interesting to note that for the first time, the number of UK newspaper headlines about falling prices has overtaken those about rising prices.  Perhaps this in part explains why, looking forwards, expectations for future inflation have fallen significantly.  25% of participants think that there will be zero inflation, or deflation in a year’s time.  The biggest factor in the perception of future inflation is now “the strength of the British economy” – the Bank suggests that this too might be down to a deluge of negative headlines on the economy (over 1,400 such headlines in the past quarter, and not just in the Daily Mail).

The Bank’s own conclusion is interesting – the Bank of England’s inflation target is not very important in the public’s one year ahead expectations of future inflation!   The Bank does still hope however, that longer term expectations are influenced by the MPC’s 2% target.

 

Month: June 2009

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