shocking, but realistic

Credit crisis: After the binge, the UK suffers an almighty mortgage hangover
By Philip Aldrick
Last Updated: 7:07am BST 07/08/2008


Have your say Read comments

A decade of cheap credit fuelled by rising house prices came to a shuddering halt last summer when Northern Rock hit the buffers, writes Philip Aldrick

The heads of Britain's biggest mortgage lenders may not be trumpeting it from the rooftops, but in private they are all agreed. Homeowners will never have it so good again.

"People will look back at the last decade as the halcyon days of cheap mortgages," one senior banker said. "It's not going to get like that again."

advertisement
Call it the Northern Rock boom. Debt was cheap and people's appetite for it was insatiable. Leverage was not risk, but an aspiration. The bigger the debt, the larger the return. In the corporate world, private equity parlayed easy money by making "more efficient" use of companies' balance sheets - in other words, loading it with debt.

For the general public, mortgages were where ambitions collided with the credit binge.

It took a brash former building society from Newcastle to make it happen, though. Northern Rock pioneered the affordability model of mortgage lending. In the early 1990s, borrowers would be lucky to be offered a loan of three times their salary. By the time Northern Rock was finished, six times was almost the norm.

As the rivals caught up, Northern Rock became even more intrepid, developing its now infamous "Together" offer - a mortgage of up to 125pc of the value of a home at a time when a 90pc loan-to-value ratio was considered racy.

Together relied on two things, which themselves required blind optimism. First, that debt would remain cheap and, second, that house prices would continue to rise.

It is no coincidence that Northern Rock is the UK's worst casualty of the credit crunch.

Chief executive Adam Applegarth harnessed his growth model to the wholesale markets, where funding was unfettered, and turned his back on deposits, only to witness the markets seize up and his money supply cut off - the first step on the lender's humiliating route to nationalisation.

Northern Rock neatly bookends the mortgage boom, but the consequences will long outlast the now state-owned bank. Britain is going through the first convulsions of change now.

As early as last October, Andy Hornby, chief executive of the UK's largest lender, HBOS, which owns Halifax, said: "The mortgage market is about to undergo a fundamental shift." Hector Sants, chief executive of the Financial Services Authority, said: "I don't think the markets here will ever return to the way they were... Easy credit is not necessarily good for either consumers or the economy in the long term."

Part 1: Newcastle is still reeling from Northern Rock
Part 2: US property dream is now a nightmare
Part 3: Risky debt notes could be a losing game
The message is clear. Expensive mortgages are here to stay, and the numbers bear this out. First, availability has dried up. According to the Council of Mortgage Lenders, net mortgage lending is on course to halve and the volume of housing transactions to fall by 30pc to 40pc this year. Hornby believes next year will be even worse.

Data compiled by Credit Suisse shows that there were 17,300 mortgage products on the market in June 2007. Today there are just 4,000.

Last year, 100 financial institutions were vying for mortgage business. Now, almost all net new lending is provided by just five banks - Lloyds TSB, Abbey, HBOS, HSBC, Barclays and Royal Bank of Scotland. Building societies actually took £526m out of the market in June.

It's not just that there is less availability. Mortgages are also less affordable. According to the Bank of England, the average mortgage rate of 6.63pc is now at its highest since 2000, despite interest rates being cut by three quarter of a percentage point since July last year.

Money markets are to blame for the bulk of the increase, as the banks' own cost of funding has soared in the credit crisis, but lenders have also managed to improve their profit margins as competition has fallen away.

Recent Bank of England data shows that the spread over base rate is now about 150 points, according to Credit Suisse's credit availability monitor - back at levels last seen in 1999. Last year, the spread was 30 to 40 basis points at best. "At that level, banks were barely covering their costs," says Credit Suisse analyst Jonathan Pierce.

In essence, mortgages had become unsustainably cheap. Lenders, Northern Rock in particular, were using short-term but cut-price wholesale markets to fund on a massive scale. Sir James Crosby, in his report into mortgage finance for the Treasury, noted that British institutions used the money markets for £78bn of new mortgages in 2006 - the last great boom year.

"By 2006, such funding equated to around two thirds of net new mortgage lending," Sir James said. The markets are now shut. Not only are investors refusing to provide the banks with the money to lend on, but they want their money back - at the rate of £40bn a year, Sir James reckons. The credit squeeze is not about to loosen its grip.

When it came to wholesale funding, Northern Rock was again the archetype. With just 76 branches and little interest in more expensive customer deposits, the bank kept its cost base artificially low. The more mortgages it sold, the more efficient it became.

Only, it was a model built on sand. When the wholesale markets seized, Northern Rock could no longer fund affordably and its mortgages became loss-making - as the negative interest margin of -0.13pc disclosed with this week's results makes clear. Northern Rock may not have been to blame for the sub-prime crisis that closed the money markets down, but its model was so high-octane that it never had time to adjust.

Northern Rock was the extreme, but where it went the rest of the market followed. In fact, mortgages had become so cheap by 2006 that some lenders - such as Lloyds, Abbey and HSBC - decided to all but pull out of the market. Others, like HBOS, tried to match Northern Rock before belatedly switching their focus from volume to profit margin. Far from an example of bank profiteering, signs that margins in the mortgage market are improving are signs of health. Risk is being repriced to reflect what it should have been.

It is even possible to connect the unsustainable mortgage market to banks' decisions to load up on structured credit assets now considered "toxic". Mortgage margins were whittled so thin that banks began looking elsewhere for margin. The super-safe, AAA-rated gilts in their Treasury portfolios were considered "inefficient".

So, in keeping with the global search for yield, many switched into high-yielding AAA-rated US sub-prime securities.

HBOS, which saw its retail profit margin crumple gradually from 1.92pc in 2003 to 1.66pc in 2007, is now taking a more prudent approach and placing its Treasury portfolio in "extremely liquid assets that may have a lower yield".

The binge is over now and the hangover has kicked in. Sir James says it may not be until 2010 that the markets start to show signs of life again.

Compared with the 1929 Wall Street crash - and the similarities are manifold - that would be good going. Banks were so hamstrung after over-leveraging themselves in the stock market boom of 1929 that the consequent credit constraint saw car sales fall from 4.5m in 1929 to 1.1m in 1932. Sales did not recover to 1929 levels for 20 years.

Credit is more readily available this time. The UK banks have recapitalised with £21bn of cash injections in the past few months, which gives their balance sheets more room to carry loans. And, as HSBC's UK retail bank head, Joe Garner, said: "Those that did not overly feast in the good times are not in famine now times are tough."

For borrowers, the picture is clear. They will have to pay more for mortgages, and high loan-to-value deals will remain scarce. The Northern Rock boom made Britain a larger property-owning democracy, but unfortunately, the country wasn't ready.

Tomorrow: Ambrose Evans-Pritchard on how the monetary gods failed us

Have your say




Post this story to: del.icio.us | Digg | Newsvine | NowPublic | Reddit | Fark

Comments
Nu-Labour should never have embarked on concreting over the south east just to build holiday homes for eastern European and others coz that's all they are doing! Many of these people will be off when the welfare bonanza ends.
Posted by mike on August 7, 2008 2:37 PM
Report this comment

Government? What Government?
Its totally laughable that public money is used to prop up a failing business that had a non existent risk strategy and regularly took business away from better regulated lenders. An adequate government would have put in basic requirements to manage risk in this very emotive lending sector, namely:-
No self certification.
No lending in excess of 100% of valuation.

If this had been in place 7 years ago whilst we couldnt have contaned the muistakes made in America but at least it wouldn't have reduced our own mortgage lenders to basket cases and provided the specultors market that has so much de-stabilised our housing market.
A never thought that anyone could have done worse than Lawson but Brown has!!
Posted by Dave J on August 7, 2008 1:59 PM
Report this comment

"By 2006, such funding equated to around TWO THIRDS of net new mortgage lending," Sir James said. The markets are now shut. Not only are investors refusing to provide the banks with the money to lend on, but they want their money back - at the rate of £40bn a year, Sir James reckons. The credit squeeze is not about to loosen its grip."

Therefore, the £21BN capital raised by UK banks in recent months is considerably less than they need to repay THEIR fleeing investors?

Last year, I thought house prices would fall 25%. Now, I think 50% is more realistic; shocking, but realistic, in my opinion.

I chose to sell and rent early last Summer, but I think every ordinary person will pay for this housing bubble when Government hands us the next tax rises, and devalued £, buying less.

That's the good news for those of us who can afford to pay. The bad news: personal and financial ruin for many households...while thieving politicians enjoy inflation-busting pay rises, expense accounts, and index-linked pensions reward failed civil servants - all of them rewarded for their failure to manage UK PLC, and the Banksters, in particular.