UK Mortgage Rates: The Slow Drift Higher and the Impending Danger for UK House Prices

Today’s blog is an excerpt from our forthcoming May HindeSight, Eyes Wide Shut, which we will release later this week.  The report discusses the UK, its soaring debt burden, how it is impacting the economy, and how the government is moving towards financial repression in order to deal with the problem.  The following excerpt is about the parlous state of UK property, and the growing likelihood of another sharp dive in UK house prices.

 

UK Mortgage Rates: The Slow Drift Higher and the Impending Danger for UK House Prices

 

The UK property market, prior to the financial crisis, was one of the most overvalued in the world, fuelled by ease of access to cheap credit.  Since then, prices are almost 12% off their peak, although they have subsequently bounced 9% from their nadir in 2009.  Indeed, as the chart below shows, the UK is the only main housing market to have had any sustained bounce.  We argue the UK is at high risk of a further downturn in housing as rates have bottomed and the mortgage market becomes significantly more sensitive to moves in rates.

 

Global Property Prices 2004 = 100 to 2012

Source: Standard Chartered

 

In response to the crisis, banks in the UK and further afield tightened credit conditions dramatically.  As house prices fell, many mortgage holders slumped into negative equity.  Confidence plummeted.  There was a real risk of a depression as a vicious circle of falling property prices impacted banks’ balance sheets, who contracted lending further, having a detrimental effect on the broader economy.

 

The Bank of England cut rates sharply in 2008 and 2009 to an historic low of 0.5%, where they languish currently.  During the credit boom in the lead up to the financial crisis so-called tracker mortgages became very popular.  Slightly different to the ARMs (Adjustable Rate Mortgages) which had super-low ‘teaser’ rates that were becoming pervasive in the US, they were like ARMs in that they were likewise responsible for helping fuel the mortgage and thus the property market in the UK.

 

Tracker mortgages were, by definition, directly linked to the Bank of England’s base rate.  The BoE thus knew by rapidly cutting the base rate this would ‘mainline’ confidence back in to the economy as borrowers who would otherwise have had to default on their loans could continue to afford their repayments as they fell sharply.

 

The belief was that the rate cuts would be a temporary measure and, once confidence was restored, rates could be restored to more normal levels.  So far, this has not happened.  And, in fact, it is not likely to happen for the foreseeable future.  As the following chart from McKinsey shows, total debt to GDP in the UK is one of the largest in the world. 

 

The UK’s total debt to GDP has not gone down, and has in fact increased since the onset of the crisis.  Most other major countries, other than Japan, have shown some sort of deleveraging over the past few years.  The UK, however, has grown addicted to low rates, protecting borrowers from default.  Low rates in the UK are now absolutely essential to keep the economy from a renewed and protracted slump.  Furthermore, low rates have helped keep the mortgage market growing over the last few years.  Indeed, in terms of total loans outstanding, the trend rate of increase has barely decreased.  Again, no sign of deleveraging.

 

Source: FSA

 

There are signs the problem could be coming home to roost.  In 2007, the majority of mortgages were fixed rate.  Fixed rate deals in the UK tend to be much shorter than in the US (2 and 3 year deals are very common; finding non-punitive deals longer than 5 years is very difficult).  As many of these expire, lenders automatically move on to the SVR (Standard Variable Rate).  In the past, mortgage holders tended to remortgage but, with banks’ tighter lending conditions, this is more difficult to do.

 

Indeed, fixed rate mortgages, from composing over 50% of outstanding mortgages (by balance) in 2008, now only account for less than 30% of mortgages.

 

Source: FSA

 

The SVR is almost always higher than the main fixed rates, with it being eg on average 95bps (0.95%) higher than the 2 year rate over the past decade.  So, it is highly likely any borrower will have a sudden increase in their monthly repayments when they come off the fixed term.  Indeed, the average SVR is currently 75bps higher than the average 2 year rate.  Using the average loan value of outstanding mortgages, this equates to an increase equivalent to almost 25% of the UK average real disposable income (equivalent to over £900 per year).  This will have a material impact on already straitened household balance sheets.  (As an aside, the average real disposable income per head in the UK has fallen since 2007, from £3,695 per year to £3,645 today.)

 

The greatest risk, with the high (and growing) percentage of mortgages outstanding on variable rates, is the increased risk that rates move higher, which would immediately impact many borrowers at around the same time.  SVRs are likely to move if the BoE raise rates, but since 2009, the spread between the BoE’s base rate and the SVR has risen sharply.  In fact, the SVR has continued to trend up in the absence of any rate moves from the BoE at all.  Banks are in no mood for giving any quarter to borrowers as they try to meet much stricter capital ratios soon to be imposed.  Further, fixed rates, as well, look to have bottomed and are moving up.  Mortgage holders will already be beginning to feel more stretched from increased repayments.

 

Source: FSA

 

Our analysis shows that even a 25bp increase in the variable rate would eat up about a seventh of the average worker’s disposable income.  A 5% increase in the rate would completely overwhelm it.  We draw your attention back to the chart above on the composition of the mortgage market by type: over 70% of mortgages (by balance) are variable rate so these effects will be now be much more widespread than they were even a few years ago.  Significantly fewer borrowers are now able to weather any storm behind the shelter of a fixed rate.

 

There are already signs of stress.  According to the FSA, the UK banking regulatory body, lenders are showing forbearance for borrowers who are struggling to meet repayments, by moving them onto cheaper-to-service interest-only mortgages.  Not only does this store up the fundamental problem of overstretched and insolvent lenders for later, it too increases the sensitivity of borrowers to rates.

 

Percentage of mortgages taken into possession

Source: CML

 

The low absolute number of repossessions and borrowers in arrears in the UK will mask underlying difficulties borrowers have servicing their loans.  Unlike the US, most mortgages in the UK are not non-recourse; therefore banks have a claim on a borrower for any shortfall arising from the sale of a repossessed property.  In the UK, banks can pursue the debtor for 12 years or more (12 years in England, 20 years in Scotland).  This will help ensure mortgage holders in the UK will continue to make their payments far beyond the point they would otherwise if they had a non-recourse loan.  But at some point, as rates continue to rise, this will become impossible, and we would expect to see the number of repossessions rise quickly.

 

The UK experienced its first major property bubble in the 1970s. Back then, credit was much more tightly controlled, but residential property prices were still increasing over 30% on the year at their peak in 1974.  There were a number of reasons for this, including relaxed conditions allowing high street banks to compete with building societies on originating residential mortgages; an over-optimistic assessment of property values; and a Government-imposed cap on the mortgage rate.

 

There was also a minimum lending rate (MLR) that sat at just under 12% in 1973.  But even as property prices fell from their overvalued levels and rates remained at double-digit levels, there were not mass defaults.  This was because lenders very rarely lent more than three times income and the rampant wage inflation of the 1970s (due to heavy unionization) enabled borrowers to keep making repayments.  As a result, the house price to income ratio fell from 3.8 to its long-term average of 2.8 by the mid-1970s, without significant repossessions.

 

Today is different.  Real wages in the UK continue to decline, and the house price to income ratio remains over 5, having reached a peak of 6.5.

 

 

The composition of the mortgage market in the UK represents an increasing fragility in UK property.  Borrowers are becoming more tied to variable rates, leaving them exposed to base rate rises from the Bank of England, or rate rises independent of the BoE from still beleaguered banks looking to bolster their capital ratios.  Both fixed and variable rates looked to have bottomed and are turning up even though the base rate remains anchored.  Forbearance by lenders only defers the problem and, in the case of interest-only mortgages, could exacerbate the problem as borrowers are more sensitive to rate rises.  These structural changes to the mortgage market leave UK property vulnerable to another correction.

 

The income-to-house price ratio will mean revert, as it always has.  Unlike in the 1970s, though, this time it is likely house prices will fall to meet wages rather than the other way around.


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