Fears of a ‘credit crunch’ – when it becomes harder for banks, companies and consumers to get access to loans and cash to run their operations – have intensified over the past couple of weeks, especially since the effect of the US non-conforming crises was felt across global markets.
On Friday 10 August, the BBC reported that Japan’s central bank had followed the European Central Bank in pumping money into the market to boost liquidity. In the US, the Federal Reserve was reported to have taken similar action, pumping about $24 billion into the US banking system.
South Korea’s central bank also said it would intervene if necessary to prevent the US non-conforming crises turning into a global problem.
During the day, markets fell sharply. Billions of dollars were wiped off share values, affecting businesses and individual investors alike. Shortly after opening, the Dow Jones share index in New York was down 124.8 points, or 0.94 per cent, at 13,145.9 points. In morning trade, the London share index fell 3.1 per cent, the Paris index was down 3 per cent and German shares fell 1.6 per cent.
However by Monday 13 August, the situation was looking a little brighter; London’s FTSE 100 added 111 points to 6,149 in early trading, while Germany's Dax rose 81 points to 7,424.
US sitution
The situation in America has been brought about by a number of factors. A growing property market combined with low borrowing costs and fairly benign economic conditions created a strong demand for debt.
“This appetite for debt seemed to be met by an equal willingness to lend of behalf of US mortgage lenders,” says James Cotton, mortgage specialist at London & Country. “The problem was that underwriting standards deteriorated and very little checks were done on mortgage applications. There has also been evidence of widespread fraud, particularly the practice of over-inflating borrowers’ incomes.
“What magnified the problem was that between 2004 and 2006, the Fed increased US interest rates 17 times in a row from 1 per cent to 5.25 per cent. Borrowers simply couldn’t meet their mortgage payments, and delinquency and repossessions soared as a result. The fact that so many of these non-conforming loans are bundled up and sold on and then sold on again to investors round the world means that the fallout is being felt far and wide.”
The main worry is that should banks make losses, it would hurt their earnings and their profitability, making them less willing to fund the takeovers and buyouts that have underpinned much of the stock markets’ recent gains.
The non-conforming sector in the US has had a bumpy ride over the past few months – more than 100 firms have closed in the past nine months and last week saw America’s 10th largest home lender, American Home Mortgage (AHM), file for bankruptcy. AHM was not a non-conforming lender but an ‘Alt-A’ lender, targeting low-risk borrowers – which makes its downfall all the more significant.
Has it hit the UK?
Whether what is happening in the US is affecting, or will affect in the future, the UK mortgage and financial markets is open to debate. Certainly there are a few worrying signs already. Last week db mortgages withdrew its adverse products from the market until the end of the month. The lender denied it was anything to do with the US non-conforming crises and said it was simply re-pricing – a normal part of any lender’s activities.
Investec-backed Infinity Mortgages and Unity Mortgages were more upfront about the reasons why they will both be withdrawing their entire non-conforming mortgage range from the market on 17 August.
A notice on Infinity Mortgages’ website said: ‘As a consequence of significant movements in the market it has become necessary to withdraw our current range from the market with immediate effect.’
Meanwhile Close Mortgages pulled all its fixed rate mortgages and increased the rental cover on other products, while West Brom announced it was holding fire on its latest securitisation because of difficult market conditions.
It is important to make a distinction between whether the UK will be affected by the US problems or whether the UK mortgage market will face the same problems as the US did. First of all, there is no doubt that this country will be affected by the non-conforming crisis in the US. Stock markets around the world have slumped and many global banks are facing large losses – it is having an effect everywhere.
“The main problem that we are going to face is that the purchasers of mortgage-backed assets have got their fingers burnt in the US and are now nervous about what they buy, so despite the fact that the quality of mortgage-backed assets here is as good as it has even been, buyers are nervous,” says Jonathon Cornell, technical director of Hamptons International Mortgages. “This is likely to push down the price they are prepared to pay, which may well affect the price lenders will achieve when they securitise their mortgage loans.
“I think that the investors who buy mortgage-backed securities are a lot more cautious about what they are buying now. This may well make it more difficult for lenders to securitise and that would have a negative effect on the supply of mortgages in the UK.”
Paul Niven of F&C Investments says the banks’ actions follow signs that the US non-conforming crises are spreading through the financial system.
“Recent days have seen both rumour and confirmation of widespread losses among investors, particularly hedge funds, and the decision by many to close the window for investors to exit loss-making funds has led to panic over the breadth and depth of the problem. This has culminated in banks ramping up the overnight rates which are charged to each other for loans due to mistrust and uncertainty over creditworthiness of even the biggest financial institutions,” he says. “During periods such as this, investors cannot afford to be complacent. The simple fact is that non-conforming-related concerns are, and will continue to, dominate market anxiety.”
What about the UK market?
What has happened to the non-conforming market in the US and its subsequent effect on the country’s housing market and economy is bound to raise questions about whether the UK could soon see a similar situation with its own non-conforming market.
Recent figures from the Council of Mortgage Lenders (CML) show the number of mortgages in arrears of three months or more at the end of June rose to an estimated 125,100 – up 4 per cent compared with the end of December, but 3 per cent lower than at the end of June 2006.
However, at 14,000, the number of properties taken into possession in the first six months of the year rose by nearly 18 per cent compared with the previous half-year, and nearly 30 per cent compared with the first half of 2006.
The CML says that possessions have risen more sharply than arrears for the past two years for a number of reasons. Firstly, the impact of an increasing amount of non-conforming lending within the overall market, where the higher risk nature of the business means that arrears are more likely to translate through to possessions. Also, lenders are becoming more active when it comes to arrears management – typically seeking contact with the borrower to establish a repayment plan as soon as one payment is missed, so it is likely that many households avoid falling further into arrears unless their financial situation makes this unavoidable.
The Intermediary Mortgage Lenders Association (IMLA) says the CML figures are not a sign that the UK mortgage industry is going to face the same problems as the current US market, nor are they a sign that we are heading for a repeat of the 1991 recession.
Peter Williams, executive director of IMLA, says: “There is some deterioration in the figures, but they are still exceedingly low by historic standards. If we compare the number of mortgages 12 months or more in arrears with the same period of 1993, we find it is almost 11 times lower. Arrears have been fairly steady for the past few years and this tick-up takes arrears up to 2002 levels and possessions up to 1999 levels – a world away from the problems of the early 1990s. While any increase is unwelcome by both lenders and borrowers we do need to keep this in perspective. “
As for the future of the UK non-conforming market, most critics are confident that we will not see a US-style meltdown. None of the US conditions in non-conforming exist in the UK market and there are several crucial differences between the adverse credit market, products and processes in the US and the sector in the UK.
“First, borrowers in the US are more indebted than UK borrowers. The average debt per person in the US is $191,000, according to Standard & Poors and MoneyBasics, which is 3.9 times the level in the UK, where the average debt per person is $49,000,” says Alex Hammond, PR manager at Kensington Mortgages. “The US adverse credit market has grown by 400 per cent over the last four years – four times the level of growth in the UK, and in order to attract volumes so quickly, US lenders have had to adopt a more aggressive attitude to lending than their UK counterparts.”
Bankruptcies in the US are also 600 per cent above the levels in the UK, and US mortgages account for 20 per cent more income than they do in the UK. The market in the US is therefore much more volatile than in the UK, and when that volatility turns into people being unable to make their mortgage payments, there is much less margin for error. There is also oversupply of property in the US market – by contrast, the UK is subject to a shortage of properties. The result is that US house prices are now falling, while the CML forecasts 7 per cent house price inflation in the UK this year.
“Then there are the differences between the US and the UK when it comes to products,” says Hammond. “More than 50 per cent of adverse credit loans in the US during the past year were 100 per cent loan-to-value (LTV), whereas in the UK such loans have a maximum of 90 per cent LTV and the average is below 80 per cent. The less equity a borrower has in their house, the less incentive there is to maintain repayments in times of difficulty and the greater the loss severity of the loans.”
It is also common in the US for lenders to offer ‘low-start’ mortgages where payments do not even cover the interest of the loan. This leaves borrowers further stretched after the low-rate introductory period. This affordability problem is further compounded in an economic environment where interest rates are going up.
Processes in the UK are also far tighter than in the US. Affordability in the US is based on the introductory rate and half of all non-conforming mortgages have no income verification. In the UK the Financial Services Authority requires lenders to be responsible in their lending practices and polices.
“I think that the fact the US has had such problems is a major reason why we won’t,” says Cotton. “Many of the banks involved in that market also have a presence here and many others will have learnt a lesson. The crisis over there shows what can happen if you lend money without the proper underwriting and affordability checks – I’d be surprised if lenders here fall into the same trap.”
However not everyone is so sure that the current problems in America will not spread to the UK. Liberal Democrat Shadow Chancellor, Vince Cable MP, says that high-risk lending is cheerfully promoted by leading high-street banks and this is exactly the kind of debt that drives the unstable non-conforming market.
“The government and the lending industry are far too complacent about irresponsible lending and the growing bubble in the housing market,” he says. “The stresses and strains now being seen in the USA and in Germany may well be felt in Britain before long.”
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