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"Beware of little expenses. A small leak can sink a great ship,” some may evoke as being the famous words of Benjamin Franklin. (Hodges 2008)
These judicious words very nearly summarize what has been witnessed in the financial markets since the summer of 2007. The exposure of a number of global finance institutions to mass repossessions in the sub prime mortgage sector of the United States, consequently caused what can be termed as a global credit crunch, the “first major financial crisis of the 21st century.” (Reinhart & Rogoff 2008)
Global concerns over credit came apparent primarily after BNP Paribas, a French investment bank decided to suspend three of its investment funds as a result of exposure to bad debts in the US subprime mortgage market. (Kennedy 2007). Since then, numerous banks have reported enormous write-downs on the value of loans, collateralised debt obligations and mortgage backed securities, as high as around $32 billion by American investment bank Citigroup and around $13.7 billion by Swiss bank UBS (Cowie, 2008)
This has caused worldwide turmoil for both lenders and financial markets, subsequently filtering down into other economic areas from consumer confidence and employment in the financial services industry, record prices for oil and gold, record lows for the dollar against the euro due to uncertainty surrounding US bond insurers, and to an extent, housing, the latter of which this study will be focusing on in the UK.
The world’s most successful investor Warren Buffet, has since argued that the US is in recession whilst Alan Greenspan, ex-chairman of the Federal Reserve has stated that economic growth in the US has stopped (Guha, 2008)
The most notable impact of this escalating problem witnessed in the UK was the collapse of Newcastle based mortgage lender Northern Rock following the run on the bank, the first of its kind since the reign of Queen Victoria. This came as a result of it having to obtain emergency funding from the Bank of England due to the unwillingness of lenders to supply the bank with credit created through special structured financial vehicles available in the securitisation market, which its business model heavily relies on to fund its operations. (Milne & Wood, 2008). This in hindsight has led to its nationalisation, the first time a private company has been taken in by the government in over 25 years, and many pessimists fear that the US economy could fall into a full blown recession.
The subprime crisis has been another occurrence that has proven how closely linked the UK economy is to the US, with signs of a recession in the US causing the FTSE100 to suffer its biggest one-day percentage fall since 9/11, losing 5.5% of its value on January 21, 2008. (Allen, 2008) To try and put a value on the scale of the whole crisis, one real estate financing expert argued that “the Subprime Meltdown rivals the Iraqi War in consumer concerns”. (Sandler, 2007 p8)
This dissertation will give reason for the US subprime mortgage crisis, critically evaluate the UK housing market, and analyse how any speculation over the possible bursting of the housing bubble could partially or completely be as a direct or indirect consequence of the sub prime mortgage crisis in the US. Many areas of UK housing including the mortgage market and the UK’s own subprime market will be evaluated. Since the turmoil in the financial markets has threatened to cripple the US economy, many experts have argued that the subprime mortgage crisis and consequent credit crunch is far more threatening to the UK, due to its even more overvalued housing market, over-dependant on the financial services and the City of London, which was the main motivation for the title of this study.
The aim of this study is to learn whether this crisis, the worst in 60 years which has brought about an end to the super boom in the financial service industry according to Soros (2008), will surpass the trends which place the overvalued UK housing market in a better position. These trends that differentiate the UK from the US housing market are that land is scarce in the UK, there is a housing shortage, which has been facilitated by high levels of immigration, high divorces levels and more elderly citizens living alone, and the lowest unemployment figures for over 30 years, increasing consumer confidence. Additionally, lower long-term interest rates have made mortgages easier to fund, and the buy-to-let market has seen a lot of interest from both domestic and foreign investors, whilst supply of housing remains unable to keep up with this demand.
2. Literature Review and Analysis
2.1 Subprime mortgages in the US and the global credit crunch (Historical Context)
In order to assess the real impact of the US sub prime mortgage crisis on the UK housing market it is necessary to provide a brief insight into what actually happened and explain how the crisis, summarized by Reinhart & Rogoff (2008) as, “The first major financial crisis of the 21st century involving esoteric instruments, unaware regulators, and skittish investors,” became a global phenomenon.
Prior to the collapse of the sub prime market, house prices in the US were enjoying considerable appreciation. The US Federal Reserve cut interest rates several times from 6.5% in May 2000 to 3.5% in August 2001. Further reductions were made by the Fed in a bid to prevent the US from heading into a recession as a result of the events of September the 11th, and by June 2003, interest rates were set at a mere 1% (Open Market Operations, 2008). Sandler (2007, p3) recognised the need for the US Federal Reserve to lower rates due to the situation in Iraq generating “record foreign payments deficits and waning consumer power and confidence,” which in turn led to a sluggish stock market.
These exceptionally low interest rates, teamed with appreciating house prices made the US housing market seem incredibly attractive to citizens wishing to get on to the property ladder, causing house prices to start climbing a steeper than usual mountain. Sandler (2007, p4) said that these low interest rates led to new mortgage deals available to first time buyers in the US, which offered easy low cost money that was financed by unregulated global investors.
“Securitisation offers a way for an or an organisation to convert a future stable cash flow arising from a financial asset, usually some form of loan, into a lump sum cash advance. This is achieved by converting the future cash flows into tradable securities which are sold as a means of raising capital” (IFSL, 2006 p1) Mortgage Backed Securitisation makes up the major share of the securitisation market, and links within the UK housing market will be looked at later on in this report. This relatively modern phenomenon, teamed with recent advancements in financial technology, paved the way for the sub prime model of lending. Lending institutions like banks could pass on their loans to other investors through various financial instruments and securities such as Structured Investment Vehicles (SIV’s) and Collateralised Debt Obligations (CDO’s) that were supported by certain types of asset-backed securities known as Mortgage Backed Securities (MBS’s).
This enabled banks to raise more money for themselves, and they were no longer limited in their ability to lend by using liquid savings of the personal sector located within the deposits in their balance sheets. Institutional investors such as hedge funds and investment banks were more than happy to purchase these CDO’s with the original loans/mortgages made by the lending institutions, pooled together in Mortgage Backed Securities as the underlying assets, as they yielded high returns.
The practice of providing mortgages, and then selling these mortgages on to third parties also meant that lending institutions no longer held on to the risk of borrowers defaulting on their payments, which consequently led to lenders failing to be vigilant over the mortgages they issued, simply because they no longer had the incentive to do so.
Banks received payment for each cheap mortgage that was sold on, so mortgage brokers were advised to sell more of these mortgages. It is imperative to recognize that mortgage brokers did not lend their own money, so the risk of borrowers defaulting on their mortgages was offset by the incentives that brokers received for selling them. In his article on Mortgage brokers, Bennett (2007) quoted Paul Leonard, director for the California office of the Centre for Responsible Lending, in saying that brokers “have strong incentives to make abusive loans that harm consumers, and no one is stopping them.”
Bennett also quoted a study by Harvard University's Joint Centre of Housing Studies in 2004, which concluded that a broker's incentive “is to close the loan while charging the highest combination of fees and mortgage interest rates the market will bear,” Bennett identified that by deceiving mortgage illiterate borrowers into taking out risky loans, brokers could earn a commission of 3% instead of the normal 1%, “a difference between a $12,000 and $4000 commission on a $400,000 loan”. These risky loans were mortgages “with interest rates that (were) higher than market rates, with prepayment penalties charged if the loan is paid off before a certain date, and with little or no verification of the borrower's income”, however, there was no law to ensure that brokers inform borrowers on loans with cheaper rates. It was recognised that the notorious sub prime loans were among those that were associated with the highest levels of commissions for mortgage brokers, which served the rise in number sub prime loans issued during the housing boom in the US.
Sandler (2007) identified two types of new mortgages that in hindsight were to spark the whole credit crunch.
- Option Adjustable Rate Mortgages that financed 100 percent of the cost of a home. They had outlandishly low starter rates that tempted homebuyers wanting to move-up the property ladder, into taking out mortgages whose repayments they wouldn’t be able to keep up with when the low rates at least doubled after a few years.
Lenders failed to warn borrowers about the risks of higher payments if interest rates were to rise, and didn’t simulate borrowers abilities to keep up with payments by comparing their incomes to a potential mortgage rate increases, which later formidably shot up.
- Subprime loans made to people with no or poor credit history and insufficient income. They were low-documented, and provided a way of financing for both first time buyers and buyers moving up the property ladder in deprived areas. Borrowers were told that down payments were not required, as the value of the houses would go up.
Brokers that were overcome by greed, often helped to falsify borrowers income so that the mortgage would get approved, and they could receive their commission. Sandler argued that brokers had “no concern for the details of rate resets, prepayment penalties and fee disclosures” and the rationale for selling these mortgages with high credit risk was somewhat down to the tendency for house prices to always rise in value, so that in the event of borrowers being unable to keep up with payments, they could theoretically refinance.
Wheeldom (2007) gave reason for lenders to offer cheap money to risky borrowers as being the low interest rates that enticed investors to give away excess cash. Through the process of securitisation, these investors could invest in CDO’s using cheap credit, and then in turn profit from the money received by high mortgage rates charged to subprime and adjustable interest rate borrowers, whose mortgages pooled together in MBS’s became underlying securities in the CDO’s. These investors believed that strong house price inflation would mitigate the risk of defaulting borrowers.
Bundling subprime mortgages and other risky loans together with less risky mortgages and a few secure mortgages diversified individual subprime loans into safe looking mortgage-backed securities, with collateral increasing in value, and given higher ratings than individual subprime loans would have ever received. Credit or default risk was loosened by the simple probability that only a small fraction of the subprime mortgages in each CDO would actually default, again compensated by the then expected continued appreciation of house prices.
Demyanyk and Hemert (2008) summarized findings from many researchers claiming that increasing demand for MBS’s from foreign and domestic (US) investors was the basis of the whole subprime-lending boom.
Reinhart and Rogoff (2008) believe that appreciating US house prices were as a result of these “financial innovations” within real estate finance, whilst Demyanyk and Hemert (2008 p1) blame appreciating house prices from 2003-2005 masking any detection of the subprime mortgage crisis. However, when the US housing bubble burst due to a correction of the market around 2005, together with the Federal Reserves decision to increase interest rates to tackle inflation worries, defaults within the subprime sector started arising in exceedingly large volumes. By this stage however, defaults had spread to financial institutions worldwide. The innovations in housing finance, “made the resulting instruments extremely nontransparent and illiquid in the face of falling house prices” Reinhart and Rogoff (2008).
Research by Demyanyk and Hemert (2008) using loan data from half the US subprime mortgages originating between 2001 and 2006 challenges the belief that it was the adjustable rate and low documented subprime mortgages with the highest rates of foreclosures that set off the debacle. They show that all areas of subprime mortgages including fixed-rate, purchase-money, cash-out refinancing and full-documented showed higher default rates when compared to previous data 5 years before the crisis started.
Figure 1 graphically explains the problems of borrowers defaulting under the sub prime model when compared to traditional lending practices.
Figure 1a - THE NEW MODEL OF Figure 1b - HOW IT WENT WRONG
Source – BBC (2007)
The diagram shows how bondholders are affected by the crisis, especially since the value of many reposed homes had fallen largely below the value of the initial mortgage taken out, which would be seen as a bad debt in the hands of the investor who eventually realized they were holding on to that particular asset. In the second quarter of 2007, according to the Federal Reserve, Bank of England and the Securities Industry and Financial Markets Association, the US bond market was valued at $27tr, $6.8tr of which was mortgage bonds, $1.3tr of which was linked to subprime investments. (BBC, 2007)
Wheeldom (2007) said, “profiting from repossessions and re-selling was no longer an option. As a result, the returns expected by CDOs have not and may never materialize”, bonds backed by US mortgages became unfit to sell, and available funding in financial markets froze. (Cohen 2007)
The implosion of the US sub-prime market is the cause of the glumness in global financial markets. Investors in CDO’s were left with large assets, difficult to value and so hard to sell. It is because of this large-scale uncertainty that markets began to slow down, as banks were urged to hold on to their resources and were unable to trust each other, disturbing the practice of inter-bank lending, which Soros (2007) expresses as being the “heart of the financial system”. As banks became hesitant in lending to each other, credit in the financial market, which in turn funds many areas of the global economy (including the UK housing market) became stagnant. (Sturges & Reeh 2007)
“It's now conventional wisdom that a housing bubble (in the US) has burst. In fact, there were two bubbles, a housing bubble and a financing bubble. Each fuelled the other, but they didn't follow the same course” (Lahart 2007). This could also be said about the UK, where the stability of the economy is largely dependent on the financial services sector, and so a weak performance in this sector can adversely affect the UK housing market.
According to Wheeldom (2007), the threat from the repercussions of the subprime crisis in the UK is to off-balance sheet lenders, like Northern Rock, affected by restricted liquidity in the securitisation market, limiting their own ability to lend. This then filters down into the housing market and Sandler (2007) identified four groups who are affected by the Subprime crisis – Mortgagers, Homeowners (Current and prospective), Homebuilders, and Real Estate Investors, discussed later in the study.
A relatively small area of real estate in America has become the subject of worldwide panic, so it should be no surprise that the American Dialect Society, which annually charts words that have become renowned in any one-year votes on the word of the year, named ‘Subprime’ as its word of the year for 2007. (American Dialect Society, 2008)
2.2 The UK Housing Market and House Price Trends
“Shelter is one of the most fundamental human needs, and consequently, housing plays a big role in the daily life of any community” (Cameron 2005, p5)
Housing is the main asset held by the majority of households in the UK, and is therefore the biggest risk a household bears, confirmed with the high house price to earnings ratios currently being experienced as around 9:1, compared with 6:1 in the US.
Rising House Prices Since 2005
The UK saw a significant rise in house price inflation from autumn 2005, and as a result banks and building societies began to offer larger mortgages, and lending was supported by affordability of mortgages rather than borrowers incomes. The Bank of England also reduced interest rates to 4.5% in August 2005, making lending more affordable. Teamed with a shortage of supply in high demand areas house prices rose considerably.
A recent boom in house prices has partly been due to the shortage of housing in high demand areas such as London and the South-east of the country, however, the subprime mortgage crisis in the US and the consequent shortage of credit can burst what many sceptics widely believe to be a housing bubble, bigger than the one that ruptured in the US.
The UK currently has a trade deficit of around 3.5% due to capital inflows strengthening the value of sterling, and these capital inflows can be linked to manufacturing dependent areas like Wales and the financial services dependent areas such as London and the South-east, where these enhanced capital inflows are processed (European Commision, 2007). According to Reinhart & Rogoff (2008, p1), for countries with high capital inflows, housing prices “stand(s) out as the best leading indicator in the financial crisis literature”. This is true as evident in the US, with house prices being corrected due to the housing market’s failure to identify the link between its willingness to lend and the value of underlying collateral (Soros 2008).
In the UK, house price inflation did slow down at the end of 2007, supporting the view that a shortage of credit in the financial market has hit the housing market. Since house prices were considerably high prior to the subprime crisis in the US taking effect, it can be argued that a shortage of credit in the financial markets would actually help correct the overly inflated UK housing market, which depends to a certain extent on credit to fuel its growth. This can especially be seen with UK mortgage lenders dependence on the mortgage-backed security market to aid funding, which section 2.3 shows in greater depth.
Sirota (2000) identified six factors that affect house price cycles:
- Housing Supply
- Supply of Money for Financing
- Business Activities
- Population Characteristics
- Social Attitudes
Sturges & Reeh (2007) argue that the shortage of housing in the country is the main reason that can prevent UK house prices from entering a period of stagnation. They identified dissimilarities between the UK and the US as follows:
Table 1 – Key differences between the US and UK housing markets
House Price Growth (3.2%)
House Price Growth (9%)
Chronic Housing Shortage
Enough land to build on for next 400 years
Shortage of land to build on
Loose lending policies and fragmented regulation
More prudent lending practices and a solid if costly framework of regulation
The boom in house prices has come about as a result of a shortage of supply. This shortage of housing in the UK is as a result of many supply and demand factors, as well as certain demographic trends, in relation with Sirota’s 4th factor. Interest rates are substantially lower than they were during the last housing crash of the nineties, which reduced the cost of financing a mortgage.
Since mortgage payments are usually a household’s largest monthly expense, lower payments as a result of moderately low interest rates increased consumers’ confidence, encouraging borrowers to take out riskier mortgages. Demand has also been high due to lower levels of unemployment, record levels of immigration into the country, and the increase of single persons requiring a house due to rising divorce rates, increase in life expectancies, and children leaving parents’ home early.
Due to this ‘chronic’ shortage of land and housing shortage in the UK, small increases in demand would cause considerable rise in prices, whilst small decreases in demand could cause house prices to fall substantially. Cameron (2005) also identifies the considerable time lag between a rise in demand for houses, and the resulting supply, as houses take time to build.
Supply of Money and Financing
The principle way that the credit crunch can affect the UK housing market is the second factor identified by Sirota (2000), as rising borrowing costs will filter down to lenders and mortgages will become more expensive and hard to obtain, weighing down on activity in the housing market, which is explored in detail in the mortgage section of the literature review.
Three broad features associated with the UK housing market are that
- The majority of mortgages are at variable interest rates, despite many attempts to steer borrowers to less risky fixed rate loans,
- Loan to value ratios are high, meaning that borrowers loan a significant proportion of the value of the house,
- Re-mortgaging is easy to accomplish (Cameron 2005)
The increasing cost of funding in the market for banks and lenders forces them to charge higher rates to borrowers, and seeing how the majority of mortgages are at variable rates, borrowers are at substantial risk as banks reset variable rates at higher levels to maintain profit levels. This overall increase in cost of obtaining a mortgage can cause house prices to plummet as demand falls.
As the value of houses falls, UK households, who generally have high loan to value ratios, face the risk of negative equity where their house (which is also loan collateral) falls below the value of their mortgage.
Re-mortgaging is therefore hard to come by, and would cost any household participating in re-financing.
Cameron (2005) recalled work by Bank for International Settlements claiming that a 1% rise in real interest rates would diminish the value of UK homes by 2.6% over a 5 year period, supporting the fact that due to tighter lending from mortgagers, and therefore higher mortgage rates, the majority of borrowers, which use variable rate mortgages are at greater risk. Tighter lending constraints and as Cameron identified that the majority of UK lenders are at variable rates, the UK housing industry could be at greater risk than that of the US.
When you look at the bigger picture, prior to the crisis which began in the summer of 2007, the multi-trillion-dollar credit default swap market involving the trading of the securities mentioned earlier meant that credit was readily available in the UK for banks and as a result borrowers were able to borrow money to finance their homes without difficulty. The ease of obtaining credit helped push the value of property up, and rising property values in turn raised the amount of available credit. Within the housing market, demand rose again as rising housing values urged people to buy houses before they became all the more unaffordable, with the option of refinancing their mortgages as a profit, leading to a housing bubble. (Soros 2008)
Now the cycle has reversed, Cameron (2005) also identified that banks and other lenders experience losses when house prices fall, limiting their lending practices, so spending falls as people find it difficult to borrow. This in turn leads to fading demand for houses in a cyclic motion that further drives house prices down as a consequence of how the financial system works. Tighter lending by banks also has an affect on all other business activities, Sirota’s 3rd point, which then has an effect of reducing consumption within the broader economy.
Culhane (2007) conversely argues that lenders in the UK will be able to endure the subprime crisis, as they have been more responsible unlike their US counterparts. As risk evaluation technology has advanced, competition amongst lenders has risen, and the mortgage lending market has grown, however, this hasn’t sparked greed amongst UK brokers in the misuse of subprime lending on a scale witnessed in the UK. This is also due to a shortage of supply in the UK simply not allowing a US style subprime mortgage market.
Cameron (2005) assumes that the UK’s Council Tax system is only loosely related to house values. However, Atkinson (2007) estimates the rise in average council tax bills for households at 91%, whilst average earnings have only increased at around 51% over the same time period. Highest household tax bills are present in high demand regions such as the southeast, and with the government’s own debt rising, especially since the nationalisation of Northern Rock, this debt can easily passed on to households in a tax reliant country.
This can lead to households opting to move to areas with more relaxed tax policies. Council tax also relies on the value of the occupied household, so at times when household wealth, largely dependant on the value of their house is uncertain, council tax is vulnerable to a bust in the housing market, forcing the government to obtain other ways of funding themselves, in a macroeconomic sense leading to potential rises in interest rates.
By considering Sirota (2000)’s sixth factor – social attitudes, Cameron (2005) believes that falling house prices and their effects on households would make households feel less wealthy, lowering consumption. Cameron also says that falling house prices mean that households have less collateral to borrow against, resulting in re-mortgaging being hard to come by, and the UK housing market is put at a greater risk due to the high loan to value and loan to earnings ratios it’s households hold.
Consumer confidence also relies partly on the state of the financial sector, and this could go either way, as a recovery by financial institutions from the subprime crisis in the US is imperative in 2008, for speculators to judge whether global financial markets can finally commence normal business, or the crisis is longer term.
The UK has comparable weaknesses to the US, with house prices being excessively high, and household financial deficit being at a record high of 7% of disposable income, and David Miles believes the UK house price bubble is even bigger than that of the US (Wolf 2007). The downfall of the US housing market has led to many pessimists saying that the UK is headed for a long period of frozen growth, whilst other cynics believe the UK could be venerable to its own housing correction, similar to the one the US began to experience after 2005.
Mollenkamp & MacDonald (2008) estimate that 1.4 million mortgages will reset to higher rates, as a result of tightened lending in the UK, and according to Nationwide building society, repossessions were already at a 14 year high in 2007. This figure of 1.4m is a 52% increase on 2007, and as a result of higher monthly mortgage repayments, lenders in the UK are expected to face defaults on mortgages as heavily indebted households face difficulty with their financing.
Műnchau (2008) estimates UK residential property prices to be 30% above historical trends. In theory, if this trend was unchanged, a house price correction could see prices fall by 40% (after adjustment for inflation). Műnchau also argues that the UK has attracted foreign buyers, which may have pushed this house price trend line higher, but the main motive for the majority of these foreign individuals to remain in the UK was the strength of the financial sector.
With this sector under threat, only proven by the weak performance of many shares in the FTSE 100 index since the subprime debacle unfolded in 2007, these foreign households can easily leave the UK, pushing the house price trend line back to normal levels. Analysis of this trend can be seen in the empirical evidence and analysis section of this report.
A report published by the Royal Institute of Chartered Surveyors (RICS, 2007), a respected and influential measure of the UK housing market, showed that demand for housing has weakened, whilst supply remains constrained. These two variants condense a view of the UK housing market into two counterbalances:
- Weakened demand for housing as a result of many consequent factors of the subprime mortgage crisis should push house prices down
- A house price correction in the UK is being hindered by shortage of supply, a quality that the US housing market doesn’t enjoy.
The report said that surveyors outlook on the housing market was bleak due to interest rate increases and financial market uncertainty in the midst of the subprime crisis. (RICS 2007)
2.3 Lending and the Mortgage Market
As credit has tightened in financial markets as a result of the subprime mortgage crisis, the most important way that the liquidity problem can affect the UK housing market is the inability of banks to carry on funding mortgages, so the next section of this review on the UK housing market will be based on the mortgage market.
Mortgage payments are the highest percentage of most households’ disposable incomes. With high house prices, many people have taken on the biggest mortgage they get approved for. Therefore, a rise in unemployment or slow down in growth, as a result of the liquidity crisis, has an unfavourable effect on the UK housing market, as households start struggling to keep up with payments, causing mortgage delinquency rates to rise.
Put in simplistic terms, the Global Credit Crunch, caused by countless subprime borrowers defaulting in the US has caused inter-bank lending to slow down, which has caused mortgages more difficult and expensive to acquire as lenders are forced to work under tighter conditions. Also, since banks are fearful of lending to each other, they are also afraid of lending to households, as the whole probability of any borrowers defaulting seems far more threatening at a time of tight credit.
Figure 2, obtained from David Miles review of the mortgage market on behalf of the HM Treasury, illustrates the basic structure of the mortgage market, and how lenders fund household mortgages.
The main emphasis on this lending structure in the context of a credit crunch is the reliance of lenders financing their funding on global capital and money markets, and the securitisation market and selling of mortgage-backed securities. The subprime debacle in the US has made investors in the securitisation market demand higher returns for holding on to UK mortgage risk, even though lenders in the UK are more cautious (Culhane 2007), so naturally, MBS’s in the UK are far less risky than those originating in the US.
Even if the expectations of the housing market in terms of house prices were positive in the future, investors would still demand more for purchasing any mortgage related securities as a result of the credit crisis, causing each element of the whole system of lending illustrated in figure 2 more expensive. On a large scale, this can have negative impacts on demand as mortgages are generally harder to obtain and more expensive to finance for lenders and households, which in turn can trigger a housing market correction.
Source – Miles (2004), p5
Table 2 shows UK banks’ dependence on funding from the money markets created through securitisation and selling of mortgage-backed securities, according to 2006 data.
On average, 28% of mortgages issued to borrowers in 2006 were funded by lenders converting the loans into securities, and then selling them to investors in the MBS market. Although this figure is around 70-80% in the US, the risk to lenders in the UK is understandable, especially with the case of Northern Rock, whose reliance on funding its lending practices through securitisation, rather than depositors, caused its collapse and nationalisation.
Table 2 – UK MORTGAGE LENDERS FUNDING FROM SECURITISATION
Alliance & Leicester
Bradford & Bingley
Source – Schifferes (2008) – IFS & Morgan Stanley
With the drying up of the securitisation market, lenders would either have to pay higher interest to investors of their mortgages, or start paying out higher interest rates to depositors, (the alternative method of financing mortgage lending).
The consequences are that mortgage rates rise to cover the higher cost of borrowing, and any interest rate reductions by the Bank of England are simply negligible, and don’t get filtered down to borrowers. (Schifferes, 2008). If they do, the process is a long one, so any expected reductions in interest rates by the Bank of England will take a longer time to have an impact on the wider economy, including the lending market. Wolf (2007) believes that lower interest rates would recover the state of the economy through its effects on the exchange rate improving net exports rather than a direct effect of reducing borrowing costs.
David Miles argued that a squeeze on mortgage lending would cause historically high house prices to fall sharply unless the government sets up agencies similar to Fannie Mae, Freddie Mac and Ginnie Mae in the US, to help expand the mortgage market (Schifferes, 2008). These organizations “maintain a secondary market for buying and selling mortgages on a national level,” so a similar organisation in the UK, which is heavily dependant on property as being an indicator of the state of the economy at a time of crisis, would help the mortgage market survive when borrowing is hard to come by at all levels, from homeowners to mortgage lenders.
Government sponsored enterprises such as Fannie Mae securitise pools of mortgages and take up their credit default risk. This permits the resulting MBS to trade at a higher rating (Lehnert et. Al., 2006). An organisation similar to this in the UK could help ease the freezing up of the UK backed MBS market, which is considerably healthier than that of the US, but has been affected by the credit crisis due to the general risk now associated with any form of security backed by mortgages.
Wheeldon (2007) argued that the main domestic threat of the credit crisis is to off-balance sheet lenders affected by liquidity constraints in the securitisation market, as was the case with Northern Rock. Rising costs consequent to the risks in the US subprime market will severely restrict their ability to lend. On the other hand, Wheeldon identified that balance sheet lenders with their own funds (mainly deposits), are unaffected, being able to lend at their preferred margins.
Therefore, any serious impact to the lending market is a medium-term problem for off-balance sheet lenders However, as noted earlier, 28% of lending in the UK is an off-balance sheet practice, and so in accordance with Wheeldon’s analysis, lending will remain in part limited until the financial markets show signs of recovery putting an end to the ongoing subprime fiasco.
Barnard (2007) identified that the Northern Rock scandal was just a turning point to an already weakening lending market. The downfall of the mortgage lender would “tighten up lenders’ due diligence.” According to Gummer (2007), tougher UK lending as a result of the credit crisis, has led to mortgage refusal increasing from a fifth to a third of all solicits. However, the third of borrowers requesting mortgages being refused are in the same financial situation as the fifth of requesters being refused before the implosion of the subprime market. This suggests that the crisis hasn’t affected borrowers abilities to pay, just lenders abilities to loan to households.
Types of Mortgages
The mortgage market in the UK is known to be saturated with plenty of different types of mortgages available for households, however lending restrictions placed by mortgagers as a contingency of the liquidity problem in the market has been the cause of many of these mortgages being taken off the shelves by lenders.
The following table represents some examples of current mortgages on offer in the UK.
Table 3 – Current Mortgages on offer in the UK
Monthly payments fluctuate with the base rate
Interest payments remain fixed for a certain period
States a maximum possible base rate that repayments can’t go above.
Similar to the subprime mortgage in the US, this helps borrowers who can’t prove their income
Monthly payments are only on accumulating interest, and a separate financial plan is used to help pay for the actual loan value
Allow households to borrow the full value of the property, beneficial to those with inconsistent savings for a deposit.
Helps households release equity from their house when finance is required. A form of liquidating the household asset.
Source – Mortgage Guide (2007)
In a historical context, interest rates are currently quite low, so a variable rate mortgage is very attractive to households. However, tighter lending conditions in the mortgage market amid the credit crunch simply means that most lenders are not fully passing these low interest rates on to borrowers. This type of mortgage is also vulnerable to rises in base rates brought about by rises in interest rates. When the calamity in financial markets eases in the longer term, these mortgages would naturally be very expensive for households.
Capped mortgages are an alternative for variable rate borrowers afraid of rises in interest rates, however the household may not be able to reap the benefits of low interest rates if lenders ease practices and pass on low interest rates to the borrower.
At a time when lenders are charging higher rates to borrowers, interest only mortgages may seem like a good idea, as households can find alternative, cheaper methods of financing the principal loan.
As a direct result of the credit crisis after 2007, the market for 100% and 125% mortgages has shrunk considerably as numerous lenders were scrutinised for letting households take on too much debt. This suggests that many lenders are concerned about a housing bubble declining.
With the threat of house prices falling, households opting to release equity from their property face the devaluing problem similar to negative equity, where the money they release by liquidating part of their house will be far less than when the house was first bought.
Mishkin (2007) argued that rising house prices lead to more collateral for the homeowner if mortgages are readily available. However a fall in value of house prices may worsen the amount of credit available for a household, and inefficiencies of the mortgage market due to the current market conditions would make it harder for homeowners to withdraw housing equity.
Many economists have argued that mortgage equity withdrawals have a direct role in influencing consumer spending. Mishkin (2007, p12) Recent difficulties in the ability for homeowners to withdraw equity from their houses, could therefore dampen consumer confidence, leading to lower house prices bought about by lower demand due to weak refinancing possibilities in a vicious cycle.
Long-term fixed interest mortgages
The government has been keen on encouraging the uptake of longer-term fixed rate mortgages rather than the current favourable variable rate mortgages by households, susceptible to rises in interest rates and lending rates. With this type of mortgage repayments are fixed for a certain time period, so if the Bank of England base rate goes up repayments will be unharmed bringing a sense of stability to the UK housing market.
In his report on behalf of the HM treasury on the UK mortgage market, David Miles recommended a new type of mortgage for the market: Fixed Rate Mortgages with Stepped-Up Repayment Schedules (Miles, 2004, p73). The idea was to try and attract borrowers away from adjustable rate mortgages, which are exposed to any uncertain raises in interest rates. With this type of mortgage, the initial payments are low, and payments go up over time like an adjustable-rate mortgage.
The difference is that the payment schedule is set out in advance so borrowers know what to expect in the future, unlike adjustable-rate mortgages. This mortgage could allow for borrowers to carefully plan their financing, whilst mortgagers can allow low initial interest payments as the loan is interest only at the start, and the principle gets paid off with gradually, pre-arranged increases in monthly payments, and therefore negative amortisation is not generated.
With the subprime crisis forcing the Bank Of England to lower interest rates in the UK, it has also significantly weakened the dollar pushing the value of oil up to record highs, and with food and energy bills also escalating, the threat of inflation would have an adverse effect on rate setters decisions to lower interest rates.
Figure 3 depicts three different methods that lenders can use to fund fixed rate mortgages, counterbalancing any rises or falls in future interest rates and avoiding interest-rate mismatch. The diagram shows that funding fixed rate mortgages still relies on investors purchasing the pooled debt in MBS’s. However, with the popularity of variable rate mortgages being ever-present, these can in turn be used to fund fixed rate mortgages.
Lack of liquidity in the credit swaps market and the drying up of the MBS market would cause lenders of variable rate mortgages to increase rates to obtain more funding, whilst borrowers using the fixed rate lending would in effect be hedging against these rises.
Figure 3 – FIXED RATE LENDING – STRATEGIES TO AVOID INTEREST RATE MISMATCH
Source – Miles (2004), p75
However, borrowers get pushed towards taking the lower up front payment offers, which variable rate mortgages offer. They then have to accept any uncertainty about future interest rates pushing the vale of their payments up, but the Miles recommended fixed rate mortgage allows for this uncertainty to be limited, in an economy where interest rates are quite low compared to the past. However, the international money markets are a burden to this type of mortgage, and households who see their fixed interest mortgages reset at a time when the cost of short-term borrowing is high, could see their monthly payments jump, just as they would with variable rate mortgages.
Miles (2004) gave reason for the limited uptake of fixed rate mortgages as consumers being overly focused on initial payments, thereby not taking a longer-term view. It was also down to the limit placed on building societies, to use wholesale funding to finance fixed rate deals (Thomas 2007).
Love (2003) identifies the UK to be “a nation of people who move houses. Whether it be trading up or moving down to release equity, short-term rates seem to match the nature of the British as property owners,” suggesting that UK households will never grasp the benefits of fixed rate deals.
2.4 The UK’s own ‘subprime’ sector
The UK has its very own nonprime market, which will be referred as the ‘subprime’ market in the UK, offering homebuyers with poor credit records the chance to get on to the property ladder. Although brokers in this sector are far more controlled than their counterparts in the US, meaning that mass defaults in the scale of the US subprime crisis are unlikely, the credit crisis has had adverse effects on the UK’s very own subprime sector, with investors discontinuing their investments in subprime mortgage backed securities.
Due to unreasonable investors unfairly penalizing UK lenders even though the UK MBS market is far healthier than that in the US, subprime lending in the UK is looking less healthy as subprime mortgages are no longer sought after as collateral in these securities. Culhane (2007) Investors are more nervous as a result of impaired liquidity in the financial markets, consequently leading to them analysing their portfolios in greater depth, so lenders that rely on securitisation, have their profit margins compressed. This consequently leads to these lenders increasing the pricing of their mortgages, filtering down on to borrowers in the UK housing market. Whilst repossessions in the subprime sector of the UK can trigger a housing correction, these rising mortgage payments can have an adverse impact on consumer spending, which fuels the UK economy.
Sub-prime lenders in this country have responded to the US situation by tightening their criteria to preclude lending to large numbers of borrowers with adverse credit. Some, including Victoria Mortgages, have withdrawn their subprime ranges (Wheeldon 2007). Once the securitisation market recovers, investors of MBS’s will not be too enthusiastic on ‘adverse assets’ such as subprime mortgages, and tighter regulation will mean that such mortgages will not pool together with less adverse assets in a bid to create a healthy looking security. Wholesale lenders will avoid this sector, with credit quality and low risk investments being the solution to the US subprime problems, whilst any lenders that do deal in the subprime markets, will be tight-fisted with the rates they set (Tomlinson 2007).
Baxter (2007) suggests that the UK is at a similar risk to that of the US with its own subprime sector. This is down to several similarities between the two nations. Before the liquidity crisis was set in motion, there was an increase in subprime business as a percentage of total lending in the UK. Subprime defaults have also risen like they did in the US, and due to higher competition in the sector, subprime borrowers were paying low rates, making them even more vulnerable to a shock, once initial teaser rates soar, and fixed rate mortgages mature and reset at higher rates
In response to a call by the council of mortgage lenders (CML) asking lenders to classify their knowledge of the sector due to the collapse of its US counterpart, Stavro-Beauchamp (2007) believes that arrears data is where the sorting is needed in the sector. The CML have set 7 sub categories in the UK subprime sectors, however standardisation in this particular sector can discourage lenders innovation.
Culhane (2008), has expresses gratitude to the credit crunch, saying that because the problems in the US are much larger versions of the issues here, the debacle has drawn attention to misunderstandings between UK lenders and borrowers, helping in their solutions before they lead to a collapse of the housing market similar to one in the US, and this theory of the UK subprime sector learning its lessons from its US counterpart is also supported by Sturges & Reeh (2007).
The main objective of this dissertation was to study how the US sub prime debacle could potentially impact the UK housing market. This section explains how the research was carried out in order to achieve this objective, using a number of research techniques.
All of the research used in this study was based on qualitative and quantitative secondary data including textbooks, journals, the majority being based on finance and real estate, financial newspapers and articles, government reports and independent research reports relevant to the topic at hand. The majority of authors of the secondary data sources ranged from being specialists in certain areas from real estate to finance, to academic scholars and government specialists.
The bulk of the research was collected from a wide array of databases and libraries, some being available through online databases such as Business Source Complete, and the World Wide Web, and the research was divided into the separate sections that were identified in the literature review.
Secondary research was able to provide the necessary background information and helped with building the credibility of the report (McDaniel & Gates, 2005) and also provided contrasting views surrounding the subject, which were then evaluated. The majority of the research was qualitative, offering correlating and contrasting views of many experts in finance (broadly speaking) and the UK housing market, whilst relevant quantitative data was also looked at in the form of trends surrounding different areas of the UK housing market and its links with the subprime mortgage crisis in the US.
It was decided that carrying out primary data research on the basis of this topic was unnecessary as well as being beyond the scope of this study, especially as there is ample secondary data regarding the subject readily available. Also, any highly influential individuals and/or committees on the subject matter at hand would be unresponsive to questionnaires and inaccessible for interviews, whilst their invaluable views surrounding the topic proved to be readily available through the utilized literature. The ever-changing uncertainty regarding the losses faced by various institutions associated with US sub prime mortgages also contributed to the focus of the methodology carried out to write this report on secondary sourced information.
Data on real house price averages in the UK since 1952 was obtained from Nationwide building society, and this data was then statistically analysed to find an underlying house price trend (section 4.1).
Real Estate Investment Trusts (REIT’s) were selected as an important indicator of UK property performance, including the housing market, and recent performance of these trusts was analysed (section 4.5).
Once all the research had been carried out, relevant data was extracted and then organised in correspondence to the separate sections in this study.
4. Empirical Evidence and Analysis
The penultimate section of this paper examines empirical evidence gathered from former research carried out on the subject of this paper. It also explains analysis carried out on historical house prices and Real Estate Investment Trusts in the UK.
4.1 House Price Trends
Data Source – Nationwide (Appendix 1)
Using data from nationwide on average UK house prices since 1952 (Appendix 1), the following graph was illustrated, and the general trend of house prices based on real data was calculated. (nb. the 1952 house price was re-based to 100
Figure 4 – UK house prices since 1952 and the underlying trend
Data source – Nationwide (Appendix 1)
The trendline is a simple polynomial to the second order, and can be denoted by the following formula:
Y = 0.2913x² - 29.506x + 727.33[R² = 0.9267]
The coefficient of determination (R²) shows the proportion of variability in the Nationwide data set, that is accounted for by the statistical model shown above. The value of 0.9267 shows that the trend line fits the Nationwide data set to an accuracy of over 92%.
Based on the accuracy of the trendline, figure 4 shows that house prices have remained relatively stable until 1987, after which, it appears a boom and bust cycle started. In terms of the data range, a relatively small period of house price inflation above the trend after 1987 resulted in a correction in house prices lasting for the former part of the nineties. After approximately 2002, house prices in the UK have escalated above the historical trend, supporting Műnchau (2008)’s assumption that house prices in the UK are 30% above the trend.
Bootle, R (2008) forecasts a stop to growth in the UK that matches that of the recession in the 90’s. The UK housing market seems vulnerable to a downturn more severe than the one seen in 2005. Whilst the lending market is weakened by higher interest rates, and the buy-to-let market is unfavourable, Bootle predicts a house price correction in the UK housing market.
House prices in the UK proved their strength during the turbulent times of a financial crisis, as they were unaffected during the aftermath of the 9/11 events, which caused a liquidity crisis to some extent in global financial markets. However, at this time, they were still below the trend shown above, which proves that they may be susceptible to the liquidity crisis brought on buy the subprime mortgage crisis triggering a downturn in the seeming boom-bust cycle.
4.2 Rising Debt in Households
House prices have rapidly risen since the mid 1990’s, and the upswing has lasted longer and is steeper than the previous boom period. As a result, housing finance debt has also risen, while interest rates have steadily declined, and debt-servicing costs remained relatively stable. However, the credit squeeze has had an adverse effect on the cost of mortgage servicing, leading to tightening lending conditions in the UK housing market. Rising costs of lending have their toll on UK households, who are somewhat overly leveraged.
Gyntelberg et al (2007)’s research on stability in housing finance markets proved that the majority of borrowers in the UK are able to embrace falling house prices as well as increasing interest rates. They also distinguished that the rise in house prices and rise in household debt coincided with a period of low interest rates and easy access to credit, as did Girouard et al (2007). Also, the increased use of variable mortgages increases payment risks due to rising lending rates, and recent innovations in housing finance has led to households not fully understanding the risk of interest rate shock. This in turn has led to the questioning of investors being unable to evaluate their own portfolio risk due to the unreliability of borrowers to actually finance their mortgages at times of crisis.
Girouard et al (2007)’s research on rising debt and household vulnerability found that whilst household debt has recently risen steeply, so has total household net wealth due to the appreciation of house prices. This high-priced housing asset provides households with a financial cushion against negative shock. They also found that in the UK, which has a flexible mortgage market, households with high housing wealth are more able to finance interest rate shocks.
Elbourne (2008)’s research on the UK housing market suggested that movements in house prices explain about one-seventh of the fall in consumption following changes in interest rates, whilst Campbell & Cocco (2005) analyzed the relationship between household consumption and house prices. They showed that the relationship between these two variables varies in different regions. As a result of the liquidity squeeze, lower demand may cause house prices to drop in the UK, but demand in London is likely to remain high, suggesting that a downturn in house prices will not largely affect the capital.
On the other hand, London is also home to the UK’s financial industry, and weakening performance here could have a detrimental effect on demand for housing in this region. Campbell & Cocco concluded that UK house prices are directly related to the ease or difficulty of borrowing in the economy as a whole, and that UK house prices are correlated with overall conditions in the financial market.
In their research explaining differences between the US and UK household wealth distributions, Banks et al (2002) concluded that UK households hold relatively small amounts of financial assets as a fraction of their total wealth, compared to American households. This suggests that UK households’ total wealth should be unharmed by weak performances in stocks exposed to the subprime crisis, dissimilar from their US counterparts. However, Banks et al (2002) also found that household wealth is concentrated in housing in the UK, so a fall in house prices here could directly affect borrowers abilities to finance their mortgages.
Kane (2007)’s research on central banks in financial hub countries during turbulent times found that during the interbank crisis of summer 2007, governments used repurchase agreements to transfer large amounts of taxpayer funds, to numerous institutions whose recklessness in finding, pricing, and securitising poorly underwritten loans led to the crisis in the first place.
These funds were supposed to help finance different areas of the economy, so in order to raise more finance to carry on funding these areas, one scenario is that governments may have to increase taxes, having an effect on individuals households wealth which is already prone to high taxes in the UK.
Dorling & Cornford (1995) explained that mortgage lenders capability to react to downturns in the housing market is limited due to the competitive nature of the lending market. Their research on house price falls and negative equity showed that due to the nature of house prices to always rise over time, there has been no incentive for governments to formulate a direct policy to negative equity. They defined equity in housing as the difference between the market value of property at a given point in time and the outstanding value of the mortgage secured on that property.
House price falls as a result of the credit squeeze means that the people at risk of losing out are those whose houses may fall below the value of the mortgage on their property. This threat of negative equity can consequently cause skeptics to sell at a time when they think house prices are peaking. Whilst this can be true to some extent, houses aren’t tradable like normal assets, and the essential shelter that they provide us with is fundamental economic and social health. This should mean that households that suffer from negative equity if house prices do fall, will ride out the storm based on the fact that in the long term, their equity will rise back on to values significantly larger that their mortgages.
4.3 The Mortgage Market
The main debate surrounding the mortgage market is UK households’ tendency to opt for more risky variable rate mortgages, mentioned in section 2.3. The Miles review of the mortgage market in 2004 examined how UK borrowers could be distract from their dependence on variable-rate mortgages by longer term fixed rate mortgages. In helping the cash flows of households less susceptible to the base rate, this type of mortgage would however make lenders more sensitive to base rate change, a possible reason for mortgage companies to disregard the recommendations of David Miles.
Research carried out by Przansnyski & Lawrence (2004), concluded that borrowers who choose to refinance their mortgages between fixed-rate and variable-rate loans are now capable of gaining valuable insights into the effects of their refinancing decisions, thus allowing borrowers to compare alternative mortgages and help minimize the risks of any interest rate changes.
Stephens & Quilgar (2007) reported findings of a survey of lenders' arrears and possessions and practices in 2005. They found that a repeat of the early 1990s housing crisis is improbable, even though consumers are facing higher interest rates and rising debt levels. They learned that arrears in the non-prime sector were four times greater than the prime sector, whilst houses as collateral on sub-prime mortgages were ten times more likely face repossessions than prime properties. In reference to the UK ‘subprime’ sector they concluded that there is a high around of uncertainty with this sectors performance during a market downturn, as the sector was still in its beginnings during the recession in the 1990s.
4.4 Housebuilders – Meeting Demand
The chronic shortage of housing supply in the UK mentioned in section 2.2 shows the increased importance for housebuilders in the UK to deliver housing stock that meets market requirements, while maintaining regulations set by governing bodies. Barratt, the UK’s second largest housebuilder has felt the turmoil in debt markets, combined with interest rate rises in early 2007, causing tightening lending standards that have triggered negative customer attitudes in the housing market to have an adverse effect on the company’s short-term future.
Barkers review of housing supply and delivering future housing needs in the UK made several recommendations relative to housebuilders. Barker (2004) necessitated the need for public policy to allocate more land for development. The review also pointed out the need for more competition amongst housebuilders to aid quicker responses to changing market conditions, such as the liquidity crisis’s strain on the housing market.
Barker suggested that the housebuilding industry needs to express ability and compliance to a changed environment where less volatile and increasing house prices should motivate housebuilders to be keen on supplying demand.
On the subject of a boom and bust cycle in the UK housing market, the boom in house prices, when placed alongside basic economic theory was in principal, down to the fact that demand radically outweighed supply, amongst other factors. To prevent the difficulties that households will face due to any future liquidity constraints, (which seems inevitable in the way that financial markets operate), difficulties that are brought about by downturns in boom-bust cycles can be omitted from the housing market by preventing the boom-bust cycle in house prices from getting out of hand. This can be achieved by ensuring that supply can keep up with demand, to stop house prices from spiraling way above the conventional trend
The Calcutt (2007) review of housebuilding delivery placed the housebuilding industry in good shape to deliver sufficient housing stock to keep up with future demand. The review identified that housebuilders are in business to primarily deliver profits to their investors, rather than serve public interest. A downfall in house prices due to instability in the market caused by the liquidity crisis can therefore fend off investors, causing the industry to pause until house prices pick up again.
Due to the industry’s dependence on investors, Calcutt recommendations were to central & local governments to reduce the risks faced by investors in the market, however, the UK should see considerable investment, especially in London due to the 2012 Olympics, helping to keep house prices at bay. The research made 37 recommendations to the housebuilding industry and its affiliates, requesting developers and authorities to create beneficial partnerships, helping develop and regenerate existing settlements to prevent demand causing housebuilders to ruin countryside outside of towns and cities.
Overall, Calcutt’s review identified that land availability is the key so sustaining development, and based on the reviews projections, the industry is more than capable of delivering the government’s target of 240,000 new homes a year in the future, helping ease the volatility of a boom-bust cycle. The key for housebuilders is to “deliver a supply of housing where it is needed, for those who need it, at a price which is affordable for the homebuyer, which is commercially viable and which contributes to our ambitious zero carbon targets” (Calcutt, 2007, p6).
4.5 Real Estate Investment Trusts (REIT)
REIT’s are forms of equity trusts, that work like mutual funds, and they serve individual small investors enabling them to group their wealth together and collectively act as larger owners of more efficient and more profitable investments in real estate. Housing can be linked broadly to real estate, in that demand and supply conditions in both housing and the real estate market are correlated to each other (Sirota, 2000).
Lee et al (2007)’s study, examining the link between REIT’ s and the underlying real estate assets concluded that the performance of REITs can be linked to the real estate assets they support.
As seen with the examples of both securitisation, and housebuilders, the housing market is one that relies on investment, and the following chart illustrates recent performance of REIT’s in the UK.
Figure 5 – Recent Performance of UK Real Estate Investment Trusts (REITs)
Source – REITA (2008)
The chart coincides with research from Hoesli et al (2007), who found that equity markets, which include REITs, act as hedges against times of inflation risk and financial instability. After what looks like weakening performance since the start of 2007, UK REIT’s seemed to have stopped this declining trend, showing signs of stabilisation in the first part of 2007. If positive signs in the housebuilding market identified in Calcutt (2007)’s review, and factors such as the 2012 Olympics increasing demand in key areas such as London and the South-east, REITs could show considerable growth bringing more investment into the housing market in the UK. This could help prevent a prolonged period of descent in house price trends.
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