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Cyclical Opportunity for UK Secured Lenders!
Summary: Secured Lending Market
The UK economy and housing market are at the end of an unprecedented boom fuelled by cheap credit. A slowdown is inevitable in 2008 but a severe recession and housing market collapse are unlikely. Funding problems are causing some secured lenders to withdraw from the market or tighten their lending criteria, particularly for sub-prime risks. All lenders see current market conditions as an opportunity to restore margins but lenders which are dependent on wholesale funding may struggle to do so. Along with other European countries that have over-heated house prices the UK is in the early “fear” stage of a housing market downcycle – the UK housing market peaked in June 2007. Secured lending risk is probably now correctly priced – maybe generously so – and therefore there are profitable opportunities in both prime but particularly sub-prime market segments.
The US sub-prime mortgage crisis spilled over into the UK spectacularly with the run on Northern Rock bank, the UK’s fifth largest mortgage lender. Panic amongst depositors occurred for the first time in a hundred years. The British banking regulatory system was found wanting following the reform of 1989 which divided responsibility among three institutions: the Bank of England, the Financial Services Authority and the Treasury (British Government). In an embarrassing u-turn, the British government was forced to provide not only a depositors’ guarantee but also to lend money (at least £25bn) to Northern Rock in its role as lender of last resort. If Northern Rock is not sold to the private sector by mid January 2008 it may well have to be nationalised and then broken up to protect the British taxpayer. Unlike the US sub-prime mortgage market, Northern Rock’s problem derived not from low quality lending but from its business model, which relied on short term wholesale funding (3 month commercial paper) to finance its long term mortgage portfolio. The market for 3 month commercial paper dried up in August 2007 and Northern Rock’s over-dependency on this source of funding was exposed. Northern Rock faced an unanticipated liquidity crisis and was not able to borrow, either secretly from the Bank of England or from the European Central Bank as it does not have a branch in the Eurozone.
Northern Rock had the highest exposure to wholesale funding of the UK’s largest banks. However, some smaller lenders have formally withdrawn from the market. Many others have tightened their lending criteria or taken steps to reduce their volume of business. Poor lending decisions by UK unsecured lenders, such as credit card companies, have resulted in rising bad debt provisions over 2006/2007. US sub-prime mortgage losses only started to emerge in the third quarter of 2007 in the results of US banks. Given that there is no market price to value such assets, the actual quantum of losses that will emerge over 2007/8 remains very unclear at the time of writing but is expected to be up to $300 billion.
Significant losses wherever they lie confirm that risk for all sorts of financial instruments have been underpriced for years. This is a fact that has been rapidly acknowledged by global bankers and investors. The consumer boom in the US, Europe and elsewhere lasted too long, fuelled by a seemingly infinite supply of cheap money. Markets were driven by greed for an easy buck. Insatiable demand was strong and supply was even stronger! Suppliers of credit were either naïve or greedy.
In 2006, world economic growth was 5.4% - its fastest rate for a decade. The IMF forecasts that growth will decelerate to 5.2% in 2007 and 4.8% in 2008. The UK grew by 3.2% in 2006 and the IMF forecasts growth of 2.9% in 2007 and 2.2% in 2008. UK demand for secured credit may well slow over 2007/8 but we are probably talking about a deceleration in growth rather than a fall.
But what about the supply of credit, especially the supply of credit to individuals? It is clear that supply is lurching downwards. Prime lenders are raising their prices and tightening their lending criteria to restore profit margins – they are no longer chasing market share. Many sub-prime lenders are raising their prices just to maintain profit margins as they rely on wholesale funding which has become more expensive: LIBOR at 6.5% is currently 100 basis points above base rate at 5.5%. The combination of a wholesale funding shortage, market withdrawals and tighter lending criteria is reducing the supply of credit. In fact, the broad UK money supply may be contracting. Repricing for risk? Borrowers are borrowing against the security of their homes. But hardly anyone would dispute the view that UK house prices are over-inflated and a correction would be justified. Remember 1990-92 when house prices fell by 20%? There are good reasons to argue that this will not happen this time round – the economy is stronger and interest rates are lower. Yet secured lending is a huge market and a reduction of market capacity is a natural occurrence during an economic downcycle, especially after such a protracted credit boom. Never underestimate the power of cycles in any business segment! The upcycle is characterised by capacity rushing in and forcing down prices. The downcycle is characterised by capacity rushing out and forcing up prices. The winners are those market participants which are strong enough to ride out the cycle without getting hurt too badly and those market participants which time their entry and exit cleverly. The upcycle is characterised by greed. The downcycle is characterised by fear. Where are we now? Clearly the downcycle.
When should lenders re-enter the market? The particular nature of the financial industry is that capital can enter and leave quickly. Prices can be adjusted overnight. Will 2008/2009 provide golden opportunities for secured lenders? The answer must be “yes”. Why? UK households are already well into the initial phase of accepting a new economic reality. Interest rates rose for more than a year peaking at 5.75% - only borrowers completing two year fixed rate mortgage deals priced at around 4% will have encountered a mortgage payment shock. In response to signs of the slowing economy, the Bank Of England cut interest rates by 0.25% to 5.5% in December 2007 and a further cut is expect in the first quarter of 2008. Borrowers with secure incomes will therefore gain increasing benefits through 2008 and there may be opportunities to fixed rates well below 6%. But borrowers who are exposed to the slowing economy and lose their jobs will suffer – home repossessions have been rising steadily in 2007 and will rise further in 2008. UK households will also accept that their homes are unlikely to rise significantly in value for at least three years. But they have still substantial equity to draw down if necessary – and many are doing just that. UK workers are generally unable to force through inflation busting wage deals. Immigration provides a major source of cheap labour and the developing economies remain highly competitive still. These factors will keep the lid on inflation – rising food and petrol prices should be temporary and drop out of the figures in early 2008. Unemployment is at a low point and a modest increase from 2008 will surprise no-one. Homeowners will therefore be buffeted by more difficult times ahead but a severe economic downturn with a house price collapse are unlikely.
Burtplan Personal Finance is a leading UK loan broker and mortgage introducer. With 50 years experience, the company helps borrowers obtain low rate loans and mortgages which are arranged in the shortest time possible. Burtplan Personal Finance works with independent secured homeowner loan brokers who negotiate the best possible deals for their clients. Visit Burtplan for more information about
secured loans.
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