Look to a future of repossessions and reset shock

In recent years, rising prices have covered many traps and fractures lurking in the property market, while falling house prices will expose them. Consider the following two unfolding dangers; rising default rates and introductory fixed rates.

When house prices are rising, default rates are naturally low. That is not to say that in recent years people have not overextended themselves with unserviceable mortgages. Rather, when someone got into repayment difficulties, the current value of the house was invariably higher than when the house was initially bought. Therefore, the unfortunate homeowner could quietly sell the house, and payoff the mortgage and the accumulated payment arrears. In such circumstances, repossessions and defaults remained historically low.

Incidentally, this generated a false sense of security about housing affordability. Banks looked at default rates and repossessions and thought that people could absorb ever larger mountains of debt. Houses might be inflated, but people are still paying, therefore housing affordability must be reasonable. This logic lulled the banks into misjudging the risks of mortgage lending into an inflated and bloated housing market.

However, the situation is now very different. With house prices falling, people will be desperate to avoid repossession, since the subsequent enforced sale would involve capital loss. This generates a sticky situation for banks. On the one hand, if the banks offer distressed homeowners a degree of forbearance, the ratio of bad loans to total loans will increase, weakening the financial viability of the bank. On the other hand, any attempt to accelerate repossessions will generate a wave of bad publicity and in any event, generate immediate capital losses since the recovered money will invariably be lower than the initial mortgage.

A second danger comes from introductory fixed rates. Many mortgages over the last two or three years seemed affordable because of low teaser rates. In the coming months, many of these introductory offers will expire, and mortgage rates will rise, generating what the Americans call "reset shock".

Given the current level of interest rates, many homeowners will be pushed towards default and repossessions will rise. The Bank of England understand this and that is why the monetary policy committee is desperate to cut interest rates. However, inflation remains high while economic growth continues to be remarkably robust. From a wider macroeconomic perspective, an interest rate cut is totally unjustified. However, the housing market is screaming out for one.

Even if the Bank of England shamelessly tried to save the housing market by relaxing monetary policy, it is inconceivable that they could reduce rates back to the levels of two years ago. One or maybe two interest rate reductions would save some people from repossession, but many more homeowners would continue to be in deep trouble. Moreover, a growing number of banks are showing an increasing reluctance to issue new loans to customers with poor credit histories.

One by one, banks are exiting the high risk mortgage business. Credit standards are tightening, and this in part explains why mortgage approvals were so low in October. Furthermore, distressed homeowners will find it increasingly difficult to find a bank willing to refinance mortgages at lower rates.

These two factors; rising default rates and mortgage resets will help accelerate the housing crash which started this summer. Everything now goes into reverse; default rates will rise, creating a flood of repossessed homes that will depress prices further. The lack of introductory rates will trap people into nasty mortgages they thought that they could refinance but now have to repay. The higher reset rates will push many of them into default and again putting downward pressure on prices.

It all serves to point to a deeper truth about housing bubbles; whatever financial benefit a bubble might generate, it invariably takes it back later. As my dear old grandmother used to say; " first comes the laughter, then comes the tears".