Saturday, 8 December 2007

UK overloaded with household debt

UK households are drowning in debt.

The numbers are extraordinary. Take a look at the following three charts that compares the level of personal debt to UK annual output (GDP).

Since 1999, personal sector debt increased from around 65 percent of GDP to just over 100 percent of GDP. In the last four years alone, personal sector debt rose by an astounding 10 percentage points of GDP.

Loans secured on housing have driven up personal sector debt. Over the last ten years, secured debt - which includes mortgages and home equity loans - increased by over 30 percentage points of GDP.

Unsecured debt (basically credit cards and unsecured bank loans) now stands at around 16 percent of GDP. By historical standards, this is a very high number. However, the ratio has fallen slightly since Christmas 2005. Proving that they are not completely stupid, banks have become increasingly worried about the capacity of people to repay unsecured debt. In response, they have quietly tightened lending standards. Nevertheless, this modest reduction has been overwhelmed by phenomenal growth of housing-related credit.

The Banks are trapped

Why did the banks allow housing debt to reach such dangerous levels? Unfortunately,banks took far too much comfort in their loan to value ratios, and relied too heavily on house values as collateral.

Rising house prices and easy credit enticed the banks into over-extending themselves. As house prices went up, loan to house price ratios (LTV ratios) allowed banks to hand out ever larger mortgages. As mortgage loans increased in size, house prices went up even further. Bigger loans meant higher house prices. This generated a cycle of increasing house prices, with in turn permitted ever larger mortgage loans, and so it went on for for eight or so years.

Banks also took some comfort from the fact that their mortgage loans were collateralized on an asset that was strongly appreciating in value. In the unlikely event that someone defaulted, the bank could encourage the mortgage holder to sell up and repay. With rising house values, people who found themselves in repayments difficulties, could often sell at a profit, and walk away without incurring any financial losses. This kept default rates at historically low levels, and persuaded the banks that mortgage lending was a comparatively riskless activity.

However, this spinning wheel was poisoning UK households with credit. The housing bubble could only continue with ever-growing debt levels. After 8 years of a relentless credit-financed housing bubble, the banks have pushed households to the very limits in terms of debt servicing costs.

Now, the wheel has suddenly stopped and moved into reverse. House prices are now falling and as they do, the LTV formula works in reverse. Banks will have to reduce the size of their mortgages to maintain their loan to house price ratios. This means less credit, which will reduce housing demand. LTV ratios are about to cut away the foundation of the UK housing bubble. The banks are now overexposed to a market that is in deep trouble.

Of course, the banks are not the only culprits. Regulatory oversight was virtually non-existent. The Financial Services Agency paid little attention to the increasingly risky behaviour of mortgage lenders. The Bank of England played its part in this sorry state of affairs. It provided the low interest rates that fired up the lending boom. However, the banks will have to carry the can. After all, that huge stock of personal debt is on their balance sheets.

Sentiment is shifting

In some respects, the US subprime crisis helped obscure this deeper balance sheet problems within the UK banking sector. With the value of housing collateral beginning to fall, and defaults likely to rise, bank balance sheets will come under serious stress. As such, the UK has its very own home grown credit crunch that has very little to do with rising default rates in the US.

UK Banks now face a serious funding crisis. Around a quarter of mortgage funding came from borrowing from other financial institutions via the wholesale money market. Now, these institutions are looking at the UK housing market with enormous skepticism. Any further lending to the likes of Northern Rock, Paragon, and the Alliance and Leicester looks extremely risky. Since the summer, institutional financing has dried up, and as a consequence, mortgage availability is tightening very quickly. Remember the golden rule of housing; no, it is not "location, location, location", it is "easy credit equals rising property values".

What happens next

In terms of personal sector debt, the bucket is now full. UK households can not absorb any more debt. Markets are responding to this new reality. The more prudent banks are scrambling for cash in order to defend their balance sheets against rising defaults. Vulnerable banks are selling off valuable assets to raise cash. Other banks haven't fully understood the new reality and for a while, they may be dazzled by the Bank of England's recent interest rate reduction. For a while longer, some banks might continue lending.

Without credit, there can be no bubbles. Once the flow of cheap mortgages stop, house prices will dive. At first, the declines will be slow. Those tedious conversations about rising property prices will stop. Home sales will fall off first. Housing inventory will begin to rise and the estate agents will begin to close. The crash will be slow but it will be relentless.

The real danger comes from buy-to-let speculators. If they start to off-load their money-losing investments, house prices could seriously fall, and then the banks could be staring into the abyss.

(Data sources: Household debt from the Bank of England - amounts outstanding of net lending to individuals - LPQVTXC; amounts outstanding of secured net lending to individuals- LPQVTXK; amounts outstanding of unsecured net lending to individuals - LPQVZRI; Gross domestic product from the ONS - YBHA. All data series are seasonally adjusted. Estimates for 2007 based on data for the first three quarters)


speedtheplow said...

Couldn't agree more with your sentiments and analysis. But the jury is still out on whether there will be a crash, for the simple reason that interest rates are low and going lower (as low as Japan?). We all know that there is monstrous inflation in the UK--not just housing, but food, utilities, transport, etc. But as long as the BoE refuses to count these items in its inflationary reports, do they exist as far as the market's perception is concerned? We'll see. Like you, I am an angry renter; returned to UK last year after 15 years away to find housing utterly and absurdly priced. I want a crash more than most, and I think the reckless lending, buying, profiteering etc. warrants it. But will it happen? It took 15% interest rates in 91 to make it happen last time...

ukhousingbubble said...

I don't think the jury is out wrt to a crash. Every housing indicator is flashing red; affordability, price-to-income ratios, inventory, etc. Having said that, I think the recent interest rate cut might encourage one or two more liquid banks to keep lending.

Regarding your point about interest rates, We need to be clear what we mean by interest rates. For example, if a bank like Northern Rock can not get funding from the wholesale market, then its interest rate is infinite. Likewise, if someone is looking for a 100 percent LTV loan but can't find a single bank that is prepared to extend the credit, again the interest rate is negative.

At the moment, mortgage lenders are facing a credit shortage. They can not get medium term loans to finance more mortgages. Unless this changes, then mortgage lending will contract, and with it, demand for housing will fall.

My key point is that the personal sector is close to being "banked out". Nominal interest rates are already quite low. Incomes are not rising (a major theme for an upcoming post). Personal sector debt simply can not grow further.

Perhaps for this reason alone, I believe the bubble will burst.

Markbaldy said...

I beleive that the BOE is not independent of the government one bit ! Artifically low interest rates fuelling the housing bubble have been influenced totally by Gordon Brown over the last 10 years.
His so called "miracle economy" that has staved off recession is based entirely on borrowed money riding the back of crazy house price inlation... and so the cycle has gone on... till now that is.
Why did Alistair Darling bail out Northern Rock... well I am sure that if it had been allowd to go belly up and other banks/building societies had followed, then the whole economy would have been shown up for wht it is, a sham.
I am only glad that Labour are still in power now that the wheels are falling off the economy so they rightly get the blame !