Mortgage spreads decline

(Click on chart for larger image)

During the housing bubble, UK banks got rather carried away. In a rush to get money out the door, banks cut their interest margins to encourage buyers to take up mortgages. In the process, banks may have created the conditions that could place some of the more reckless banks into serious difficulties in the near future.

To understand the sticky situation that banks now find themselves in, take a look at the above chart. It illustrates what happened to the effective mortgage spread since the beginning of the decade. The effective mortgage spread is defined as the difference between the effective interest rate on the stock of outstanding mortgages and the appropriate funding rate. Or to put it in slightly more simple terms, the chart measures the difference between the interest rate that banks received on their mortgages and what they had to pay on deposits and other sources of financing.

During the early part of the decade, banks demanded from their borrowers at least one full percentage point over their funding costs. At times, banks required almost 1.5 percentage points. However, spreads declined dramatically and the housing bubble madness took hold. Just before the credit crunch, banks accepted an effective spread of just 0.41 percentage points. To illustrate with a simple numerical example, if banks had to pay 5 percent on their deposits, they lent out mortgages with rates of just 5.41 percent. Back in 2001, a comparable mortgage rate would have been more like 6.41 percent.

With margins declining, banks lent to clients who purchased an asset whose price had broken free from long run fundamentals. More than any other mortgage product, it was the exploding buy-to-let market typified this reckless and short-sighted behaviour.

In the last ten years, the number of buy-to-let mortgages has risen from almost zero to over one million. These mortgages generated an increase in the number of rental properties and pushed down rental yields. The declining cash flow from the sector meant that new investors became increasingly dependent on future capital gains to ensure that their investments would remain profitable. So as lending to the housing market was becoming increasingly risky, banks were prepared to offer lower interest rates relative to their funding costs.

Banks are now stuck with a mountain of loans that are, at best, only marginally profitable. With spreads so low, the banks have little room to absorb any losses due to rising defaults. However, far too many people took out these loans for essentially a speculative punt on future house prices. Defaults are now almost certainly about to rise, and when they do, banks could find themselves in a deep dark hole.

Banks have already started to respond to this growing thread. The mortgage spread data (which comes from October's Bank of England Financial Stability Report) finishes in August, just as the credit crunch begins. Although data for the later months of 2007 is not yet available, there is strong anecdotal evidence pointing to a gradual increase in mortgage spreads. Banks are no longer prepared to gamble on the housing market.

Given current market conditions, only banks with a death wish would keep their spreads at just 41 basis points. The banks are now moving into reverse, anxiously trying to steer away from the rapidly approaching housing crash. Worried banks are trying to filter out high risk customers by removing some of their more highly leveraged and irresponsible products. The 125 percent loan-to-value products have all but disappeared, while mortgage approvals have fallen off a cliff.

Without credit, there can be no bubble. From now on, it is going to get a lot harder to get a mortgage and as credit conditions tighten, housing inventory will begin to rise and slowly but surely, the weight of unsold houses and their desperate owners will become unbearable. House prices will crash.