What we have been witnessing or perhaps, expressed more correctly, are starting to witness (depending on where you believe we are in the current cycle), is a great unwind or deleveraging. As has been covered in much detail in the press, most notably by Robert Peston in his various Blogs, we (as a nation) have consistently been borrowing more than we have been saving and ultimately, as everyone knows, there comes a point when the debt has to start being repaid.

Within the banking system there exists currently a loan to deposit ratio of 145%. In simple terms over £700bn, be it corporate loans, home loans etc, was not financed from internal resources but through the wholesale funding markets. With these now effectively shut, it has fallen to the government to try and fill the substantial funding gap. With regard to mortgage funding, with house prices continuing to fall, it is perhaps understandable that with lender’s finances under severe strain, higher risk loans are unlikely to be written.

The end of the beginning?

Without a re-opening of the capital markets, we are looking at continued government intervention aimed at supporting the banks to continue to lend, at least towards the levels of the last couple of years. If we view the credit bubble of the last few years as an addiction, the role of government is to prevent the UK economy undergoing the equivalent of ‘cold turkey’ which would have massive implications for businesses and the economy as a whole. The question that the events of the last few months lead to inevitably is ‘where is the end or at least the beginning of the end? 

The start of the crisis

What started off as an issue revolving around US sub-prime lending has snowballed in what is now generally regarded as an impending global recession. Whilst the economic debate has now shifted from one of mortgage lending and falling house prices, to that of corporate failure and economic recession, we are firmly of the belief that the stabilisation of house prices will restore confidence and mark, if not the end, but at least the beginning of the end of the current cycle

The importance of housing in the global economy

House prices are important in two respects. From a funding and capital markets perspective, house prices underpin huge amounts of paper debt issued over the last few years. As prices fall, so does the intrinsic value of the debt, hence the huge mark to market losses (MTM) and in many cases on US RMBS paper, real losses. Until the value of underlying assets stops falling, you can’t draw a line and uncertainty remains as to what the overall exposure and loss maybe. Additionally, with literally $ trillions of mortgage debt already in the market, all of it substantially written down, there is little hope of new issuance without either government guarantees or signs that we are reaching the end of falling prices. Secondly, house prices are a ‘barometer’ of general economic confidence. If we as a nation feel good, confident and secure, we spend more and prices rise.

This will not end until US house prices stop falling…(Alan Greenspan)

Despite every evidence (which I will cover a in separate blog later) that there is no linkage between the UK and US housing markets and in turn between US and UK RMBS paper, this is not being reflected in capital markets. Accordingly, the return of the capital markets is almost entirely dependent on US house prices stabilising. At this point, as well as a line being drawn under losses, both MTM and real, new deals, (low LTV and conservatively structured), start making a lot of sense for two reasons;- (1) The loss severity is likely to be low to zero (2) Spreads or margins on deal will be very high meaning good returns for both issuers and also investors. In short, the stabilisation of house prices will represent a complete resetting of the bar for investors and issuers. The million dollar question therefore is when?

Case Schiller index

The most widely regarded index in the US is the 20 city Case Schiller index . Given its sheer scale, the US market has much greater regional variations. This combined with the rapid growth of sub-prime lending in regions such as California and Florida and speculative building in these regions (supported by sub-prime lending), produced a very distorted picture when house prices rose rapidly. The correction is equally distorted, focusing primarily on the regions where prices rose the most. As can be seen from the graph below of the 20 city areas, rapid divergence is now being replaced with rapid convergence (note the stronger red line is the average composite 20 city index) - click on the graph to view in a seperate window

 
With the current rate of decline and the reducing supply side imbalance (private housing starts have fallen by over 30% in the last year) we believe that along similar lines to our view of the UK, the approximate bottom of the market will be viewable in the latter half of 2009. This view is supported by some very interesting research by Nomura on parallels between the Japanese experience in the 1990’s and the current US experience. Click here to view

Given the greater supply in the US, we would anticipate a period of ‘bumping along the bottom’, where prices are flat or in certain months fall or rise slightly, but the large scale corrections that have destroyed confidence in the US housing market will have occurred.