In a post last week we took issue with just one of the comments made by a certain Jim Rogers. In an excellent article in this weeks Sunday Times, David Smith expands on some of the more extreme comments that have had undue publicity (relative to their accuracy) entitled Britain is not Iceland. Is EU the next Japan? . This is well worth a read to put much of the negativity in its rightful place.

As most of you will be aware, the government has today announced a further series of measures to try and get the banks lending again, and ensure that what is likely to be a recession doesn’t tip over into a depression.

One of the fundamental problems when entering a slow-down/recession, is changes to behaviour. In times of uncertainty a common and natural behavioural reaction is to spend less. However the danger with this particular recession is that lack of spending is being driven in large part by the lack of available credit. This is impacting, very severely, the housing market, but is also having major implications in other areas, notably car manufacturing, where nearly 50% of new cars are bought (or rather were) with finance (Honda has today announced that its UK plants will shut for 4 months from March!).

Whilst the credit bubble that we have all witnessed since 2000 (the point at which banks effectively ceased to be funded entirely by matched deposits) has now clearly burst, the government’s actions are clearly aimed at ensuring a gradual return to normal lending conditions rather than simply going the equivalent of ‘cold turkey’.  There is over £700bn of debt owed to British banks, which was funded in some way or other through the wholesale markets. With the wholesale markets still remaining effectively closed, the only way to avoid a massive contraction of lending, with disastrous consequences for both consumers and businesses, is for the government to step in. With this is mind, 5 key announcements were made today:

Extending the time period of the special liquidity scheme and extending the maturity date for the Bank of England’s Discount Window Facility which provides liquidity to the banking sector by allowing them to swap less liquid assets.

Establishing  a new Bank of England facility for purchasing high quality assets: In effect this means the government buying up, by the issuance of liquid treasury notes (initially up to £50bn), a range of AAA type assets including such things as corporate bonds, commercial paper and a limited range of ABS in paper format. The buying of assets (rather than simply a temporary ‘parking ‘of assets to date) represents an important departure here not only in allowing banks to remove certain assets from their balance sheets and free up capital for lending, but also in the widening scope of acceptable securities. The buying of assets also potentially marks the start of quantative easing (click here for more details).

An asset protection scheme:  This is effectively insurance for the banks (after the banks take an agreed first loss piece) on assets they hold. One of the biggest issues for banks is provisioning and effectively holding back cash in case of future losses (which may or may not occur). The very real issue here is that the effective hoarding of liquidity actually makes future losses more likely by starving business of the funding they need. So, for a price, the government will provide insurance on agreed assets, reducing provisioning required and freeing cash for the banks to lend. As the government is keen to emphasise, all the help offered is on the proviso that banks agree to lend more.

Adoption of the Crosby report: As covered in our blog on 25th November 2008 (click here), the government will be pressing ahead by offering full or partial guarantees for AAA mortgage backed securities, corporate and consumer debt. As over 30% of the UK mortgage market was funded through the issuance of mortgage bonds pre-crunch, its disappearance had a major impact.

Allowing NR to become a net lender again: as we covered in our blog before Christmas, the Rock has been sorely missed both in terms of its attitude and approach and also its contribution to net lending. Running its mortgage book down by circa £20bn a year has had a major impact in terms of mortgage availability and the announcement that it now (subject to EU approval) intends to recommence lending in a more substantive way is very welcome (click here for more details).

Checkmate’s view

The above moves are very welcome given the extra liquidity that should be injected into the lending markets. Whilst there is focus quite naturally on the UK’s largest banks, a concern does exist that the proposal to date focuses purely on tier one deposit-taking institutions. Relying on a handful of major banks for mortgage lending should be a market concern, particularly as I would argue that with one or two exceptions, mortgage lending is not their forte. As many intermediaries will testify, service from several of the big 6 has regularly suffered from delays and processing issues even with current low volumes. The aim or hope must surely be that liquidity trickles down to the smaller lenders who are more responsive and capable of delivering the right products to consumers.

Whilst adoption of the Crosby report will undoubtedly have a benefit, the guarantee on AAA paper only will mean a continued focus on lower risk, lower LTV loans, an area where you can get loans currently. It is higher LTVs and help to FTBs where we feel there needs to be greater focus and none of the above appears to address this important area. An insurance scheme, backed by the government whereby lenders were offered (at a price) insurance on lending above 75% LTV is the area where help was really needed. As we have pointed out in earlier blogs, house prices are largely a function of liquidity. The more difficult it remains for anyone, other than those with a substantial deposit, to buy, the longer house prices will decline and the more painful this recession is going to be. Getting lending moving again is partly about creating liquidity but also about removing some of the perceived risk. Addressing the risk of new lending has to be a priority and concentrating Government support on the deposit-taking banks only will not help the market as much as a more widely drawn set of initiatives.

 
The latest Nationwide house index was published today which showing a moderation in the rate of decline with prices falling 0.40% in November as against 1.3% in October. The annual rate of decline is now down to 13.9%. Whilst this is obviously positive news for homeowners, we do not believe that this marks the end of house price declines. With deteriorating economic conditions and funding for homeowners still constrained, we believe that prices will continue to fall until around Q3 next year when we believe they will begin to stabilise.

Predicting when the market will begin to stabilise and then when it will recover is obviously partly a matter of conjecture. However we believe that there are 3 key indicators pointing to Q3 2009 as the likely timing:-

• The rate of decline over the last few months means that by Q3 2009 prices will be down around 25–30% from their peak. Whilst we do not believe that affordability issues were the trigger for house price declines, we do see them as an important part of the recovery process. With prices off circa 30% and with interest rates significantly lower, affordability will be back to levels not seen since the late 1990s. Most people fundamentally know that in the long term housing is one of the best and most secure investments, irrespective of its actual function as a roof over your head. With prices down significantly and affordability at very good levels, we expect buyers to start to return to the market. Obviously affordability is linked to available funding, a major issue to date, which links into our second point

• The government is throwing the proverbial kitchen sink at the banks and the economy in general, with Mervyn King refusing to rule out nationalising the banks if they refuse to play ball. The pressure on the banks; the Crosby report recommending government intervention in the RMBS markets and the fact that the government already owns a lender (Northern Rock), will mean that whilst not returning to ‘normal’ (when we look back at history the 2006/7 lending will be seen as anything but) liquidity will be significantly improved by the summer of 2009. As a related point, if the government really needed to, it could change the mandate of the Rock and postpone or reduce the repayment of its debt allowing it to restart a serious lending program again (but not with 125% LTV products!). In effect the Rock would be lending government money directly to consumers.

• The final point are the basic macro factors underpinning UK housing. In simple terms we aren’t building enough housing in the right places and haven’t been for 20+ years. House building is virtually coming to a standstill at present and the government’s target of 200,000 new homes a year rising to 250,000 by 2016 looks very unachievable. Couple this decreasing household size and increasing population and you have a very strong supply demand imbalance that act as a medium term brake on house prices and a long term accelerator.

 
There are obviously a number of unknowns at present, particularly around the length and depth of the recession and levels of unemployment, but we continue to see the current correction as very short and sharp. For a number of reasons, which I will cover in a separate blog, this is NOT the early 1990’s

Details of the latest Nationwide report can be found by clicking here

Yesterday as part of his pre-budget speech, the Chancellor announced the findings of the long awaited Crosby report. As part of the next steps a detailed scheme needs to worked up and then approval obtained from the European Commission before it can be implemented, hopefully in the spring of 2009

Summary of the findings;

• “Without intervention, the market in mortgage-backed securities won’t return any time soon…”
• Banks cannot rely on strong savings inflows as a source of funding
• As a result competition between lenders is reducing and even ‘well capitalised banks’ are unlikely to return to normal lending volumes, resulting in a significant reduction in lending between 2008 – 2010

Crosby states that there is in his view a clear case for government intervention with -

“A large injection of funding into the banking system, delivered in a way that feeds directly through into mortgage lending and real activity in the housing market, would ameliorate the economic consequences of the shortage of mortgage finance and deliver tangible benefits to consumers.”

Overall three broad measures are suggested:-

• Greater standardisation and improved transparency of the asset-backed structures used in wholesale funding markets;
• Revisions of the recently adopted ‘mark to market’ international accounting conventions; or
• New initiatives from the Bank of England specifically designed to stimulate new net mortgage lending.

Whilst the first two initiatives are likely to bring longer term benefits and greater transparency they are unlikely to have an effect in the short to medium term. Accordingly Crosby states that
“Alternatives to direct government intervention won’t happen or won’t take effect sufficiently quickly…”

With regard to the last point Crosby states that -

“If the Government were to favour secondary intervention in the mortgage market, injecting some sort of Government guarantee into mortgage funding markets looks like the best option…”

“In order to ensure that the benefit of such cheap funding fed directly through to the housing market itself, banks would only be able to attach guarantees to new lending they had made in connection with housing transactions which involved a genuine change of ownership i.e. house moves, buy to let purchases and first time purchases but not remortgages (our emphasis). Certain types of mortgages (a small minority) would also be excluded; for example near ‘100 per cent LTV’ mortgages and loans to borrowers with seriously impaired credit records”

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• The guarantee is likely to apply to AAA RMBS securities only. These will in effect be ‘triple wrapped’ with the three levels of security, the deal, the issuer and then finally the government with the guarantee around the interest and the principal balance for the life of the notes
• It is suggested that £100Bn of guarantees are made available over 2009 and 2010 with these being auctioned by the government so that banks most in need of the guarantees to be able to issue can access them
• Gradually as the RMBS market recovers it is felt that banks would no longer need or be willing to pay for guarantees and the scheme would end
Our opinion

Checkmate believes that the introduction of this scheme at its earliest opportunity will provide a significant boost to the UK housing market at a time when it is most needed. As we have pointed out in earlier blogs, the start of the house price fall was a direct result of the withdrawal of mortgage funding from significant sections of the UK market. Without intervention there is every possibility that as much as a housing market over corrects on the way up, it may also over-correct on the way down.

The disappointing element is the exclusion of remortgages from the guarantee given the large numbers of UK borrowers who are likely to be stuck on lenders uncompetitive SVRs. Remortgaging has in recent years consistently made up circa 40% of the UK mortgage market and the exclusion of funding to this section of the market means that the benefits of broader and cheaper mortgage funding will not be passed on. The inability of existing home owners to access cheaper funding, whilst not having the same direct impact as purchases, will in its turn ultimately affect prices and the level of available cash in the economy.

The report is very readable. For full detail of the report please click here

Good news in the finance sector at the moment and particularly the mortgage market is rare, so it was good to see a recent speech by Hector Sants, Chief Executive, FSA entitled “Regulation & Entrepreneurs – What is the role of regulation in facilitating the development of innovation & entrepreneurs ?”.

Mr Sants talks of the FSA being required to “have regard to the desirability of facilitating innovation” by which he means that the regulator will not place unnecessary obstacles in the way and will support new initiatives, especially those that promote healthy competition in the UK and provide consumers with greater choice.

He also comments on a regulatory environment that encourages creativity, innovation and competition which must allow firms to be free to take risks and make mistakes. As regulators the FSA are not looking to eliminate risk, stating “it is simply not possible” but they do want firms to understand the risks they are taking and manage these appropriately.

One of the most positive points mentioned, which we found especially encouraging, was where he explained how the FSA “and its guiding beliefs and objectives contribute to making the UK an environment in which entrepreneurship is rewarded, and in which entrepreneurs in the financial services sector, in particular, can succeed”

Given our planned launch into the market in 2009 with innovation as a key component of our proposition, it was very refreshing to read. Full details of the speech can be found by clicking here

Tony Rogers

Compliance Manager

The recent HBOS index showed that average house prices have fallen by 13.7% over the 12 months to October. On a seasonally adjusted rolling three month basis they are currently dropping at an annualised rate of over 20%. Most commentators believe that there is still a way to go, with a general view that a peak to trough fall of circa 30% is likely before we see some stabilisation.

The current fall in house prices is unusual is in that the catalyst and trigger has been the liquidity crisis and the inability to fund mortgages leaving 2008 gross lending at least 25% down on 2007. Whilst availability of credit is important to the recovery of the market, we are of the view that the current rate of decline will mean that by Q3 next year we will be at or very close to the bottom of the housing market. In other words we believe that we are experiencing a very short, very sharp correction compared to the gradual drift of house prices over some years that we saw in 1991.

A number of analysts have talked about affordability as a key determinant. Our view is that whilst this is undoubtedly a factor, supply issues have changed the long term relationship between how much of their income people are prepared to commit to housing. Simply looking back through time and comparing for example levels of household expenditure on mortgages in the 1970s and those in the 2000s misses the point.

If you subscribe to the affordability argument, a more recent period of analysis makes more sense. Taking 1997 as a start point (this was the point at which house prices started to grow again after the last adjustment), we’ve examined the relationship through time with affordability and house prices both set at ‘zero’. Affordability consists of changes to average earnings and changes to interest rates, house prices is the HBOS seasonally adjusted Quarterly index.

As you will note from the graph there would appear to be a strong correlation between affordability and prices until the beginning of Q1 2004, at which point interest rates rose and house prices further accelerated. Whilst 1997 may not be the point of long term equilibrium in terms of prices and affordability (given that prices had been flat for 5+ years) and hence the point to start the graph, the current rate of decline juxtaposed against falls in interest rates projected forward, has us back and beyond the equilibrium point by Q3 2009.  

Whilst the above is simplistic analysis it does make a valuable point that come the latter half of 2009, prices and affordability will be at very low recent historic levels. We anticipate at this point opportunistic buyers will begin to return. There may be a few months of ‘bumping along the bottom’ but the widespread falls should be over.

Our view on prices is largely supported by a recent article from Savills research published in The Times last week which looks forward and beyond 2010. Definitely worth a read. Click here to view.

Finally in this blog, I have deliberately steered away from the macro factors that obviously influence the debate, the most notable of which is the long term shortage of housing. I will cover this in a later blog.

As most of you will be aware, the historic relationship between Bank Base Rate (BBR or repo rate) has broken down over the last twelve months as inter-bank lending has all but stopped. Rather than 3 month London Inter-Bank Offered Rate (LIBOR) exceeding BBR by a long term average of circa 13bps, it had moved to as wide as 178bps in recent weeks.

Whilst the relationship between BBR and LIBOR remains far from the historical average there have been some signs in recent weeks of the gap tightening - particularly after the recent dramatic cuts to BBR.

The LIBOR/BBR spread remains an important indicator of the health of the banks and the level of trust within the banking system. A wide difference between BBR and LIBOR indicates not only a shortage of available funding but an unwillingness of banks to lend to each other. The Feds decision to allow Lehman to fall sent shockwaves through the markets, bringing inter-bank lending to a virtual standstill and LIBOR rates spiralling again (see graph below). The gradual recovery since this time stems largely from widespread government intervention in the system, by pumping of billions into both the banks directly themselves and indirectly into the money markets.

Whilst the level of inter-bank lending remains low, with lenders very reliant on retail depositors, the signs at this stage are at least positive that we are on the road to recovery. Exactly how quickly and indeed if we ever return to the previous long term equilibrium remains open to debate. When we get here though, advisors and customers will need to better understand how LIBOR works as this will be the basis for many tracker products.

To keep an eye on LIBOR click on the ‘Money Markets’ link on this page.  

Stephen Knight, Executive Chairman, Checkmate Mortgages Limited

Recently Alan Greenspan, former chairman of the US Federal Reserve, and generally considered to be one of the leading economists of his generation, said the the current, worldwide liquidity freeze was a ‘once in a century experience’ which had taken him ‘by surprise’. On that basis, what chance do we mere mortals have in understanding how it happened, and when it’s going to end?

I’m going to have a go in this blog. But the extent to which my view is better than yours, or anybody else’s, is a matter for conjecture.

As many predicted, house prices are falling, and arrears and repossessions are rising. But I now know what a maths examiner feels like when candidates have got to the right answers through the wrong workings.

Take house prices. Economists and commentators predicted house price falls based on an out-dated and inaccurate formula called the house price/earnings ratio. This relates average house prices to average earnings. The problem with it is that the majority of mortgages are funded by two incomes, not one, moreover, the average income figure includes those who are not, and never will be, homeowners. The CML affordability measure, which relates the first monthly payment to the initial income, while not perfect, showed that matters had not in fact reached a tipping point for most.

The truth is that house prices are falling due to the liquidity freeze, under which people cannot borrow at the LTVs they need or, in some cases, at all.

Let’s look at arrears and repossessions. I chaired a conference recently at which politicians and consumer group representatives continually repeated the mantra that lenders and borrowers had acted irresponsibly, until I pointed out that, according to the CML, less than 2% of loans were 90 days or more down. That does not support the accusation of irresponsibility. The reason that arrears and repossessions are now starting to rise is because the liquidity freeze is creating higher interest rates (based off LIBOR) and higher unemployment through recession.

Although the UK was indebted to record levels, it would have been manageable absent the liquidity freeze.  So, what caused the freeze, and when will it end?

Sub prime lending got massively out of control in the US. Imagine blowing up a balloon and not stopping. Eventually it will burst and scatter its pieces everywhere. Some players felt that the ‘gravy train’ could never end and bonds supported by sub prime collateral were sliced and diced so many times to create new investment vehicles that, in the end, there were more AAA issues in the market than there was AAA collateral to back them.

The US balloon burst. Arrears went through the roof. It was clear that large numbers of borrowers should never have been offered such mortgages and were going to default. Some of the collateral had no value. And, due to the US-invented mark-to-market accounting policy, where the value of investments held in the books must reflect what you can sell them for, as opposed to what they might be worth over the longer term, the fallout started to produce big book losses for financial institutions. So much so that banks stopped lending to each other for fear of undeclared exposure to sub prime collateral.

Two other factors made the initial US problem into a worldwide crisis. The first was a general impression in the US that their institutions had ”fessed up’ to their exposure to sub prime whereas European institutions had not. I don’t know how much truth there is/was in this. Having been in Director positions with two US financial institutions I know there is a tendency, even among very bright US executives, to assume that all markets work like the US, whereas the UK, for example, was much more regulated in our product design and underwriting processes, with sub prime lending not even reaching a quarter of US exposure. That has got to be sorted out.

Then Lehman Brothers collapsed. When historians look back at this period, the decision to let Lehman swing will be seen to have been disastrous. On top of the issue of sub prime exposure, there were then concerns about exposure to Lehman, either directly or through credit default swaps. All banks borrow short and lend longer, so a determined run on any institution will bring it down. Due to Lehmans, the world suffered a banking crisis that has now seen unprecedented nationalisations and takeovers.

The UK Government has to be applauded for the lead it has given the world in this area. The trouble is that a nationalised bank, or one benefiting from significant and expensive government capital, has conflicting interests. The Government wants increased new lending, but the banks concerned feel that repaying the Government’s loans and capital is a higher priority. The Government would like base rate reductions passed onto consumers, whereas the fully or partly nationalised banks want to keep margins high to rebuild capital and encourage borrowers to move away. That will take quite a while to sort.

So, when will it end? I’m tempted to say ‘ask Mr Greenspan!’. But instead I’ll have a go.

The world is in recession caused by the liquidity freeze. Can this go on for years? I don’t think so. A specific event has caused it. Governments around the world are being very front-footed in their actions to support banks and reduce rates. I think that, by Q2/Q3 ‘09, we could be at, or at least be seeing, the bottom. Once you can see the bottom, that is the time to act, and take advantage of the under-supply in the UK mortgage market.

I’ve always found that, if you try to sell exactly at the top, or buy precisely at the bottom, of markets then you will lose out unless you are very lucky. Instead you need to read shapes. I sold Private Label in 1998, a few years before the decline of the prime market design and distribution model, because I felt that this was an emerging shape. I subsequently resigned as chairman of GMAC RFC in April 2007 because I could see a massive supply-side adjustment emerging (not a liquidity freeze!) and it wasn’t my style to dismantle something that I had largely created. I created Checkmate because I can see a major opportunity to launch, at the first sign of thawing, an intermediary-focused, innovation-led new mortgage lender.

We are therefore quietly building our business so that we are ready to launch when market conditions permit. Opportunity always accompanies adversity.