One thing I’ve noticed is that when people look back at house price changes, they tend to somehow ignore the contextual setting, in particular the impact of inflation. Whilst actual changes in house prices are important for individuals as it determines how much equity they have in their property, what also needs to considered is the ‘real’ change when inflation is taken into account.

 

If you look at the seasonally adjusted HBOS index, the index peaked in May 1989 at 227.4 and fell to its lowest point in this cycle in June 1995 at 197.3, overall a peak to trough decline of just under 14%. However the decline in real terms when inflation is included was actually much more severe. The early 1990s was a period where the government struggled to get Inflation under control. At the start of the 1989 decline, inflation (RPI) was at 8.3% and peaked at 10.9% in October 1990. When you analyse house price inflation and include the real effect of inflation, the decline was much more severe than the headline figures suggest. With inflation included the end of the house price decline was October 1995 when house prices in real terms were just 55.97% of the May 1989 values, a 44% drop!

 

As you will see from the graph below it took until early 2002 for ‘real’ values to recover back to 1989 levels (this of course this doesn’t mean or infer house prices became overvalued at this point as some very analysts have suggested).

 

Whilst the current house price decline is indeed severe, we are looking at inflation falling sharply with a widespread view of RPI falling below 1.0% within the next 12 months. Taking this into context, the decline in prices we are seeing is still as yet far from the issues we experienced in the first half of the 90s.

 

As always, the lesson here is don’t take history out of its context…

 

 
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”

______________________________________

• 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

 

 

One thing we’ve noticed is that when the subject of house prices are raised, there are frequent references to the ‘fundamental factors’ that underpin the UK housing market. Whilst it is accepted knowledge that we haven’t been building enough homes for a number of years, you rarely seem to actually see any facts and figures backing this up.

 

To address this, we’ve done a short piece of research to illustrate why over any reasonable period of time, housing remain a very strong investment opportunity.

 

 

Population increase

 

•         The UK population continues to grow (Office of National Statistics (ONS))

 

–         1971 – 55.9M

–         2007 – 61.0M

–         2021 – 67.1M

 

 

Household size continues to decrease (ONS)

 

–         1971 – 2.9 per household

–         2001 – 2.4 per household

–         2026 – 2.1 per household

 

 

Housing starts

 

-       1970 -  362,000 (ONS)

–         2007 -  160,000 (House Builders Federation and ONS)

–         2010 -  130,000 (Savills estimate)

 

 

The above numbers contrast with the governments stated aim to build 200,000 new homes per year rising to 240,000 by 2016 (2007 Comprehensive spending review). Indeed if you look at the latest available reports, housing starts in the year on year quarter to June 2008 were 19% down, with private house building starts down 27%. (click here for more details). The starts figure can also be a little mis-leading as we have seen many builders in recent months moth-balling sites part way through completion. Given what has happened to house prices since we expect this figure to continue to deteriorate   

 

With social housing starts now increasingly dependent on private developers including an element of social housing in a new development, the dramatic fall in private housing starts look likely to spill over to the social sector. Without widespread government intervention in the social sector (which looks increasingly likely) house building in the UK is likely to come to a virtual halt given that many of the housing associations into with most the ex -local authority housing now resides are highly indebted.

 

 

The outcome of the housing/population imbalance

 

Basic economics will tell you a demand/supply imbalance will lead to price rises. Whilst it is perhaps difficult to look beyond the current falling house prices, viewed over a period of a few years housing will again recover and rise substantially. Faced with a sustained shortage, the level of income people are prepared to commit to housing will also again rise.

 

 

Savills research have produced some very interesting work looking not only at likely declines but also likely recovery times back to 2007 values and beyond to 2020 – click here to view   

 

 

Whilst we still have a little way to go before we reach stability, the medium and long term outlook remains very positive

 

 

 

 

 

 

 

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.

 

 

 

In the plethora of programmes about the credit crunch it was very refreshing to watch a programme on Channel 4 entitled ‘the ascent of money’. Rather than simply re-examining the issues and reasons behind the current financial turmoil, it looked at the history of money through the ages, the development of banks and the importance of debt and finance to the growth and functioning of world trade. Some interesting parallels were drawn between the basics of banking in the middle ages and some recent banking practices. This was the first in a series but well worth an hour of your time  

To view the programme click here

 

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.

Prior to its launch in 2009, Checkmate Mortgages, founded by Stephen Knight, today announced the appointment of two non executive directors:

Jeremy Sillem is Managing Partner and co-Founder of Spencer House Partners LLP, a private equity firm.  Prior to establishing Spencer House, Jeremy spent 28 years with Lazard LLC in a variety of senior positions followed by a spell as Chairman of Bear Stearns International.

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