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.

A lack of available funding is causing a severe and sharp downturn, not just in the housing market, but now in the economy in general. Whilst the lack of funding is being cited as the root of the problems, I think we all need to realise that to get the markets lending again is actually a far more complicated process than simply increasing available funds. Simply increased funding without addressing other areas is not on its own going to resolve matters. Whilst I will restrict my comments here to those relating to the housing market, many of the thoughts below are applicable to lending in general. To get lending moving again we need to address all of the following areas:-

 
The impact of restricted liquidity – balancing demand and supply

High (relative) mortgage rates - As can be seen, falling BBR, falling LIBOR and falling swap rates are largely failing to be passed on to consumers to anything like their full extent. As rates have fallen, tracker margins have widened and as I write, the best two year fix (with a large deposit) is around 4.0% (with most rates 0.50%+ higher) when 2 year swap rates are around 2.29%. With limited funding lenders have had to try to manage demand from both borrowers but also from savers. With wholesale markets effectively shut a number of major lenders are effectively funded from deposits only.  Competition for savings is fierce and with falling rates savers are now moaning about their returns (I must say I find this view rather strange – savings returns should be seen against inflation not in absolute terms – getting 3% on savings when inflation is arguably now negative is a better return than a year ago!).  In short, the benefit from lower interest rates is largely failing to get passed on. If mortgage rates remain relatively high, disposal income doesn’t improve and this in turn impacts spending in the general economy.

Falling asset values and increased risk

With funding in short supply, it is understandable that available funds go towards lower LTV/risk assets. However with house prices falling, even with sufficient funds, lenders are going to be reluctant to lend above 75% (60% is now the new 75%) when due to continuing property price falls, the LTV in a year’s time could be significantly higher. Simply pumping money into the markets doesn’t resolve this issue and government initiatives to date have focused on creating liquidity for lower risk/lower LTV assets for a handful of the largest instituations. Without available funding above 75%, falling asset values has the potential to become the ‘perfect storm’ as values continue to fall as FTBs and others without a 25%+ deposit can’t enter the market.

Lenders tightening criteria or put more aptly, often closing the stable door after the horse has bolted…

As brokers will testify, rates and availability are far from the only issues. The end of the credit boom has seen a drastic pulling back on criteria. Whilst some of this may be sensible, many of the loans written in the last few years (and performing well), can now no longer be re-financed. Far from preventing new ‘bad’ loans being written, the new reality is that many loans written in the boom years are now effectively stuck on more expensive SVRs. Far from now preventing poorer quality business being written, (simply because most of it already has), the new criteria actually risks the opposite in turning performing loans into non-performing. The following broad areas have come under ‘criteria attack’

Restrictive loan sizes – Not only are some of the ‘best’ deals below 60% LTV, many are also capped at £250K or £500K. This ensures that available funds are spread amongst more customers but penalises the higher end of the housing market
More restrictive criteria - One way of managing demand is through price, the other is criteria. This is a lot less transparent than rate, but it is fairly obvious to most in the industry that lenders have tightened credit rules/scores and tightening general lending rules.
Lower income multiples – As most lenders now operate Debt to Income Calculations (DTI), these are again a very opaque way of reducing demand and also an attempt to belatedly manage risk. We have heard of numerous examples of clients attempting to remortgage only to be told that they now “can’t afford it”, despite the fact that they are borrowing the same amount as previous, earning more than they did 2+ years ago  and switching to a lower rate!

Property valuations - From bull to bear…

The final issue is one for surveyors. Whilst many could arguably be accused of over-valuing in the good times (hindsight is wonderful thing), the opposite would now seem to apply in many instances. A lack of sales comparables may not be helping, but with potential concerns over PI insurance and undoubted pressure from lenders, we are hearing of many instances where (anecdotally) properties are being down-valued over and beyond where the current market would indicate. This is obvious a very nefarious area but increasing comments from brokers and some estate agents are that the rather than just simply pricing to where the property stands at present, future falls in value are also being priced in when lenders should and indeed are taking further falls into account in their maximum LTVs.  Whilst from a lender’s perspective caution appears to makes sense, the fewer customers able to buy or re-finance the greater the ultimate fall in prices.  

Breaking the cycle – Getting lending again

Whilst the above issues are complex, one thing is clear. To get the market moving, intervention is clearly needed and not just on the funding side. Without this we risk prices falling further and faster than is justified and risk a subsequent bounce back once the market returns (an end or some controlling of ‘boom/bust’ house prices must surely be a priority once we have tackled the current problems).

If lenders can’t be persuaded or calljolled into the higher LTV end of the market and to relax some elements of criteria, some form of insurance needs to be offered to them to cover their perceived risks. We have mentioned before the role of Mortgage Indemnity Gaurantees or MIGs previuolsy and their role in the early 1990’s down-turn. In the midst of a recession, persuading private insurance firms to step in at anything like a reasonable premium looks unlikely. However a simple solution (relative to the myriad of proposals thus far) is for the government to offer lenders insurance on loans above a certain LTV for a fee. This would not only encourage lenders to lend but would also reduce the level of provisioning they would need to hold against future losses thus freeing up more money for lending

This would, from the perspective of all parties, be a commercial venture. If defaults are much lower than expected, (which may well be the outcome if MIG helps stabilise the lending and housing markets) the government makes a profit. Either way lenders can lend with the certainty that losses or a percentage of losses above a certain LTV are covered. Governments underwriting lending to consumers should always be a last resort but it should be remembered that the government is already in this space via the Homebuyers scheme . Without this step however we very much fear a longer and more painful downturn than is necessary.

Many of you will have seen the comments on the prospects for the UK this week by Jim Rogers Chairman of Singapore based Rogers holdings. Mr Rogers gave an extremely pessimistic view of the UK with comments  such as “I would urge you to sell any sterling you might have,”. As ‘The Times’ reported “The reaction was instant - though it is impossible to say how much was attributable to Mr Rogers. The pound slumped, by almost 4 per cent at one point, falling to a seven-year low against the dollar and an all-time low against the Japanese yen.”

While Mr Roger’s comments have the potential to become a self-fulfilling prophecy, he did give some rationale to back up his comments. One in particular did stick out as appearing very wide of the mark when you look at all the available data, namely the prospects for the UK housing market. He says the UK housing market is arguably in a worse state than that of the US, given pockets of strength in the US.

Mmmmmm….let’s look at the data that might support that:-

 
US housing market

The main index in the US is the Case Schiller index which produces both national and regional data. The 20 city composite index has been falling since July 2006 and shows no sign yet of slowing. Average values are off over 23% since the peak (up to end of October 2008). Compare this over the same period to the HBOS index which peaked in July 2007 where values are off just under 16% thus far. If you start the comparison of both indexes from the point the US index starting falling, you get the following picture (both indices set at 100 at the start)

You may argue that the above comparison is perhaps biased as the UK graph is falling from a higher point. Accordingly if you compare both indices from the point they both started falling (both set at 100) you get the following picture:-

Whilst both indices are now falling at comparable rates, the UK still has some considerable way to go to catch up with the US particularly as the last set of US results (published 30.12.08) marked the steepest decline in the history of the Case Schiller index.

Additionally as Roger’s alluded to, there are strong regional differences in the US which means that depending on your location you are likely to be significantly above or below the average of the 20 city index. For example, Phoenix tops the chart at over 40% down so far (and still falling) closely followed by the likes of Los Angles, San Diego, and Miami at circa 35% down whereas Dallas and Charlotte are essentially flat.

The cause of house price declines – different catalysts = different results

Our view is that the decline of UK house prices is very much a result of the liquidity freeze. Decades of under-supply, simply resulted in high prices (natural supply/demand economics), supported by readily available credit. It is the withdrawal of credit, particularly to the higher LTV and niche sectors that started the decline and threatens to prolong and exacerbate the decline (more on this in a separate blog later).

In the US the catalyst was several years of very strong house price growth driven by speculation and the oversupply of housing, particular in the boom markets on California and Florida. The growth of the sub-prime market (which at its peak accounted for circa 25% of the overall market) brought new borrowers into the housing sector and with it a construction boom. Prices in the US market peaked and then began to fall simply as affordability conditions deteriorated, speculators pulled out, and confidence plunged. In short people lost confidence that prices were sustainable. It was is the fall-out of the US housing bubble which started the crisis and the UK in this context can be seen as somewhat of a victim rather than an instigator.

Supply and demand

In an earlier blog  we outlined the longer term issues the UK market faces, which will create an increasing housing shortage as time progresses. Unlike the US where land is generally not an issue, the UK, even if planning is relaxed will still face supply constraints. With a high owner occupation level and an ownership mentality, the saying (allegedly from mark Twain) “buy land they ain’t making it anymore” seems very apt. To add one of my own ”the UK isn’t the US so stop the lazy comparisons”

Press release, 21th January 2009

Checkmate Mortgages, the new lender preparing for its UK launch, today revealed that it had confidentially been providing for some time a remortgage analysis and execution service on behalf of private equity companies and hedge funds who are contemplating the discounted purchase of residential mortgage assets.  Having completed its fifth assignment the company is publicising this activity as part of a wider roll out.

The only part of the mortgage market which is currently subject to frenzied activity is portfolio selling.  This matches the willingness of exiting lenders who wish to sell with the opportunistic qualities of private equity companies and hedge funds who wish to buy the pool at a discount to par.  A key factor in determining the correct price to pay is how quickly, and at what cost, the loans could be subsequently remortgaged, thereby delivering the purchaser with a speedy and substantial profit.

This is where Checkmate comes in.  The company already employs analysts, risk professionals and a sales team, all of whom combine to look at each loan to be purchased.  Probable remortgage incentives to be offered to borrowers are sense-checked with brokers and packagers, and then refined into a client report indicating the remortgage potential of that pool, typically backed up by 50 pages of further analysis.

If the bidder is successful, Checkmate’s remortgage execution service can then click in, offering liaison and sales management services to ensure that the theory of the analysis is delivered in the execution.  Other benefits on offer include the use of Checkmate’s unique scorecard and AVM, and more general market analytics.

“Whilst our clients to date have been from the private equity and hedge fund sectors,” said Stephen Knight, Executive Chairman, “we see equal application for existing lenders who perhaps want to quietly deleverage their balance sheets, or who wish to go down the remortgage route rather than discounted portfolio sale”.

With Basle II requiring greater capital for certain categories of loan, remortgaging those assets could be sensible for existing lenders as well as freeing up some welcome cash during the liquidity freeze. Moreover, those lenders having difficulty valuing their pools on a mark-to-market basis can obtain an accurate net value by Checkmate analysing the cost of remortgaging and deducting this from par.

Having proven that its combination of analysts, risk and sales professionals - relatively unusual in this market - can add real value to participants, Checkmate is looking to carefully expand its client base.

“We will not take on more than we can deliver against,” concluded Stephen Knight,” and our focus remains on the bigger and more sustainable project of launching an exciting new intermediary-focussed mortgage lender. But if the systems and people we have employed for that purpose can in the meantime help players in the business of portfolio selling and valuation, then everybody wins”.

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.

Article reproduced from this month’s Credit Today with permission.

It may not be the easiest time to set up a mortgage lending company, but Stephen Knight isn’t the sort of person to let that stop him.
Previously chairman of GMAC-RFC  and founder of Private Label, which grew to be the largest privately owned mortgage distributor in the UK under his stewardship, Knight is now setting up new lender Checkmate, and in 2009 he’s looking for funding.  “From the ashes of the credit crunch will come opportunity,” he predicts, sitting in his serviced office a stone’s throw from St James’ Park.
It’s going to be a slow game getting a new lender off the ground, but that’s not something that concerns Knight, who has built a team of around 31 people, 20 of whom came from GMAC.  “So far it has taken a year and we’ve put our management in place and raised our equity.”  As well as Knight himself, RIT Capital Partners and Lord Rothschild’s family interests have invested a total of around £15m to get Checkmate up and running.
However Knight underwent at least 55 knock backs from equity sources to get to this point.  Now he has to persuade someone to fund the mortgages themselves.  The aim is to launch sometime in 2009 and lend £500m in the first year, rising to £6bn by 2013.  “We expect to get turned down by funders for six months and then someone will say yes and off we’ll go,” says Knight.

Intermediary Loyalty
“I think there will be a tremendous advantage as the balance sheet lenders have taken over now - they’re the only ones able to lend but they’re not really geared up to deal with intermediaries.” Knight adds that Checkmate hopes to win “disproportionate support” from intermediaries by offering reasonably priced products and a “slick” service.
Ray Boulger, senior technical manager at mortgage broker Charcol, says the intermediary community will welcome the new lender though an important factor will be the price of funding as it will dictate the deals it can offer: “What the market is really crying out for is decent pricing for mortgages of 75 to 80 per cent LTV so I envisage Checkmate doing lower risk lending at the launch.”
He adds that the intermdiary community has a lot of confidence in Knight’s abilities.  “Stephen built up a very good reputation when he was at GMAC.  Net lending next year is likely to be close to zero so any additional funding has the potential to make an impact.”
Stroud and Swindon Building Society is also throwing mortgage brokers a lifeline with its new broker subsidiary In The Loop Mortgages, which will initially lend through a small number of brokers.

Knight is so convinced that he can make Checkmate work that he is inviting funders to hold back part of Checkmate’s earnings for a year - if a loan goes into arrears during that period, they won’t have to give the money back.  “One of our prime objectives is a better quality of mortgage asset.”  Other carrots for investors include the opportunity for the first four through the gate to take an equity stake.
Knight’s philosophy is that income multiples are not the best determinant of a customer’s ability and willingness to pay their mortgage back.  While at GMAC he instigated a predictive credit score to predict arrears, which was initially run in parallel to normal processes, then implemented as a replacement.  “There may be individual exceptions, but at the portfolio level the arrears performance will be better,” he says.  He also pioneered decision automation and instant credit decisioning.

Changing parameters
Despite his confidence about Checkmate, Knight says the credit crunch has changed the mortgage picture.  The company won’t be offering sub-prime or self-certified products and will telephone interview every client after an offer is issued.  Checkmate is also already investing in new technologies to try and minimise fraud risk.
In addition, the lender will apply a harsh debt to income ratio, taking the reversionary rate and adding one per cent when it calculates ability to pay.  Meanwhile, city advisers say they are talking to others interested in setting up mortgage lenders to replace those that have fallen victim to the crunch.  The test will be getting funding, but those that can will be well placed to take advantage of the inevitable need for mortgages - specialist and otherwise.

Lawrence Guthrie, managing director of corporate adviser Hawkpoint, says a few people are beginning to think there may be an opportunity to launch in the mortgage sector.  “So many people had to close their doors and the banks are dealing with their own major problems - plus they’ll be nervous,” he says.
While Knight says he doesn’t intend to become a specialist lender in the sub-prime or self-certification areas, Guthrie says others will look at ways to get into the sector.  In the long term, the supply and demand imbalance should even out, the question is just how long will it take.