As readers of our blog will be aware, we have been iterating for some time that we believe the housing market is now at, or very close to, the bottom. This has a number of positive implications, not least of which is that lender’s appetite to lend should start to increase, given the knowledge that their exposure going forward will be much reduced. 

 

The lack of mortgage products above 75% LTV has always been due to two factors: firstly a general shortage of funding and secondly, a reluctance to lend above 75% LTV given that property prices were falling with no clear view of where the bottom was. As the consensus grows that stability is returning to the housing market (see nationwide report issued today) we expect to see lenders gradually increasing the range and availability of products. Indeed some high level research we carried out recently has seen the number of lenders offering 90% LTV products increase from just 5 at the beginning of May to 9 last week. Not conclusive proof by many means but at least a step in the right direction.

Whilst the above may all be good news, the mortgage market faces an additional problem, that of trying to process the loans. In a previous blog entitled “so much dependent on so few” we highlighted what we saw as the looming processing issue. Essentially if you look who was actually doing the lending in 2007 and then look at who remains, there is a serious processing capacity issue. Approximately 90% of current business is being processed by just eight lenders.

 Below is the CML table of the largest lenders in 2007. Highlighted in yellow are those lenders where new originations have either effectively ceased or at a level far below their peak. Crossed through in grey are those lenders who simply no longer exist. Adding together the closed and non/under-lending, you lose over 42% of market capacity. This of course ignores the fact that all the Building Societies, inc Nationwide, are lending at significantly reduced levels from the peak. Exact figures are hard to come by but I would be surprised if the building Societies combined are currently lending more than 25% of their 2007 levels.

 

 

The issue of increasing dependence on a handful of large banks was highlighted last week in the Bank of England financial stability report (issue No 25). At 70 pages it is a long read that I would best describe overall as ‘cautiously optimistic’. There were contained within a number of interesting graphs that put numbers around issues we were all aware of but to date had nothing concrete that evidenced our views. The first graph that is worthy of note is the contribution of the major UK banks to the growth in overall lending (not exclusively mortgages) compared to foreign lenders.

 

 

Whilst UK banks are expected to now make up the shortfall in both mortgage and other lending, the infrastructure clearly cannot be expected to cope with such an increase in demand in such a short space of time. We are hearing and indeed many of the major lenders themselves are reporting major delays  and issues on the servicing of loans. Nearly all the major lenders have servicing issues from time and time, but for the major lenders to be struggling to cope with demand now, when gross mortgage lending at circa £145Bn is 40% of the market peak, is clearly worrying. If there isn’t the processing capacity, as well as service suffering, there is clearly less incentive for lenders to compete with lower margins. Margins themselves, again illustrated in the Bank of England report have reached historically high levels.

 

 As a result of this development, we are talking to the largest lenders about whether our new £10M computer system, which combines sophisticated credit checks with a 20 minute internet based mortgage offer could help. Still early days but watch this space.  

 

 

 

 

 

 

Supply and demand

 

In the discussion of house prices, most commentators and analysts tend to focus on the relationship between prices and individual or household incomes. These measures of affordability, some very crude and simplistic, others more sophisticated, tend in many instances to lead to the view that prices were bound to correct as the house price/income relationship was no longer sustainable and that a house price correction was therefore ‘inevitable’. Aside from the flawed assumption that the house price/income relationship is something that is a constant through time (i.e. that people will always commit the same portion of their income to housing through time), the big unanswered question is why house prices have (until the recent period) been rising so fast in the first place?

 

Large parts of the media would seem to be firmly of the view that much of the price rises up until 2007 were largely the result of irrational exuberance and speculation that drove prices to unreasonable levels. It would not be going too far to say that price rises were somehow seen as a  part of national housing hysteria. Whilst in any rapidly rising market there is an element of speculation, the biggest reason why prices rose and will rise again in the future, is the most basic and fundamental:- SUPPLY

 

 

The impact of falling prices on housing development

 

It is an often stated fact that we are not building enough housing to cater for demand. This statement held true even in the peak of the market when 177,000 dwellings were commenced in England in 2006/7. The situation is now significantly worse, with housing starts in Q1 2009 in England at just 37% of the market peak

 

 

Whilst the fall-off in housing starts is clearly a reaction to falling property prices, it would be wrong to assume that building levels will simply pick up again once property prices stabilise and/or start to rise. New developments operate in a long cycle of land purchase, planning and development that can typically be  3 - 5 years. In addition, many of the land banks currently held by developers were purchased at the peak of the market, making development often marginal until prices pick back up again to circa 2007 values. The most optimistic scenarios I have seen (assuming no widespread government intervention) do not have house building levels coming back to the 2006/7 levels until 2016/17.  In short we are looking at a 10 year period where house building remains constrained.

 

 

 

The levels of house building are of course irrelevant without looking at the demand side. Two crucial factors at inter-play here; Rising population levels and decreasing household size. The UK is in a relatively unusual position in Europe in that the population is continuing to rise (unlike for example Southern Europe and Germany).

 

 

At the same time, as people live longer and more often in single person households, the average household size continues to diminish

 

 

 

 

The net result is a government estimate that from now until 2031, an average of 250,000 new households will form every year in England. If you juxtapose this against the anticipated level of house building, the net result is a massive under-supply of new homes.  In the graph below, the shortfall year on year is demonstrated by taking government estimates on household formation and comparing this with assumed dwelling formation (I have assumed housing starts recover to their peak by 2017 and then continue at this level.

-  refer to part two for rest of Blog

 

 

 

 

 

 

 

 

… Continued…

 

If both the above lines play out, 2031 will see an net shortfall of an additional 2.5M dwellings.

 

 

Impact of under-supply on prices

 

The recent report from the National Housing and Planning Advice Unit (NHAPU) in May 2009 highlighted the issue of supply on property prices, focusing on the lower quartile income earners, those most vulnerable in an under-supplied market. Taking three different projections for future house building, optimistic, pessimistic, median, they looked at the impact of each on house price to earnings ratio for lower quartile earners. Far from the 2007 peak being an aberration, prices relative to earnings in all three scenarios surpass the 2007 peak by 2020 (graphs from NHAPU report).  

 

 

 

International context

 

As we have covered in earlier blogs whilst the current price trends may be similar in the UK and USA, the fundamentals underpinning both markets are very different. In the US there is an estimated excess stock over requirements of over 1 million homes. This will work through the system but it will take time. In the UK the situation is almost the reverse.  Prices fell in the UK in response to a liquidity issue, certainly not over-supply. As this is addressed prices will inevitably start to climb again.

 

 

‘Safe as houses’ is an often over-used expression, but faced with the demand/supply in-balance and the recent price falls, investing in UK housing looks extremely attractive again

The truth is: the Mortgage market NEEDS securitisation

 

Over the past 18 months the word ‘securitisation’ has become synonymous with the credit crunch and has been demonised to such an extent that rational discussion of its future role in funding the mortgage market has become virtually impossible.

 

Whilst it is undeniably true that some of the deals issued, particularly the ones that relied heavily on ’financial black arts’ and (a)  had a great deal of complexity/lack of transparency and (b) were responsible for much of the financial fear and contagion that went around the financial sector, the truth is that securitisation, used in the right way and context, still has an essential role to play in the funding of mortgage products in the future.

 

 

Putting securitisation in perspective  

 

So much has already been said about securitisation and the global credit crunch that I won’t go into any detailed analysis here. A very short précis would be that what started off as a relatively simple funding and risk transference mechanism became in many instances far too complex, with many of the underlying assumptions (particularly from the rating agencies in the US), flawed. So complex in fact that in some deals became impossible to properly assess in terms of risk.

 

Cheap credit and the ‘carry’ trade between borrowing ‘short’ and buying ‘long’ meant that demand continued to grow from the SIVs and conduits encouraging/allowing lenders to package up more and more assets into ever more complex details, many of which in the light of day now, were entirely inappropriate.  In short, securitisation ended up being used for assets and in ways for which it was never originally designed.

 

So in the ‘demonising’ of securitisation it is important to get the perspective right. Whilst some deals have ‘blown up’, most notably US non-conforming/Alt A mortgage deals and the CDOs, UK residential mortgage deals, the immediate area that concerns us, continue in the main to perform within expectations. Senior notes (AAA/AA) are not under threat and the biggest concern for most investors is not whether the capital is ultimately safe but the timing around when the notes will be pre-paid given the slowing redemptions of mortgage loans. In short this is more a timing and liquidity issue for most investors in UK RMBS rather than a collateral performance issue.      

 

 

Will there again be a market for new mortgage issuance?

 

For a market to return there has to be demand/need from both sides - the issuer and investor. From the issuer’s side, there is still a clear funding issue with most of the banks. Whilst immediate cash/liquidity issues have been addressed, access to longer term funding remains problematic. This is evidenced in all aspects of lending but particularly mortgages where not only has the price of funding increased dramatically, but the level of funding  has significantly reduced.

 

The figures from the CML clearly show this with gross mortgage lending falling from circa £360Bn in 2007 to circa £160Bn this year. Whilst the £360Bn figure may be an aberration at the height of the market, clearly lending at today’s levels does not go anywhere near satisfying demand which we estimate around the £250Bn level per annum. Without the ability to generate funding from external investors, the mortgage market is going to be left short of funding for the long term..

 

On the investor side demand will always exist for quality, transparent assets with high returns. The question is how far new deals can go towards satisfying these requirements.   

 

 

‘Back to basics’ for new issuance   

 

It is accepted by all sides that for the securitisation market to return, significant changes are required. However we believe that securitisation, used in the right way still offers both issuers and funders a good way, of generating funding/good returns with minimal risk.

 

Whilst in the past securitisation was used by issuers as both a means of funding and risk transference, it is accepted now that new issues will not be able to transfer all the risk without the issuers themselves retaining a significant piece. Securitisation will therefore become much more about funding rather than risk transference. In addition all of the factors, which in hindsight made securitisation of mortgage assets a higher than often appreciated risk, have been addressed. By this I am referring to the assumptions made by the UK ratings agencies, (which are now clearly being tested and from a UK perspective are actually, believe it or not, not too far off the mark), but most importantly the quality of the underlying collateral.

 

Assets generated post credit crunch have all the advantages and none of the dis-advantages of pre-crunch legacy assets. Assets being generated now have higher margins, tighter criteria (built on post credit crunch learnings) but most importantly the underlying collateral, the houses, are at the or near the bottom of the price cycle. Losing money at the bottom of the property cycle is going to be very difficult to achieve!

 

With more conservative structured deals, a ‘sharing’ of the risk between issuers and investors, a complete re-setting of the bar in terms of the underlying collateral, and much greater investor returns than were ever previously available, it is perfectly feasible that investors will once again look at high quality, transparent securitisation paper.   

 

 

Market timing

 

With a clear imbalance on the mortgage funding side, we are very much of a view that that securitisation will return. The only thing that is a little unclear at present is the timing.

 

With the SIVs and the conduits purchasing over half the securitisation paper pre-crunch, clearly their subsequent closure combined with the slowing pre-pay speed of mortgage assets has meant a glut of paper in the market. This can be seen in the very wide spreads in the secondary markets which is more a reflection of liquidity than of underlying performance concerns. However, excess paper is clearly a timing issue. As house prices level and existing mortgage paper continues to redeem, confidence starts to return and over-supply diminishes.  

 

One of the biggest problems in the market is the lack of issuance to test new demand and pricing. As outlined above, new deals would be so superior to existing deals that they would hardly bear comparison. Our view is that within the next 12 months we will see the first of several new deals coming to market as some lenders look to release some cash. Whilst the price may be wide and the demand limited, it will represent the start.     

 

 

Ultimately markets themselves find solutions to funding issues and clearly securitisation, with the right structure and right price will address the requirements from both sides. The mortgage market needs funding and securitisation is ultimately a long term part of the solution rather than the underlying problem.

 

 

 

 

 

The latest Halifax House Price Index  was published yesterday showing an increase for the month of May of 2.60%. This follows on from both the Nationwide, which showed an increase of 1.20% for May and the land registry data which although always a month, behind showed prices essentially flat for April. It has been many months since all three main indices showed positive trends.

Given the low level of transactions and mortgage approvals, caution has been expressed from many analysts around putting too much store on one month’s figures. Whilst we agree with this approach, it also needs to be recognised that there is a trend emerging over the last few months of slowing price declines indicating to us that we could be at or near the bottom of the market. With all three main indices indicating similar trends rather than, as in the past, contrasting trends, it becomes difficult to argue that figures are perhaps in some way ‘suspect’.

Part of the caution around figures may perhaps stem from the reluctance of the main housing indices to make future predictions given that this either risks becomes a self-fulfilling prophecy (when house prices were falling) or they risk getting it badly wrong if for example prices are rising. Whilst it understandable to express caution around rising house prices given the low levels of transactions, the current data around house price rises are if anything probably more robust than the data that showed house prices falling in previous months as they are based on higher transactional volumes (albeit still low in an historical context). Any caution around low transactional figures has to work both ways, i.e. making the figures for last month as valid as the figures which showed them falling previously!

One of the few research firms who are prepared to provide forecasts and have (in our view) been generally quite historically accurate are Savills. Their latest report (from beginning of May) is well worth a read as it provides a good overview and supports our view that the recovery will be led from the prime markets of London and the South East. Indeed there is strong anecdotal evidence that the markets here are already in the process of recovery with increasing stories of sealed bids and the return of gazumping.  Even on a national Macro level there is strong evidence of stability returning to the market as the graph below indicates.

 

As we have iterated for over a year, property is now at its most affordable for a generation. Our view has always been that Q3 2009 would see (on a macro level) prices stabilise. This now looks less like a well informed prediction. We anticipate that there will be a period (particularly on a average national level) of ‘bumping along the bottom’, but affordability along with constrained supply (particularly in London and the South East and in the family housing sector) will prevent prices falling significantly further. From the bottom, the only way is up!