Battening down the hatches - what a Greek exit would mean for the UK mortgage market

At the beginning of the year, I wrote a blog predicting a Greek departure from the euro. I suggested that this was the inevitable scenario given that Greece has debt at 144 per cent of GDP and its economy was and is in a downward spiral of contraction and austerity. Well, now most analysts have come out of the woodwork and seem to agree with my view.

In my posting, I also suggested that although Greece would take a massive hit, optimistically its departure could be manageable if the markets were convinced that no other countries would follow, particularly vulnerable countries such as Spain and Italy. I said that it would need international officials to put a firewall around Greece to avoid the markets getting spooked. Of course all this holds true today although thus far I’m not sure if European officials are doing enough to reassure the markets as witnessed last week. Confusion reigns supreme with Angela Merkel and President Hollande saying that they want to keep Greece in the euro but Christine Lagarde, head of the International Monetary Fund raising the possibility of orchestrating an ‘orderly exit’ for Greece from the eurozone.

So there you have it, although I still predict a Greek exit sooner rather than later, I guess much hangs on how the Greek elections in June turn out.

So what would a return to the drachma mean and how would the UK, in particular the housing market, be affected? It all comes back to my earlier point and how the exit is handled. Worst case scenario it will be complete chaos. In the words of Charles Dallara, the International Institute of Finance chief,  the damage to the rest of Europe from a Greek exit would be ‘somewhere between catastrophic and Armageddon’. Therefore potentially a complete temporary collapse of the banking system although from a UK perspective, Mervyn King, Governor of the Bank of England has suggested that contingency plans are in place were this to happen after warning that the eurozone was showing signs of ‘tearing itself apart’.

Even in the best case scenario, the UK would inevitably be affected by this scenario. Already there are signs that investors are spooked as customers withdrew their monies from Santander UK in the wake of the downgrading of the bank’s credit rating. And we should expect more of this jittery behaviour.

On a national level, certainly economic growth would collapse as our export market would nose dive bearing in mind half our market is in the eurozone. Plus our goods would be that much more expensive to buy as our currency increases in value being perceived as a (relatively) safe haven.

As for the mortgage market, I foresee banks resorting to behaviour last seen at the outset of the Credit Crisis, storing up capital and abandoning aspirations of market share. This is evident already to some extent and with more stringent regulation on the horizon, in the form of Basle III which will have a wide ranging impact on bank’s capital holdings, this behaviour is set to continue.  With total disruption to banking capital markets, it will prove harder for banks to raise new debt and significantly more expensive. So the cost of funding would inevitably rocket and homeowners would be hit by increases in mortgage rates. Banks would be keen to pass on costs to the consumer so upward pricing of mortgages would persist. On top of this mortgage availability would dry up and the possibility of obtaining credit would dwindle. This will inevitably have a knock-on effect to house prices which will fall significantly as consumer confidence is dented further. The exception to this would be the London market where luxury houses in particular will rise exponentially. Already Savills reports that homes costing more than £1.5m jumped by 39% in April as investors from Greece and Spain in particular seek a safe haven for their monies.

All in all, not a rosy picture then. But going full circle, back to my blog again, it all comes down to how orderly our plans are to resolve the situation. Because resolve it we must before we, and our EU partners, can move forward. 

The Chinese Way

What a contrast. Let’s stop for a moment and look at how the UK is dealing with an economic downturn as opposed to China and we will see that we are literally worlds apart.

Just to recap. The UK has gone into a technical recession with GDP shrinking by 0.2% in the first quarter of 2012. Deleveraging is the order of the day. Banks are looking to shore up their capital in light of new regulation which is starting to kick in. Plus they have MMR shadowing them and the impending restrictions on capital requirements resulting from Basle III requiring banks to increase levels of highest quality capital to 7% by 2019.

And Mervyn King is putting in his two pennies worth stating that banks haven’t gone nearly far enough and need to improve their ratios considerably from 20:1. So the resulting impact is that banks are choosing to lend less, both to businesses and consumers. Lloyds Banking Group announced recently that it is planning to cut its share of the UK mortgage market from 28% to 25% and no doubt other lenders will follow. Inevitably credit will dry up or only be available to the less risky elements of society and will be risk priced accordingly.

Sadly of course this will have a knock on impact to the economy with mortgage lending faltering and a subsequent knock on effect to house prices. Thus potentially dampening the economy still further. But let’s wait and see.

And what of China? Well China’s manufacturing activity seems to have turned a corner expanding for the fifth month in a row, easing concerns about a sharp slowdown. The worries about a global slowdown and its impact on China’s economy had seen the country take steps to ease monetary policy in order to boost growth. China’s central bank has cut the amount of money banks need to hold in reserves twice in the past few months to try and stimulate lending in the country. The move saw Chinese banks extend new loans in March, much more than forecast. Analysts said the increased availability of credit had started to have a positive impact on the economy. And subsequently, China’s economy is likely to grow at an annual rate of 8.5% in the second quarter, up from 8.1% in the first three months of the year. So good news for the Chinese.

Of course we have to put in some caveats. The UK economy is vastly different to that of China with different concerns and pressure points. The government, Bank of England and FSA are hugely worried that unless we take these measures we are vastly exposed to a potential second banking crisis. I take on board these points. Still, maybe, just maybe, there are some lessons to be learnt from the Chinese approach?   

And the watchword for today is….

In addition to the various debates around the implementation of MMR, the dissipation of interest only loans and the merits of NewBuy schemes, there lurks a sinister spectre which in itself could have more impact on the mortgage world than anything else at present.

It’s been there for a while. In fact the original version (Basle I) may have very well driven the start of the credit crunch. This spectre is none other than Basle III and its implementation.

What does this mean? Well, a whole range of things and I would be happy to take anyone through them in more detail. In fact I’m in the process of drafting an essay around the whole subject matter which I hope to publish shortly. However for the sake of this blog I’ll keep it brief. In a nutshell, banks will be required to hold considerably more capital and liquidity than they have previously.

Some are already addressing this through de-leveraging. Those of you who have read my previous articles and blogs will have seen me mention this before. Perhaps I was getting ahead of myself but it is certainly something that banks are picking up with a huge amount of fervour today in their bid to aggressively dump assets and cut back on lending.

On Wednesday the IMF forecast that a drastic contraction of European balance sheets during the next 18 months could jeopardise financial stability and economic growth in Europe and beyond. In its Global Financial Stability Report, the IMF warned that European banks looked set to shrink their balance sheets by $2.6 trillion (€2 trillion) over that period. It is suggested that a quarter of deleveraging will come from reductions in lending, alongside sales of securities and assets as banks try to shore up their finances.

The most worrying aspects of this activity are, of course, how it will affect the economy. There is a danger that this could go into an uncontrollable tailspin, threatening to drive Europe into a new vicious cycle in which business and households are deprived of credit. This will, in turn, depress the economy leading to more strains within the banking system. The International Monetary Fund has already said that credit supply in the euro area could shrink by 1.7% as European banks dump almost 7% of their assets by the end of 2013.

So restricting credit lines could have a significant impact on the economy – in particular house prices where borrowers, primarily first time buyers even with NewBuy, have limited access to monies.

But almost bizarrely on top of this, you have the euro area and the City of London calling on banks to maintain the flow of lending to the economy on top of raising capital ratios.

So what’s a bank to do?

Well it certainly has to comply with Basle III and that means taking action. Deleveraging is certainly the watchword but how to do it profitably and without alienating your customer base is a fine art – one that some practise well, for example Bob Young at Capital Home Loans, but others may need a little help with.

At yesterday’s HSBC Great Housing Market Debate 2012 the mood was fairly sanguine about the prospects for recovery and house price rises. I’m not so optimistic given the global liquidity issues. I think we are getting ahead of ourselves a little. One thing’s for sure though, be prepared to see that term deleveraging around for some time to come. 

The price of AAA

The latest news from Fitch doesn’t seem like good news. The ratings agency announced on Wednesday that the UK’s highly-prized AAA credit rating was at risk and more likely than not to be downgraded. It said the ‘risks and uncertainty’ surrounding the Coalition’s austerity plans were ‘material’. The credit rating agency put a slightly greater than one in two chance on a downgrade for the UK over the next two years. This follows Moody’s report last month that also put Britain’s AAA rating on a negative outlook. This has spooked the markets somewhat although Standard & Poor’s is yet to follow along the same path, maintaining the UK’s current AAA status.

Some would say that this is a major setback for George Osborne ahead of the Budget and gives him little room to manoeuvre and give any unfunded handouts. However it can be argued that this gives him the perfect excuse to stand firm and maintain his tough stance on austerity measures. In fact the Treasury has already said that the decision by Fitch was a lesson for anyone hoping for giveaways in the Budget.

I think on the whole the Chancellor is right to take this stance. I am much more optimistic about the state of the economy going forward than I have been for a long time, albeit unemployment remaining stubbornly high. I believe the government should stick to its fiscal austerity plans and in doing so, I predict that we will see modest growth in the second half of 2012.

So the message is stand firm. In doing so I believe that the UK is likely to retain its AAA rating.

Steady as she goes.  

It's all about risk

So what’s to be made of the recent furore over interest-only loans? There seems to be much comment in the market following Lloyds Banking Group’s decision to bring in changes to interest-only mortgage criteria after Santander cut its interest-only LTV from 75% to 50%. Last week, Accord announced the withdrawal of their 75% and 85% LTV products following an uplift in interest-only applications blamed partly on the recent decisions taken by Santander and Lloyds. Leeds is the latest lender to announce cuts in criteria.

Are interest-only loans all bad and if not then why are lenders running away from them?

It’s worth remembering that these products came out of the growing market for endowment and pension backed mortgages in the 1980s and early 1990s. The mortgages were heavily marketed and distributed through IFAs who were also selling the investment product. From a lender’s perspective, they were happy because there was a known repayment vehicle, and in the case of endowments, these were assigned as security. However, as it wasn’t possible to assign a pension, lenders inevitably moved away from assigning endowments in the interests of speed and easy processing and by the mid 1990s no lenders were assigning endowments. 

Somewhere along the line some lenders also dropped the need to investigate whether a repayment vehicle existed at all and then interest-only really took off. If you were a lender that tried to investigate the viability of repayment plans then you were deemed “too picky” by the intermediary and so followed suit or lost market share. Today we have thousands of interest-only borrowers who have a loan but no way to repay it. This has been compounded by underperforming low cost endowments and where there was a settlement by the insurer in lieu of damages, the proceeds would have been paid directly to the borrower rather than being credited to the mortgage account. They will have been spent long ago. The interest-only time bomb is a significant issue which still needs resolving.

And that is what the FSA are trying to prevent from happening again.

Interest-only loans aren’t being outlawed going forward but the principles of ensuring sensible repayment plans are in place are being re-established.

From a brokers perspective it has been argued that the FSA and lenders are over-reacting with tightening of rules and cuts in criteria but I think this overlooks the whole picture. In fact there are two main reasons for the lenders slide towards a more prudent approach to this product and their recent tightening of criteria: the first is that going forward, lenders will be required to assess affordability on interest-only mortgages on a capital and interest repayment basis unless there is evidence that the borrower has a “robust” vehicle in place to provide for repayment. The lender will be required to obtain evidence of the repayment vehicle prior to completion of the loan and will be expected to check on the performance or continued existence of the vehicle during the life of the loan. The lender’s policy for interest-only mortgages will be required to be set at board level.

Beneath that though is the fear that lenders will be challenged retrospectively on these decisions which could lead to regulatory and reputational sanction. In short, the interest-only product is now seen to carry more risk.

Secondly, and this is significant, despite more positive noises in the market, funding and capital remains in relatively short supply. Any one of the major lenders could lend multiples of their current volumes if they wanted to and they are having to regulate business volumes in a variety of ways. Additionally, higher LTV mortgages require multiples of the capital that, for example a sub-80% LTV mortgage would. Capital is scarce and with Basel III just 10 months away it’s getting scarcer. Is it any wonder then that one of the ways lenders have chosen to manage their risk, capital and funding issues is to cut the criteria back by invoking a lower LTV on these higher risk products? Essentially they are requiring the borrower to put in the capital rather than do it themselves.

Interest-only lending has its place but is an undeniably higher risk product for lenders and one that should rightly remain as a niche rather than mainstream product. That’s how it started; the market just lost sight of that.

On the positive side, there is a great opportunity for a new niche player here who is prepared to understand and manage the risks properly.

The next big thing

So what do we have to look forward to in 2012?   Mortgage lending is likely to be flat and unexciting and in my view, mortgage growth will not be high on the agenda for many CEOs’or finance directors of banks and building societies, regulators and central bankers. My prediction is that focus will continue on building up capital and liquidity reserves and being able to weather any storms that may yet be unleashed from the Eurozone in particular. Isn’t 2012 supposed to be the year the world comes to an end? The Bank of England will want to see that if nothing else, the British banking system survives.

To achieve this deleveraging will continue to be a key requirement. Sir Mervyn King has been vocal on this point saying that although banks leverage ratios have halved to 20:1 from the levels they were at before QE started, they are still too high. This is consistent with a recent report published by McKinsey Global which stated that Britain’s total public and private sector debt had risen to a rather massive 507% of GDP. Unlike Sweden in the early 1990s, McKinsey don’t consider that we have deleveraged anything like enough at present

There are three main ways a bank or building society can achieve this deleveraging: issue more equity capital, retain more profits as part of Tier I capital reserves or shrink loan books through deleveraging programmes. Other mechanisms such as freeing up capital through risk transfers will also have their place and I see that Barclays have already availed themselves of such a transaction earlier this month.

We will see an increase in banks actively encouraging borrowers to move their mortgage accounts away through one means or another. We will also see an increase in mortgage and other asset sales if I am correct. And I’m not the only one who sees things this way: Bob Young from Capital Home Loans has also identified the importance that deleveraging will have in 2012 and that it needs to be done intelligently. Like me he believes this has to be done with considerable thought and skill utilising a number of mechanisms, not just the simple re-broking of loans that we sometimes see.

Some banks are managing their deleveraging programmes themselves but to handle this effectively calls for a wide range of key skills including cross-selling techniques, JVs with other lenders and of course corporate and structured finance experience. This is not something that every lender will feel it has the ability to deliver so we can expect a growth in advisory and outsourcing to insightful individuals and firms.

It does seem to be a very pragmatic solution and we are going to see more and more of this type of activity going forward. However there is an art to this and the key is to get the balance right.

An orderly withdrawal

Well it’s that time of year isn’t it? We all dust ourselves down from the new year frivolities and start making predictions for the year ahead. Flavour of the month is of course the European crisis and the great debate as to what is going to happen to the eurozone.

There are of course the pessimists who see a disorderly break up as inevitable and disastrous consequences for the European economy and there are those that are more sanguine who see EU leaders resolving to repair the root of the mess. Last week, Mark Mobius a fund manager from Franklin Templeton predicted salvation by July. ‘The European crisis is not as deep and terrible as people think’ he said. ‘Nations…are in a process of negotiations and that takes time’.

His scenario depends on many changes happening in France’s elections, successful negotiation of the stability pact and progess in financing the rescue funds. All big asks, I think.

For what it’s worth, I'm not sure I see the euro as viable over the medium term, largely because the big debtor states have no chance of repaying what they owe. Greece is of course first in line for departure. It has debt at 144 per cent of GDP and its economy in a downward spiral of contraction and austerity. Redemption therefore seems improbable and it is becoming increasingly clear to me that Greece is not going to last much longer in the single currency.

So what would happen? Well, I think when we get to this inevitable scenario, it all depends on how orderly the departure is. Undoubtedly the situation needs to be handled carefully. Whilst the Greek economy would undoubtedly take a massive hit, Greece accounts for only 2 per cent of eurozone GDP, so optimistically its departure could be manageable if the markets were convinced that no other countries would follow. It would need international officials to believe that they can put a firewall around Greece; it needs the market to believe that this is an exception. The last thing we need is for it to get spooked.

The success of this scenario is very much in the detail.