One year on: how is the UK mortgage market faring?

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A year ago, the global financial system was poised on the brink of collapse. Some of the biggest effects of the crisis were in the US, where developments in the sub-prime mortgage market triggered the near-collapse of the financial system. Lehman Brothers became the largest firm in US history to file for bankruptcy. Merrill Lynch, having sustained heavy sub-prime losses, was taken over by Bank of America. And the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) were taken into government ownership.

But while the biggest casualties of the financial crisis were in the US, there was upheaval on a global scale. Addressing a business audience shortly afterwards, the governor of the Bank of England, Mervyn King, said it was difficult to exaggerate the severity and importance of events. “Not since the beginning of the First World War has our banking system been so close to collapse,” he added.

The financial crisis provoked a huge policy response from governments and central banks around the world. As Mervyn King said in his speech to businessmen, “an extraordinary, almost unimaginable, sequence of events…culminated…in announcements around the world of a recapitalisation of the banking system.” But recapitalisation was only part of the challenge. The crisis affected liquidity and funding, and there were policy measures targeted at these areas as well.

As we know, a collapse of the global financial system was narrowly averted. But there was enormous disruption and huge consequences for the UK mortgage market and for firms operating within it. So, a year on, how have UK lenders been affected by the crisis, and by the policy intervention of governments and central banks? And what measures do we need now for the steady improvement in market conditions of recent months to continue?

The policy response

For more than a year before last autumn's crisis, the credit crunch had disrupted the UK mortgage market. One response by the authorities was to introduce the special liquidity scheme (SLS). The SLS, implemented in April 2008, eight months after the onset of the credit crunch, enabled participants to swap existing, highly rated residential mortgage-backed securities (RMBS) and covered bonds for Treasury bills.

Having initially been criticised for failing to respond quickly to the credit crunch, UK policymakers introduced a comprehensive range of measures – and on a large scale – in response to last autumn’s financial crisis and its aftermath.

In October, the government announced a £500 billion package of measures to provide funding and capital for the banking system.

It not only increased the availability of short-term funding through the SLS, but introduced credit guarantees and provided funds to re-capitalise banks. Ultimately the government injected equity into the banking system on a huge scale through the partial nationalisation of the Royal Bank of Scotland and the Lloyds Banking Group.

In January this year, the government announced a further package of measures, including guarantees on highly-rated mortgage-backed securities and credit insurance on assets, including mortgages, that were difficult to value.

Additionally, in a measure seeking to reinforce confidence in wholesale funding markets, the Bank announced the asset purchase facility, a programme to purchase high quality, private sector assets, including asset-backed securities “created in viable securitisation structures.” This has been used to implement quantitative easing, designed to boost the money supply, though mainly through the purchase of government bonds.

Interest rates

Over and above this extensive range of initiatives to inject capital, liquidity and funding into the financial system, the Bank has also aggressively cut interest rates, initially in conjunction with central banks around the world as part of a co-ordinated response to the crisis.

Between October 2008 and March 2009, the Bank slashed rates from 5% to 0.5%, abandoning – in the face of the financial crisis – an approach it had followed for more than a decade of making modest, marginal adjustments to interest rates to nudge the economy in pursuit of inflation targets.

Collectively, these measures have done much initially to underpin, and then to stabilise and improve, conditions in the financial system. They have also helped stabilise the UK mortgage market. But there are still numerous challenges for individual firms.

Mortgage funding

Perhaps one of the most significant developments recently has been an improvement in the prospects for wholesale mortgage funding. The market remains dysfunctional, but the secondary market price of high-quality mortgage-backed securities has been rising, and is now nearing the point where new RMBS issuance could re-start. That would ease lenders’ funding constraints and reduce reliance on schemes supported by the government.

Monetary policy, in particular the decisions to cut interest rates and introduce quantitative easing, has also helped in the aftermath of the financial crisis. Quantitative easing has helped drive down the London interbank offered rate (libor).  Borrowing at this rate is, of course, not available to all lenders, and libor – like the Bank rate and swap rates – is not, in itself, a good guide to lenders’ real funding costs. But the fall in libor is an indication of improved liquidity in funding markets and a sign of improving confidence generally.

One result of the financial crisis has been a drive to reduce overall levels of indebtedness. So far, this has manifested itself most obviously at a personal and corporate level, but pressure to reduce levels of debt is also set to affect the public finances in the coming years.

Reducing debt to any significant extent is a painful, long-term process. In the short to medium term, however, low interest rates have helped ease financial pressures at a personal and corporate level, while delivering the wider benefit of encouraging economic recovery and the restoration of growth, and reinforcing confidence.

The mortgage market today

What, then, are we to conclude at this stage about the policy response to the financial crisis of a year ago? Where does the mortgage market sit now? And what are the prospects for lending in the future?

  • The mortgage market has suffered enormous disruption and remains dysfunctional, but it is in a far better position than it might have been a year after the global financial system teetered on the brink of collapse. The financial crisis has been contained and the measures implemented should help bring about economic recovery, over time, and improve conditions in the mortgage market.
  • Retail deposits will not be large enough to fund the mortgage market at its current size. For many years, retail deposits were essentially the only source of funding for lenders. By 2002, however, the scale of outstanding mortgage debt had grown to exceed retail deposits – and the gap between the two continued to widen until 2007.  It was largely filled by new market entrants, often foreign-owned, using wholesale markets to fund mortgage lending. But neither of these sources is currently capable of making a significant contribution to filling the funding gap, and the government and Bank have had to act as a substitute source of wholesale funds. Many of the challenges for borrowers and lenders now are essentially driven by a process of adjustment to a mortgage market constrained by the volume of retail deposits. The funding shortage will continue to ration mortgage lending until wholesale markets are functioning more effectively.
  • Recovery of the mortgage market is likely to continue to be a slow process.  Pressures to reduce overall levels of debt will persist and the capacity to borrow will be limited not only by the continuing shortage of wholesale funding. Although funding conditions may slowly improve if a market for RMBS is restored, the emergence of negative equity for some borrowers will also act as a constraint. Earlier this year, we estimated that 900,000 owner-occupiers had a mortgage that is larger than the value of their home. The vast majority are able to continue making their payments and, for them, negative equity is not an immediate problem – and may never be so. We also estimated that two-thirds of these borrowers have negative equity of less than £10,000. But the ability to borrow will continue to be limited by what is likely to be a slow recovery in house prices. This will limit the potential of customers with negative or small amounts of equity to take out new loans.
  • The slow improvement in mortgage market conditions means that cautious lending criteria will continue to prevail. Lenders will remain risk-averse. While a shortage of funding persists, the most attractive products will continue to be more readily available to customers with unblemished payment records and those borrowing conservatively relative to their income or the value of their property. Concerns about the unwinding of government funding support play a role here. Lenders will have to re-pay £185 billion to the Bank when the SLS comes to an end in 2011, for example. Uncertainty about how these sums will be re-financed is bound to make lenders cautious.
  • Lenders have been affected in different ways by the financial crisis, by the policy measures in response to it and by mortgage market conditions.  Different types of lending institution, large and small lenders, and firms that rely on different sources of funding, have been affected in different ways. The result is that a high proportion of new lending is now being done by large firms, as our recently published table of the largest mortgage lenders showed. Smaller, deposit-taking firms – many of which are currently writing only a small amount of mortgage business – often face greater regulatory constraints and have benefited less from government support. Many specialist lenders, meanwhile, have been removed from the market by the closure of wholesale funding options. But the recovery in sentiment both in the UK housing market and in wholesale finance markets may pave the way to a re-emergence of an RMBS market, allowing specialists to re-enter the mortgage market. It will also help deposit-takers, allowing them to reduce their reliance on retail deposits.
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