UK housing market balanced on knife-edge

But so far, the impact on the banks seems to have been minimal.

Full-year results from the largest lenders – released over the past few weeks – show little evidence that homeowners are struggling to pay their mortgages, let alone defaulting on the scale seen in the United States. Bank executives also play down the prospect of further trouble. Though they acknowledge that turmoil in the money markets has raised the cost of borrowing, they insist mortgage lending has been more prudent than in the US. Most mortgages are worth significantly less than the value of the houses against which they are secured. As long as economic growth and employment remain stable, they argue, the housing market should hold up. However, some analysts are sceptical. They point out that the British housing market has only just begun to feel the pinch, and that problems will take time to come through. They also argue that falling house prices could trigger a downward spiral that would potentially leave banks facing greater losses than in the early 1990s recession.

“If the current dislocation in funding persists and if expectations of house price falls become more widespread banks will change their behaviour further, leading to increased tightening of underwriting standards and increases in bad debt mitigation, such as repossession,” warns Michael Helsby, banking analyst at Morgan Stanley.

The fundamental question is how the credit squeeze will impact the cost of mortgage borrowing, and how this will feed through into house prices. As much of the recent growth in the mortgage market was funded through the capital markets, the recent turmoil is bound to have an effect. At the same time, mortgages are becoming harder to obtain. Many niche lenders that used the securitisation markets to offer mortgages to people who would previously have found it hard to get a mortgage have been forced to scale back new lending.

Borrowers on introductory fixed-rate deals who cannot remortgage are facing “payment shock” when those terms expire. According to the Financial Services Authority, 1.4m people will face a sharp jump in repayments this year.

So far, there is little evidence of this leading to defaults. According to the Council of Mortgage Lenders, just 1.10 per cent of all mortgages were three months behind with payments at the end of 2007. In the US, almost 6 per cent of mortgages are now 30 days past due – the highest level since records began in the 1970s. Repossessions in Britain last year hit an eight-year high, but remain at a third of the 1991 peak. Andy Hornby, chief executive of HBOS, Britain’s largest mortgage lender, predicts the mortgage market will continue to grow in coming years, though at a slower rate than in the past. Immigration and population growth will boost demand, he argues, while employment will be the key factor in determining whether or not borrowers keep up with their payments. But some analysts question this, arguing that current prices can only be sustained if homeowners are willing to take on an even greater debt burden. This proportion is already high when compared to historical levels.

According to Leigh Goodwin, an analyst at Fox-Pitt, Kelton, someone buying a house today will, on average, spend 24 per cent of their income servicing the mortgage over its 25-year life. This compares to just 14 per cent at the peak of the last housing boom, in 1989.

These figures suggest that one of the factors in peoples’ decision to buy property is an expectation that it will continue to rise in value. If house prices fall, this spiral could go into reverse, triggering a broader slump. It is also unclear how buy-to-let investors, who have yet to weather a serious downturn, would respond if prices fell.

“When house prices fall, the mortgage goes from being the last thing people stop paying to be being the first thing they stop paying,” says Mr Goodwin. “The potential for something very nasty is with us.” Most bank executives dismiss this, arguing that prices will at worst remain flat for a few years – the equivalent of a slight drop when adjusted for inflation. The next 12 months will be crucial in determining which prediction is correct.

By Peter Thal Larsen, Banking Editor Published: March 7 2008 17:09 | Last updated: March 7 2008 17:09