Balance sheet balancing act

Lending Strategy April 2010

As the election draws closer, bringing political and economic uncertainties, it is difficult to generate interest in a longer term assessment of market prospects.

Focussing on small variations in policy only adds to the feeling that the effect of the election result on the mortgage market will be modest in the medium term. In many senses it is the eco- nomics of the situation and the need for balance sheet adjustment from both government and consumers that is driving the outcome.

But whoever wins will inherit a difficult portfolio of problems, many of which will not be addressed in 10 years let alone five. I do not expect housing and mortgages to be high on the priority list as it is left to the regulator to control the mortgage lending industry.

The boundaries between regulation and macroeconomic policy look set to merge in several areas as policy makers widen their remit.

But I think this is a good time to look more closely at the balance sheet adjustment we have seen so far and assess the likely implications for mortgage lending in the medium term.

We have seen a sea change in the performance of the household sector in relation to debt as the recession and the lack of new credit supply have had an effect. The balance sheet of the household sector has seen a slowdown in the growth of mortgage and other debts while income growth has remained resilient. Also, the financial assets of the sector have recovered as the equity market has risen sharply.

The mortgage debt to income ratio in the past 35 years shows two distinct peaks, one in 1989 and one in 2008. At the time of the 1988/89 boom many commentators believed the debt to income ratio had risen as far as it could when it reached 0.81.

But following the protracted downturn of the early 1990s the ratio started to rise quite sharply again from around 1999, reaching a record 1.35 in 2008 before easing to 1.28 in 2009.

The likely path of the debt to income ratio and indeed the corresponding wealth to income ratio will have a big bearing on the size and growth of the mortgage market.

Using this simplified and stylised approach makes it easier to look at the issues facing us as an industry. Macroeconomic policy changes will affect the path but perhaps not the final destination of the ratios.

The balance sheet of the household sector has seen a slowdown in the growth of mortgage and other debts, while income has grown and assets have recovered their value in line with a robust equity market

The chart below shows our main forecast for the debt to income ratio from 2010 to 2015. I have also added a more optimistic scenario (similar to 1991/92) and a more pessimistic forecast whereby the rate of balance sheet adjustment accelerates and the debt to income ratio returns to 2002 levels.

These relatively modest scenarios have dramatic implications for the likely size of the gross and net lending markets in the next five years.

The main forecast shows the debt to income ratio easing from 1.28 to around 1.1. This implies that gross lending will average around £186bn a year, with net lending of around £16bn a year.

The faster balance sheet adjustment scenario shows the debt to income ratio falling to around 1.08. This results in net lending averaging only £6bn a year and gross lending of nearer £170bn. This represents gross lending of less than half the level recorded in 2007 and much closer to the level seen in 2001. This scenario is more likely to prevail in a period of depressed equity markets and low economic growth.

Higher interest rates may accelerate the rate of adjustment if combined with poor eco- nomic performance.

The 1991/92-type scenario shows a more upbeat assessment, with a quicker recovery in confidence. Under this the debt to income ratio remains flat at 2009 levels and mortgage debt grows in line with income.

This implies net lending of around £50bn a year and gross lending of nearer £230bn. For this to happen we would need to see a robust recovery in the housing market and the economy, and the absence of heavy regulation.

The short-term outlook for the mortgage market is gloomy as lenders focus on rebuilding balance sheet strength but pressure should start to ease in the next couple of years.

Adjusting balance sheets now will put the market on a more sustainable footing. If only government deficits could be turned around so efficiently.

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