Contagion alert

29 August 2011 | By Samuel Dale

A double whammy of debt crises in the eurozone and US has led to fears of a double dip recession. The fear is seen in plummeting stock markets, with the FTSE losing tens of billions of pounds in the past fortnight and regularly dipping below 5000.

The question for lenders is whether there will be a second credit crunch and how this will affect the UK mortgage market. It is worth considering the political crisis in the US and the economic strife in Europe to assess the impact. The first event this year was the need for a bailout of the Irish economy by the European Central Bank.

Lloyds Banking Group and other major banks had exposure to the Irish housing market and reported losses. A default has not been ruled out and if it came, the losses would be much higher and inevitably restrict lending.

Similarly, the Greek troubles were well documented when it needed an ECB bailout in 2010. Earlier this year it became apparent the terms of the loans were too strict for the Greek economy to cope with and it would default. To prevent a default on such a monumental loan the ECB signed off a second bailout, but it still may not be enough.

UK banks are exposed to Greece, notably the Royal Bank of Scotland which wrote off £840m of Greek bonds in its results this year, reflecting a 50% charge on its holdings.

BNP Paribas and Societe Generales are also taking a 21% hit on their Greek exposure so RBS has a more pessimistic view of Greek debt. Specific exposure to European countries in trouble has left banks out of pocket and will inevitably lead them to tighten their lending.
General uncertainty is also showing signs of harming the securitisation market with West Bromwich Building Society claiming it held back from securitising loans because of eurozone woes.

Double dip fears
Morgan Stanley claims the risks of a second credit crunch are now more likely and has downgraded its growth projections across the globe.
Tony Ward, chief executive of Home Funding, says the ability to raise debt since the beginning of the credit crisis has eased but problems in the global financial markets are not helpful.

“Markets don’t function well when there is uncertainty and we still have a fair measure of that,” he says. “The focus right now is on France with a possible downgrade its public debt to annual wealth ratio is high at 81%, the UK’s is 80%.

“There is focus on French banks’ exposure to toxic debt and President Nicolas Sarkozy is trying to play the role of fixer by encouraging the Germans to find a European solution by sharing the European liabilities. I’m sure the focus will keep moving.”

Ward says the UK is relatively unscathed despite inflation rising and gross domestic product remaining flat.

“We are close to a recession at this point and high inflation is keeping economic activity low,” he says. “Uncertainty about jobs, riots and other things which don’t lead to a feel-good factor all keep the lid on spending. It’s no wonder GDP is flatlining. I don’t see this suddenly reversing.”
Ward adds that there is no chance of funding easing for the mortgage market soon.

“Demand has fallen for mortgage loans since the end of last year, so even if lenders had more funding mortgage lending would still be relatively mute,” he says. “Expect rates to stay low for some time to come. There will be no sudden return to higher levels of lending and the funding markets are likely to stay difficult for some time.”

Ray Boulger, senior technical manager at John Charcol, says the situation in the eurozone is worrying and when politicians fail to act markets will take control.

There is also speculation that in the past couple of weeks a major unnamed European bank took out a £300m emergency loan from the ECB.

This on top of poor results has made investors more jittery about the stability of banks and when confidence dwindles things can deteriorate rapidly as in 2008.

Despite low gilts and an expectation that interest rates will remain low for at least another year LIBOR has risen slightly.

“One would expect LIBOR to be edging down rather than up,” says Boulger. “Although it is only a small move it is symbolic of early concern about unsecured inter-bank lending.”

Worries over inter-bank lending means less confidence in the banking system and a squeeze on funding in the wholesale markets.

Subsequently this would lead to a squeeze in mortgage lending as banks look to control demand.

“We could have the bizarre situation where swap rates are falling but fixed rate deals are rising as lenders look to control their supply,” says Boulger. “The mortgage market has been having a good few months especially with access to high LTVs but that could end abruptly.”

But Boulger adds there is a silver lining for those on tracker mortgages as they can expect low rates for a long time. He also points out that building societies are offering most of the current best buy deals and they raise their money from savings.

However, increased competition from banks for saving accounts could see their funding dry up again as it did in 2008 and 2009.

A second credit crunch would clearly have a major impact on the UK economy and especially the mortgage market. Slower bank lending means less lending to business, slower business growth and ultimately to a slowdown in economic growth.

US crisis
The eurozone crisis, a source of concern for UK lenders, is compounded by events in the US. A political crisis saw Congress go to the wire to approve a $2.5trillion raising of its debt ceiling.

But the deal did not do enough to convince Standard & Poor’s as it downgraded the US credit rating from its prized AAA to AA+.

Initially the fears were that US Treasuries would rise in cost and not be the safe haven they have always been for the market. The creditworthiness of the US is still an issue for the market and both Moody’s and Fitch Ratings have called for tough deficit reduction plans.

But the tumultuous global stock markets have seen US Treasuries become a safe haven once more and drop to record lows.

Ward says no downgrade is good for business but the move has not yet had a major impact on US creditworthiness.

“US Treasuries have not seen a massive hike in rates since the downgrades, which might have been expected, so one could conclude that the US is still seen as a relative safe haven,” he says.

“UK gilt yields have also been trending down which suggests that comparatively the UK is also seen as a safe bet. It’s all relative. So providing the chancellor and the Bank of England can press on with their strategy to get the debt burden down and keep economic activity up with gentle stimulation through low rates, the market will give us the benefit of the doubt.”

Boulger says the markets have effectively stuck two fingers up to Standard & Poor’s downgrade as US Treasuries are at record lows.

“Whatever happened in the US affects the UK and the move to safe havens has pushed gilts down to their lowest rates for over 100 years,” he says. “If gilts are low then swap rates are low, which means fixed rate mortgages drop in price as we have seen.”

Fixed rates slashed
The impact has been seen on the high street with mortgage rates being cut in recent weeks by up to 1.5% to lure clients on to fixes.

Moneyfacts.co.uk reports that a 3.39% five-year fix from Chelsea Building Society and a 2.99% four-year fix with Coventry Building Society are the lowest it has ever recorded.

Jon King, managing director of More2Life, says there could be a silver lining for those looking to release equity in their homes.
“Usually one would pay a penalty on the difference between swap rates and the actual rate as when transferring to a lifetime mortgage borrowers have it for the rest of their lives,” he says.

“But with rates so low now there will be no penalty and that could be attractive for borrowers.”

But cheap fixed rates and fewer equity release penalties pale into insignificance in the wider context of US and eurozone troubles.

For now the UK has avoided a downgrade and much impact from the debt crisis in the US. In Europe the crisis of confidence is pushing the system dangerously close to credit crunch and recession.

These words should send a shudder down the spine of the UK mortgage market and it must hope that the virus doesn’t spread here.

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