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Chewing over the future

About this time last year Lending Strategy invited a group of senior lending executives to a lunch with David Smith, economics editor of the Sunday Times.

The idea then was for Smith to talk about his new book on the growing economies of China and India and what this might mean for UK Limited but that proved impossible – by that time the events at Northern Rock and the virtual disappearance of securitisation as a funding model had created a more compelling talking point.

Everyone at the lunch wanted to know Smith’s view on the developing crisis and whether the situation would result in a house price crash and seriously affect the wider economy.

UK executives from prominent companies such as Lehman Brothers and Bear Stearns were well represented around the table and their seemingly strange reluctance to join in the subsequent table talk was better understood shortly after the event in that many of them were asked to clear their desks and vacate their corporate palaces in the City even before we had gone to press.

Nor did the attrition rate slow much during 2008. When we first conceived the idea for our most recent lunch and talked it over with our sponsors, Homeloan Management Limited and legal specialist Salans, the invitation list was supposed to include all the lending industry chief executives who have graced the front covers of our magazine since the beginning of 2008.

Gosh, we were being as optimistic as Smith had been at last year’s lunch when he looked ahead to see what this year might have in store for us.

At that time we could never have imagined the toll the credit crunch would take on the industry, its leaders and ultimately the housing and mortgage markets and the economy.

It would be invidious to reproduce a list of the fallen but they were very much on our minds when we gathered at Sartoria’s restaurant in London’s Savile Row on November 12 – a group of survivors keen to hear a message of hope from one of the top economic journalists and authors in the country.

Smith obviously knew he had the burden of history weighing heavily on his shoulders.

“Normally when I come back to speak at events people have forgotten what I said a year earlier, which is quite good”, he said, “But thanks to Lending Strategy, Murray’s gimlet eye and a copy of last year’s magazine I know I am not going to be so lucky today.”

The rest of this article represents Smith’s thoughts as presented at the lunch, in his own words:

Last year, my original invitation was to talk about developments in China and India, about which I had just published a book, but I unwisely went into the housing market and the outlook for the UK economy.

I said then that there would not be a house price crash because they are rare and don’t happen in the absence of a recession – I didn’t expect a recession or a house price crash.

Now, things have changed dramatically. Let me take it on the chin and just talk about why things have turned out so differently and where they might be going from here, with the caveat that you should take what I say with a pinch of salt, bearing in mind what happened a year ago – I knew should have stuck to China and India!

Anyway, a year on we have seen an unprecedented crash in activity. In fact, it’s quite remarkable how housing activity has declined in the past 12 months.

One useful measure of this is the decline of 70% in mortgage approvals in 12 months.

To set that in context, in the housing recession of the early 1990s approvals fell by 60% but it took four years for that to happen, so a 70% fall in approvals in just 12 months is extraordinary.

People will have differing views on whether we have seen a crash in prices. Certainly, based on lenders’ data, we’ve seen falls expressed by Nationwide and Halifax of roughly 15% in 12 months – surely a crash in anybody’s book.

Knowing there’s an interested party here [Phil Jenks, chief operating officer at HBOS – ed.] I have a bit of an issue with lenders’ data. I’m not suggesting that house prices aren’t falling sharply, but there’s quite a discrepancy between the various measures.

The Department of Communities and Local Government index is down 5% compared with a year ago, which looks a bit low to me; the Financial Times index, which is probably the most complete one, is a bit backward-looking and it’s down by 6%; Land Registry figures are down 8%, and Rightmove says there has been a price fall of about 5%. That’s quite a range.

We obviously have a thin market at the moment, which is exaggerating price effects. And importantly, when people say house prices are falling more rapidly than at the equivalent stage of the 1990s recession, it depends where you are in the country.

Normally one sees a housing market ripple effect whereby certain regions fall first and that effect then ripples out into other regions. It’s a gradual process and is one reason why it took so long to reach the full extent of the fall in mortgage approvals in the 1990s.

At this stage in that recession towards Government policy riddled with inconsistencies the end of 1990, we were seeing house prices in the South-East and East Anglia down by roughly 20% compared with a year earlier, on their way to a total fall of nearly 40%.

Prices in the north of England and Scotland were not falling at all at that stage – it took a long time for that to happen. This is one reason why there was such a discrepancy between lenders’ figures in the early 1990s. For example, during 1990 the Halifax index didn’t fall at all and the Nationwide index fell by 10% because of the southern bias of the Nationwide index and an element of northern bias in the Halifax index.

Of course, they are closer together now. The nature of the current housing correction or crash is that everyone is in it together – everyone in the country is suffering the same effects from the credit crunch and the same degree of mortgage rationing. What we are seeing now is not the normal ripple effect – it is a compressed housing correction.

So does what has happened to prices and activity in the housing market meet the normal rules of house price correction apply or does it only happen in recessionary conditions?

One thing seems certain – we are in a recession. It appears that the economy stopped growing in the second quarter of this year, fell pretty sharply in the third quarter and will fall again. The Bank of England’s forecast for the economy projects a decline not far short of 2% in GDP during 2009.

There are two interesting things about that. One is that it’s definitely at the aggressive end of the range of forecasters’ expectations for next year – most forecasts have in mind a decline in GDP of around about 1% so the Bank has really gone for it in this forecast, having said just a few months ago that we would get down roughly to the zero line but not fall below it.

I suspect this reflects what many of you around this table have experienced – a sharp downturn in activity over the past couple of months with collapses in prices, confidence and activity.

I also think the Bank was a little slow to spot this and it had quite a hard time at the relevant press conference – we’re in recession so it does meet the rule for housing corrections. On some measures, the fall in house prices started before the economy was in recession and I think that is fair enough.

There were slightly strange things happening last autumn to do with the introduction of Home Information Packs and this might have affected some house price measures, but you would expect these measures to anticipate the downturn as they did in the early 1990s. Then theystarted falling ahead of the economy formally going into recession, so that pattern is being replicated.

The same factors that have affected the housing market have acted with a delay on the wider economy. In the late 1980s and early 1990s the cause of the recession and the housing crash was 15% interest rates. The cause this time has been the credit crunch.

Is there any light at the end of the tunnel? We’ve seen distinct phases during this crunch and my excuse for last year is that we had been through the autumn phase and the mood was one of relief rather than self-congratulation. The Northern Rock saga had been difficult but the number of other casualties was quite small and, crucially, in the money markets interest rates had come down a lot. In October and November the world’s central banks and finance ministers had started to congratulate themselves that the worst was over.

We then saw the second phase at the end of the year, and that again could be put down to an end-of-year scramble for liquidity. Again, money market rates went up sharply and central banks provided liquidity so things improved markedly in January and February.

The third phase in March was when the funding gap really came through in the UK mortgage market, and that was the time when lots of products were withdrawn. It was at that time that First What the lending luminaries said over lunch

David Cowie disputes the idea that suspending mark to market is a good idea:

David Smith on debt: Direct said it was so inundated with applications that it had to close its process down for a couple of weeks.

At first, that was explained as something minor, then it was realised that everyone was in a rush to withdraw and close down due to the lack of funding.

That was the time when it would have been quite useful for the government to have done something, if it was going to do something in the mortgage-backed securities market.

I wrote a piece at that time to the effect that if there was going to be any form of guarantee or intervention in that market, this was the time to do it. Instead, the response was to commission Sir James Crosby to do his review and there will be a report published alongside the pre-Budget report, but I suspect the moment has passed.

The third phase was still going on until we got to September and October, and this was a deadly period which Bank governor Mervyn King has described as the nearest we have seen to a meltdown of the financial system since the early days of World War I.

Today [a reference to the Bank’s Quarterly Review briefing – ed.] King was suggesting it was possibly even longer than that and that it is definitely the worstfinancial crisis in human history.

I have some confidence that this may turn out to be the moment of capitulation – of high drama. But the response to it with the recapitalisation of the banks and the rest of the packages may turn out to be the worst part of the financial phase of this crisis, and it may be possible to look forward now.

When we look back on this we will say that the September/October period was the eye of the storm but there’s still a big adjustment to come.

The Bank put some interesting stuff in its Financial Stability Report. I was particularly struck by what it described as the funding gap.

The funding gap is the gap between what banks get from depositors and what they get from the wholesale markets. It identified a gap of £740bn in the middle of 2008. The Bank’s prescription was to get that down to something like 2003 levels – not for wholesale funding to disappear, but for it to be significantly smaller. The 2003 level was around £265bn.

This is not consistent with a return to 2007 lending patterns – it’s consistent with a slowdown but as the Bank put it, not a collapse in lending. It’s view was that without the rescue there would have been a calamitous collapse in lending. The Bank sees lending continuing but at a lower rate than before the crunch.

The economic uncertainties are enormous because none of us have experience of a credit crunch. We have experience of measures to rein back credit through policies and controls, and experience of action by central banks to restrict the growth of credit by raising interest rates, but not of a credit crunch that emanates from the markets.

We don’t know how much lending capacity we’ve lost permanently and we don’t know how long it’s going to take to get back to some sort of normality.

That explains why the normal calibrations for policy probably don’t work anymore. That’s one reason why we saw such What the lending luminaries said over lunch

Iain Cornish on the credit crisis: a dramatic cut in interest rates, because the Bank has to think big. The normal sort of rate cut is now insignificant. In normal circumstances the kind of boost we’ve seen in the past 12 months would equate to a 20% devaluation of sterling and a halving of interest rates.

The inflation projection in the Bank’s report is based on a curious interest rate assumption but even so inflation will go down to 1%. The letters written next year will be written because inflation is too low, not too high. There will be further aggressive cuts.

Another unknown is to do with the fact that we’ve had a long upturn in the UK. I wouldn’t characterise it as an unsustainable boom because the numbers were not in boom territory. Economic growth tended to be between 2.5% and 3%. These were not numbers like in 1980s but still, we don’t know how the country will respond after a long period of growth.

Many professionals don’t remember the last recession and how people and businesses responded at that time. The present situation is not something with which most people are familiar.

Will this mean that there is resilience there and people expect growth to return, or will it be cumulative in the sense that people are so unused to a downturn that it makes them panic and lose focus?

These things pass. At times like this we always say things will never be the same again but they usually are more or less the same again, after an interval.

Maybe it is the case that mortgage markets will never be the same again but we will return to growth. Even given the gloomy picture from the Bank, we are definitely in a U-shaped recession – there is not likely to be a prolonged period in which the economy is on its knees.

Of course, I may be wrong – I was wrong 12 months ago – but I believe we will return to growth. If we meet this time next year I hope we will have firm grounds for optimism, and I also believe we are not going to turn into Japan, with a prolonged period of no growth along LS with deflation.

Phil Jenks on HBOS and first-time buyers: We tried to support the housing market. We hung in there and got to a situation halfway through this year whereby we had 55% of all first-time buyers taking mortgages from us.

Jenks on HBOS and housing: Neville Richardson on the new norm for first-time buyers:

Will the new norm for mortgages for first-time buyers be 85 or 90%? It depends. The typical recession lasts 12 months so what will things look like at the end of this one? Talking to people at our firm who have been there 25 years, they say that two years before they joined inflation rates were 20%, the year before they were 12% and the year they joined they were 5%. Bob Young on the government’s housing policy:

The government does not seem to have a coherent strategy for the rental sector. De facto, it has acquired a lot of social housing courtesy of Bradford & Bingley and Northern Rock. Where does it fit into the strategy? There does not seem to be one.

Young on debt:

I run a relatively small business and often talk to our borrowers to find out what’s going on. I ask if they are going to pay their mortgages and they say no because they feel that of all the debts they have, we are the least of their problems.

Meanwhile, there is an unreality in saying that house prices are not falling – they are dropping around our ears all over the country.


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