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Making sense of uncertainty

The recent Lending Strategy lunch with Sunday Times economics editor David Smith generated a fascinating debate about the future of the market and provided food for thought for the group of industry leaders.

Top of the agenda was the well publicised funding difficulty that has persisted all year, how the authorities have responded and what could have been done differently.

Of course, one critical issue was the divergence between market rates and the Bank of England base rate. Three-month sterling LIBOR has generally tracked way above base rate, reaching a massive premium of 170 basis points in October. In January LIBOR was fixed slightly below base rate – once. This demonstrates the extreme volatility of the markets and the disconnect between base rate and money market rates.

This rise in funding costs reflected the severe squeeze in the availability of funds as lenders became increasingly nervous about counterparty risk, restricting their credit lines, reducing maturities and holding on to liquidity.

In this environment, and with growing concern about the credit profile of mortgage books, the doors of the securitisation markets slammed shut, specialist lenders struggled to fund any new originations and sub-prime and self-cert virtually evaporated.

Participants in the interbank markets were right to be nervous about counterparty risk in Europe and the US. Without going into the well documented details, the extraordinary events involving well established brands such as Lehman Brothers, AIG, Lloyds TSB and HBOS wreaked havoc throughout the financial markets and the global economy. In fact, it created such a mess that drastic action was required.

As the clamour for interest rate cuts grew, some called for a 1% reduction. Then the BoE’s Monetary Policy Committee took the wind out of everyone’s sails by slashing rates by 1.5%, the biggest cut since 1981, bringing the base rate down to 3%.

What were we to make of that? Was the BoE more scared of the looming recession than inflation? Was the MPC starting to worry about the spectre of deflation? Indications from the Bank that rates may be cut even further raised the possibility that base rate could fall to zero – not something we are accustomed to, although it’s not unknown in Japan.

In any case, the message from those at the Lending Strategy lunch was that there will be further aggressive rate cuts as the Bank works increasingly hard to prevent inflation from undershooting the government target of 1%. The letters from BoE governor Mervyn King to the chancellor next year will be because inflation is too low rather than too high.

Clearly 2009 will be a difficult year – King has said as much – so it was perhaps surprising that the industry leaders were not irredeemably gloomy.

The latest thinking from the BoE implies that we have reached the bottom of the cycle and the economy won’t get any worse. At the lunch, Smith reassured everyone that while we may have a year or so of recession, we will come through the turbulence without too many battle scars. An optimistic view to give us some cheer, although the one thing we all agree on at present is that nothing is certain and little can be predicted with confidence.

And what of the housing and mortgage markets? While there was some difference of opinion in terms of the extent of, and reasons for, house price falls, there was broad agreement that the lack of availability of mortgage finance, combined with the evaporation of confidence, were key reasons for falling property values. Other factors mentioned were repossessions and estate agents cutting prices to achieve sales.

On the other hand, with prices expected to weaken further, there will come a point where there are good deals to be done and some will buy properties at what they see as bargain prices.

There are already signs of a similar situation in the stock market, which is traditionally the first index to move when things are about to take a turn for the better or worse. The low returns on cash savings as interest rates decline may provide impetus to invest in property again. Once professional investors start buying, it will be a signal that property prices are near their bottom.

The other piece in the puzzle is finance for home purchase. Mortgage lending looks pretty grim at the moment. Gross volumes crashed 45% between September 2007 and September 2008. On a net basis, mortgage lending went negative in August 2008 – unknown in modern history – although it did return to positive territory in September, with some £2.2bn lent. But that compares with a near-record net outflow of mortgage funds of £10.3bn a year earlier.

Even so, mortgages are still available for prime borrowers, albeit with LTVs well short of the 95% we became used to. On the other hand, sub-prime, self cert and non-conforming customers are struggling either to find loans for property purchase or to remortgage.

From the lenders’ perspective, there was concern that while the government says it wants lending to increase, restrictions placed on building societies and banks in terms of limiting lending, pushing for the repayment of wholesale borrowings and regulating liquidity and money market activity are having the opposite effect.

There is a tension between the authorities’ desire to protect the safety and stability of the financial services sector while at the same time taking a pro-consumer view to try to free up mortgage finance and help borrowers in difficulty to remain in their homes. With government-owned banks, this issue is particularly telling.

The other hot topic is consolidation – the effect bank mergers will have and the impact on the industry as the cost of support arrangements is passed on to the Financial Services Compensation Scheme.

There was an element of disagreement as to whether the actions taken by the government and the Financial Services Authority in facilitating the bailouts were appropriate, or whether there was any real alternative. Anecdotes about the rescue package being hammered out over a weekend highlighted the fact that this was policy made on the hoof by individuals who had never experienced this type of situation before. Indeed, this is one of the problems of the year’s events – nobody has encountered anything similar in their professional lives so the resources to deal with it were not readily available.

While some commentators have raised concerns about the possibility of megabanks dominating the market and upping their pricing, the first challenge they face is integration. They will need to integrate networks of branches and combine and rationalise management and staff, not to mention attempt to fuse cultures.

In operations, they will be presented with multiple, no doubt incompatible legacy systems – and we know only too well that large banks don’t always have the swankiest technology.

For HML the trend towards bank mergers is an opportunity as it will provoke a review of IT systems and allow us to demonstrate our credentials in providing high added-value, scaleable outsourced solutions to lenders that can be implemented quickly. In the short term, the consolidation and integration process may be a distraction from the business of getting the market back to normal but we can play an important role in supporting operational integration.

One interesting topic of debate was the impact of the media on the housing market, the economic environment and consumer confidence.

We all know that bad news sells newspapers more than good news, and that can propagate despondency among the populace, perhaps unduly. While unfavourable news cannot be stifled, Smith suggested that the multitude of housing market indicators means the same negative story about house prices is told and retold. And in many cases the data does not tell the whole story – a health warning may be needed. One option suggested was that all house price data could be published simultaneously.

Smith recounted an anecdote told by a colleague who was working as a journalist during the downturn in the 1970s. As time went on, journalists got to the point where all the interesting stories had been written and nothing much was happening. Frankly, it got boring. So this time round, there may come a time when more cheerful news is what the doctor ordered.

The BoE has acted to provide liquidity and ease the logjam in the wholesale markets and what the sector needs now is a dose of confidence and a kick-start.

It was clear from the table talk that nobody (including the Bank) thinks an acceptable level of mortgage finance can be funded from retail deposits. Some kind of wholesale funding model will need to emerge. Lenders must embrace it, and borrowers will need to have confidence in it and in the stability of house prices.

To get things moving, the market is going to need some nerve. Financially stable lenders will need to start pushing the LSboundaries of what they are offering – higher LTVs, better deals, more attractive pricing. Naturally the wider economic environment, consumer spending, inflation, and business confidence will have a big impact and there will be no return to normal for the housing and mortgage markets as long as the economy as a whole is in the doldrums.

Ultimately, it’s in everyone’s interest that the mortgage industry begins the process of returning to normal. That means freeing up liquidity, offering a range of products to a wider cross-section of customers and working with existing borrowers to keep them in their homes.

There was consensus around the table that shutting up shop or burying our heads in the sand is not the way for the industry to get through.

The sector plays a crucial role in the UK and it must now lead from the front with a positive approach. Debates such as the Lending Strategy round table help by bringing the key players together, and HML was delighted to play its part in helping to facilitate this.


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.

Money for green and transport measures

The government has pledged 100m towards insulating 60,000 homes and 535m has been committed to energy efficiency and improved rail links.

The end is nigh for securitisation deals

In a move that went largely unnoticed last week, a fatal blow was delivered to the embattled securitisation market. Indicating that there is no government appetite to allow it to continue, Granite, a £36bn behemoth in the sector and the main securitisation master trust for Northern Rock, issued a non-asset trigger.


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