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Looking forward to recovery

We have seen a sea change in the performance of the household sector in relation to debt and borrowing in the past 18 months.

Much of this has been accelerated by the reduced supply of credit and fall in property values. The true balance sheet of the household sector has seen a slowdown in the growth of mortgage and other debts while income growth has remained steady.

Figure 1 shows the mortgage debt to income ratio in the past 30 or so years. There are 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. But following the protracted economic downturn of the early 1990s the ratio started to rise sharply again, reaching a record 1.35 in 2008. Lower interest rates and much higher house prices enabled the household sector to increase debt levels while only experiencing a modest increase in the mortgage debt to total wealth ratio (see Figure 2).

The measure of total wealth used includes both housing and financial wealth and as a result there is a sharp rise in the ratio in 2008 which largely reflects declines in house prices and the equity market during the year.

Looking to the medium to long term it is interesting to review a few scenarios for the mortgage debt to income ratio and their implications for the size of the mortgage market.

Figure 3 shows our forecast for the debt to income ratio from 2009 to 2015 (shown in blue). I have added a more optimistic scenario (flat debt to income ratio) and a slightly more pessimistic forecast with the debt to income ratio heading back towards 2002/03 levels.

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

The main forecast shows the debt to income ratio easing from 1.35 to around 1.1 at the end of the forecast period. This implies that gross lending will average around £195bn a year, with net lending of around £22bn a year. If you consider a sharper decline in the debt to income ratio this would imply negative net lending for several years as accelerated mortgage repayments and depleted new lending see the market shrink.

The pessimistic scenario looks at a sharper adjustment in the debt to income ratio. This results in net lending averaging only £12bn a year and a gross lending figure of nearer £178bn. This represents gross lending of less than half that recorded in 2007 and much closer to the levels experienced in 2001.

The optimistic scenario shows a quicker recovery in confidence and borrowing. The debt to income ratio remains flat and sees mortgage debt grow in line with income. This implies net lending of around £50bn a year and gross lending of £240bn.

For this to happen we would need to see a rapid turnaround in the housing and equity markets which seems unlikely, but forecasters frequently get caught out when recovery starts.

The short-term outlook for the mortgage market is gloomy but some debt adjustment has already occurred and pressure should start to ease by the start of 2010. The data makes painful reading but the absence of growth in mortgage debt this time should put us in a better position for the recovery.

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