UK lenders can ride the US sub-prime storm

I\'ve mentioned the US sub-prime situation in passing several times in recent weeks, and have dismissed it as a relatively minor threat to the UK industry. Some people have recently asked me to justify that, so here goes.

Many of the characteristics of the UK market and other European markets are fundamentally different from those in the US.

Housing in the UK is undersupplied. Demand is therefore supporting house price appreciation. This protects lenders as LTVs naturally decline as prices rise. US housing has been oversupplied in many areas, prompting a slowdown in house price growth.

When loans have gone bad in the US, lenders have had to recover their original loans, the accrued interest, fees and expenses from properties worth the same or less than at origination.

The product mix in the US is arguably the key reason for the crash in the sub-prime industry. For example, some lenders were advancing 100% loans on a ‘no asset, no income verification’ basis.

Borrowers de-clared how much their houses were worth and how much they earned and len-ders handed over loans equal to the stated value of their properties.

Compounding this problem, these loans often had low initial rates with multiple resets meaning monthly payments rose several times over the life of the loans.

Lenders accepted excessive risks in the US to sustain volumes in the face of competition, relying on the fact that the wider economy would continue moving in their favour.

As interest rates rose and house price rises slowed, losses rose in dramatic fashion.

Lenders in the UK have been more responsible. There has been some criteria creep as risk assessment technology has improved, competition has in-creased and the market has grown, but no lender has approached the US approach to sub-prime lending. So far, so good – lending practices in the UK are sufficiently different to preclude the spread of the US disease.

But the US problems may have an effect on the UK’s capital markets. As the US problems surfaced, securitisation investors demanded higher returns for holding mortgage risk and warehouse banks accelerated lenders’ obligations to repurchase troubled assets. This pushed some lenders into bankruptcy.

Some warehouse banks with significant exposure in the US also finance sub-prime lenders in the UK. If credit committees get jittery, life could get a lot tougher for the UK lenders financed by these banks.

Lenders could also be squeezed if investors in securitisations in this country use US problems to demand higher returns for buying UK mortgage risk.

This would be pretty irrational behaviour because the performance of the UK and US mortgage markets differs for the reasons given above. However, there is a chance that US concerns will make securitisation more expensive for UK lenders.

So, the UK is sufficiently different from the US to ride out this storm. But there is a chance that a few irrational investors unfairly penalise UK lenders even though the market is likely to continue performing above expectations.

See Comment: Learning tough lessons from the US