Are house prices heading for a painful correction or will inflation continue its upward spiral? Harriet Williams reports on industry predictions for the year ahead while Stephen Knight, executive chairman of GMAC-RFC, says lenders seeking relationships with large intermediaries will need to develop remote processingExtra! Extra! Read all about it: House prices set to tumble Forecast fuels negative equity fears Odds shorten on severe correction…
To believe some of December's headlines, the housing market is set for anything but a happy new year.
From City economists to taxi drivers, pundits everywhere are getting fired up for a painful housing market correction and the consumer press has been having a field day. The language may not be so blunt in the corridors of the Bank of England, but the shapers of monetary policy are concerned.
Mervyn King, Bank of England governor-in-waiting, has warned of a “growing risk of a sharp correction” as long as house prices continue to soar upwards. Explaining its decision to leave rates on hold at the tail end of last year, the Bank's Monetary Policy Committee sees “little sign that the house price boom is drawing to an end”.
Even as an ailing manufacturing sector cried for a further rate cut to guard against a weaker than predicted economic outlook, the MPC was forced to tread the non-inflationary path with a 4% freeze. MPC minutes reveal that “a reduction in interest rates now risks stimulating house prices and household borrowing even further”. Furthermore, this would increase “the risk of a sharper fall in consumption at some point in the future”.
Essentially, the policy-makers are playing a waiting game. Monthly house price inflation increases of over 4% will have to moderate some time. The key question is when.
Nationwide hedges its bets on 2003 by picturing two very different scenarios – one which adds another 25% to house prices over the year and one where the market slows sharply.
“In the first case, growth persists on the back of unrealistic expectations on the part of borrowers. This stores up considerable risks for 2004, as it is likely the MPC would have to respond by raising rates at the same time as confidence and expectations nosedive,” says Alex Bannister, group economist at the building society.
“The alternative scenario sees confidence reduce and the market slow sharply in 2003 before stagnating in 2004.
“There remains a responsibility on the part of lenders and borrowers to be prudent,” he adds. “If they ignore this advice in a low inflation environment, where debt is not eroded quickly, the risks of a correction in the housing market increase.”
Consumer behaviour is a fickle beast. As the Bank of England says in its latest Financial Stability Review, the outlook is difficult to assess because of the uncertain dynamics of the housing market.
“One of the risks is that the exceptional rate of house price increases might continue for a while, leading ultimately to a more abrupt adjustment in both the housing market and consumers' balance sheets,” it says.
The longer house prices continue to rocket, the more painful the trip back to Earth will be. In the meantime, the MPC cannot risk lighting the touchpaper of an even larger house price boom with a rate cut.
Martin Ellis, group economist at Halifax, says the bank has had to revise forecasts upwards in 2002.
“I think the strength of house price inflation took everyone by surprise,” he says. “One thing we've underestimated is the response to a low inflation, low interest rate environment, where people are willing to take on a bigger mortgage than we thought.”
Halifax predicts that the annual rate of house price inflation will fall by two-thirds next year to just 9%, still above the long-term average of 7%.
This is broadly in line with Nationwide's central prediction that price growth will reduce to 10% in 2003 from around 25% in 2002.
Other house price calculators come up with lower numbers.
John Wriglesworth, chief economist at Hometrack, says the market is already slowing at the top end in London, with a 5% drop over the last three months on houses of over £500,000.
“I think 2003 will be a story of two halves,” he says. “There will be some falls in London, which will see prices down 5% by the end of the year. But I see the rest of the country maintaining momentum, so on average national house prices will rise 4% in 2003.”
Within the overall national figure, Halifax and Nationwide predict the slowest growth for London and the fastest for the North. Halifax says these trends should narrow the North-South price gap to 60% from its current 83%.
Prices in London are expected to increase by a modest 2% next year as the level of property prices in relation to earnings limits demand. A rise of 3% is forecast for the South-East as a whole and 5% for the South-West.
By contrast, northern England is expected to enjoy the biggest rises of between 13% and 16%, closely followed by Scotland at 12%.
Martin Ellis predicts 2003 will be “the year of the North” and the North-South divide will begin to narrow.
Despite underestimating house price rises in the past, Halifax is confident that price to earnings ratios will decelerate inflation and that last year's rises will not be repeated.
“A lot of the recent inflation looks like a one-off adjustment in a permanently low interest rate environment,” says Ellis. “Rates are at the bottom of the cycle now. We expect base rates to increase to 4.5% by the end of 2003 and to increase over two years, but within much narrower bands than the UK economy is used to.”
As to the oft-predicted but rarely seen housing market slowdown, Ellis insists it will take place even if a low rate environment looks set to stay.
“Prices have risen so much faster than earnings,” he says. “More people will find it harder to come to the housing market, which will be a natural force constraining the excessive growth of prices.”
While senior economists try to talk the housing market into a soft landing, memories of boom and bust are hard to erase.
In its Financial Stability Review, the Bank of England quotes several key indicators that are reaching “early 1990s levels”. These figures include a growth rate in household borrowing that hit over 13% in the year to the third quarter of 2002, the “highest since 1990”. Meanwhile, the household sector's debt to income ratio pushed to 120% in the second quarter of 2002, “over 10% above the peak of the early 1990s”.
The Bank says this primarily reflects the strength of mortgage borrowing, which accounts for over 80% of total household debt, and which grew by a further 12.4% in the year to quarter three.
“The robustness of mortgage borrowing reflects such inter-related factors as low interest rates, intense competition among lenders, buoyant housing market activity and above all, house prices currently rising at annual rates of around 25% to 30%,” it says.
But the strength of the housing market is keeping debt-laden consumers afloat. As the Bank's review points out, “despite rapidly growing debt and lower equity prices, the deterioration in the household sector's balance sheet position has been limited”.
This, it says, largely reflects the buoyancy of housing wealth, which accounts for about half of household's gross assets.
Terms like buoyant and confidence can prove famously short-lived in economics. The Bank finds that household ability to absorb “unexpected increases in payments or falls in income” – higher interest rates or unemployment – is shrinking. “These developments have raised further the vulnerability of the household sector to substantial rises in interest rates,” it says.
In contrast to the high base rates that heralded the end of the last house price honeymoon, a low interest rate environment has characterised recent monetary policy. Rates have now been on hold at 4% for 14 months. The Bank of England, however, finds consumers are comfortable with increasing debt. “Lending to households, both secured and unsecured, has continued to grow rapidly, without any signs of a significant increase in defaults by borrowers,” it says.
“Households' confidence in their own financial position – if not in the wider economy – remains robust [and] does not point to a marked weakening in their prospective appetite for debt.”
Mortgage lenders have whetted consumer taste for debt via product design that makes equity drawdown a convenient and cheap way to access extra money. The Bank attributes half of new borrowing in 2002 to mortgage equity withdrawal – a trend it partially ascribes to competition and product innovation in the market. The advent of flexible mortgages in particular is consistent with equity drawdown.
Many householders are using remortgage and drawdown as a substitute for new unsecured debt. However, credit card lending continues to rocket, rising by 19% over the past year.
Although homeowners might look overstretched on paper, economists say repayments are not a big strain.
Halifax's Ellis believes that it would take a large interest rate rise to do much damage. “People aren't really overstretched,” he argues. “For instance, a new borrower pays on average 15% of gross earnings on mortgage payments. That is low in historical terms. While rates stay low, higher levels of debt are serviceable. Plus we've seen a big increase in the amount of equity people have in their homes thanks to the sharp rise in house prices.”
But the Bank's review warns that some households may believe that sustainable debt levels have risen and that this perception could change rapidly if interest rates were to rise substantially, if their incomes were to fall or if the UK saw a rise in unemployment.
“Furthermore,” the Bank warns, “the perception may not fully take into account the persistence of the real burden of debt in a low inflation environment.”
Picturing the worst case scenario, the Bank asks what would happen if a slowdown in house price inflation is accompanied by rising unemployment. “The consequences are likely to be most severe for those households whose income gearing is highest and whose loan-to-income ratios have become most stretched recently,” it concludes. So borrowers forced to take the highest income multiples and loan-to-values on offer could be vulnerable.
The National Association of Citizens Advice Bureaux has already described a Bristol & West 颼 plus' deal – a secured 95% LTV mortgage plus a 15% second charge launched in December last year – as a “gamble that prices will keep rising”.
However, fixed and capped rates can shelter borrowers against the winds of economic change too. Strong competition between lenders is driving prices down.
At Hometrack, Wriglesworth says borrowers should be reaching for fixed rates. “They plan to be homeowners for a period of time, and fixed rates are a kind of insurance policy.”
Meanwhile Ray Boulger, senior technical manager at Charcol, is urging anyone looking for payment security to take advantage of the “current crop of market-leading fixes before they are replaced by more expensive deals”.
But others say the best is yet to come. Paul Banfield, partner of Sutton-based Best Advice, says that with the market starting afresh in 2003, lenders will be hungry to meet new lending targets and will reduce fixed rates purely to attract business.
“Early this year will be a good time for homebuyers to achieve a winter bargain, for competitive fixed rates – and for brokers to arrange a lot of mortgages.”
Additional reporting by Helen McCormick
House price inflation – past, present and future
2001 (Q4) 2002 (Q4) 2003 (Q4)
Region actual estimate forecast
North 12 20 16
Yorks & the Humber 12 25 15
North-West 8 30 13
East Midlands 12 41 10
West Midlands 7 38 11
East Anglia 20 25 4
South-West 16 27 5
South-East 15 22 3
Greater London 17 17 2
Wales 7 16 11
Scotland 5 13 12
N. Ireland 7 10 10
UK 12 29 9
The annual rate of house price inflation is forecast to ease to 9% in 2003, with the North-South divide expected to narrow significantly over the coming 12 months Source: HBOS
What do you think is in store for the mortgage industry?
Kevin Morgan, director of Hertfordshire-based EZI UK. “Interest rates, inflation and all other economic indicators are headed south, yet house prices are going north – it is just not sustainable. I think property prices will come down 15% in the next year, maybe 20% in London. Product-wise, I think offset will boom as borrowers seek remortgage and debt consolidation.”
John Stewart, director of Basildon-based PMI Independent Financial Advisers. “Short-term fixed rates are very popular at the moment and there is every reason to think this trend will continue in 2003. January and February are normally buoyant anyway as people look at their credit card statements, realise just how much money they have spent over Christmas and remortgage. I doubt that mortgage rates can now get any lower. Fixed rates have started creeping up, and people are becoming more cautious. But I doubt the base rate will rise. And the best product always depends on the client's circumstances, some are better off with flexibles.”
Bob Riach, proprietor of Scunthorpe-based Riach Independent Financial Advisers. “Fixed rates will definitely be popular. Some have already started going up. But I wouldn't be surprised to see another 0.25% drop in the base rate, and certainly don't expect to see any massive rise over the year, although that depends on what happens in America. House price movements will still very much depend on area. Prices are starting to drop in London, but we are always a year behind in this area, and prices will keep rising or perhaps stabilise in the North. But something needs to be done, because first-time buyers simply cannot afford to buy, even here, as earnings just aren't rising in line with house prices.”
Phillip Ambler, IFA, Chesterfield-based B Ambler Independent Financial Services. “The housing market has got three years or less. Either interest rates will rise, making buy-to-let less attractive and flooding the market with cheaper properties, or Right to Buy properties will come onto the market as people sell them on. This will lead to a big drop, or possibly a double whammy if both happen at once. But next year is unlikely to be dramatic. Decent fixed rates without tie-ins or redemption penalties are very attractive at the moment. The base rate is unlikely to move much, the UK is doing well out of the world recession.”
Mike Fitzgerald, sales director, Brentwood-based Brentchase Financial Services. “House prices will go down, especially overpriced luxury loft-style or riverside apartments. Three-bedroom semis which haven't gone through the roof will continue to remain good value for money. Prices will meander down all over the country, which is a great thing for the market and will prevent a crash. It will also enable first-time buyers to come back into the market in the spring. Some lenders' fixed rates have gone up a little, but people will be looking for the security of these products in this climate, especially in the reality-check after Christmas.”
Mark Osland, director, Croydon-based Fidelius. “There is talk of the base rate going up but this is unlikely to be significant. Redundancies will have a knock-on effect on property prices, dampening down the market fairly quickly. Fixed rates are what people want, although if they think interest rates will remain stable then many will still want discounts. Fixed rates have gone up slightly, but short-term products remain popular because many people think any rise will be small and temporary. There is still a lot or remortgaging going on. There are extra opportunities for those of us who are fully qualified at the expense of those who aren't.”
Clive Watkins, sales and marketing director, Derby-based Members Mortgages. “The buy-to-let market will continue to be robust into this year. With all the current kerfuffle about pensions, a lot of people will look at other ways of getting long-term returns on their money. I can't see there being many pressures on interest rates either up or down, and they are likely to stay around 4% for some months. Fixed rates become very popular in the mid-term of a government, while election time tends to be more volatile as far as rates are concerned. Two-year fixed rates will be popular next year, taking borrowers towards the end of this parliament, with a rethink nearer that time.”
Nigel Speirs, chief executive of Rhyl-based Buckles Investment Services. “I don't think interest rates will move an awful lot, and if they move they are likely to hitch up slightly rather than down. I wouldn't be surprised if the situation in 12 months' time is very similar to what we are seeing now. Discounts are incredibly cheap if this happens, and will stay very popular. The rate of house price increases that we have seen has got to stop, it simply isn't sustainable, although I don't believe a huge drop is at all likely. A bit of a correction is inevitable, which will be hard for people buying houses now.”
David Ellingworth, managing director of Manchester-based Effective Financial Planning. “Demand is finally being exhausted in the South and I think the North will have its time in 2003. A lot of our London-based clients are buying second or third properties in the North to let and I think growth in the northern market will outpace the South. I think everyone fears rate rises. Fixed and capped products will be popular next year. If base rates creep up to 4.5% or 5% I think we'll see people follow the herd mentality to a fixed rate.”
Paul Banfield, partner in Sutton-based Best Advice. “I can't see any major decline in house prices. There could even be a steady rise in the spring, and prices won't tail off until autumn 2003. With the market starting afresh in 2003, lenders will be hungry to meet new lending targets and will reduce fixed rates purely to attract business. Early this year will be a good time for housebuyers to achieve a winter bargain, for competitive fixed rates and for brokers to arrange a lot of mortgages.”
Expect more growth, fierce competition and product innovation
Stephen Knight, executive chairman, GMAC-RFC. According to the latest CML estimates, gross advances will break through £215bn this year – a new record. But how did we get to a market this large?
I don't propose to rake through all the history, I'll just pick on a few recent factors. Subsidised new business rates, introduced to keep some kind of volume going in the last housing market recession, have stayed with us, stimulating stronger consumer demand. Product and distribution flexibility has expanded to address this demand while access to international capital markets has allowed lenders to offer customers wider choice.
A combination of low interest rates, affordability, benign inflation, low interest rates and economic growth have all contributed to this. And the mainstream commoditisation of new lending areas such as buy-to-let, self-cert and sub-prime has combined with consumers' never-ending love affair with property to make housing possibly the most important economic factor now facing the government.
So what's next? Going forward, the main worry is a correction in house prices. Will this be the so-called soft landing, where the rate of average growth falls? Or will it be a crash, creating negative equity of the type we saw in the early 1990s? The truth is that nobody knows for sure. However, there are many more factors pointing to continual house price growth (albeit more modest than has been experienced over the past year), than the opposite.
For example, demographic factors point to a shortfall in housing supply versus the demand for household creation. Massive increases in interest rates are not expected. The economy is expected to continue growing. With equity, bond and cash deposit investment alternatives looking sad in comparison, the balance of probability is that the position with house prices looks OK over the medium-term.
Lender consolidation remains very much on the agenda because there is still over-supply. Distribution organisations which have evolved recently, e.g. packagers, networks and mortgage clubs, are going to have to continue adding value or disappear. Large intermediaries will get bigger and smaller firms will exit or club together. And we will all have to deal with regulation.
It's not just the legislation that this government introduces which will have an effect, although that will change the way mortgages are sold and put all lenders under greater scrutiny. There is also the Basle Capital Accord coming along in a couple of years, which will force lenders to allocate capital according to the type of assets they take on. This is bound to produce distortions and new initiatives. We also have European directives potentially clashing with our own legislation, adding further layers of supervision.
I don't see regulation as doom and gloom. Good regulation usually means good practice which in turn means good business. But all these new rules in a short space of time will need absorption. I see the changed behaviour and market distortions arising from this market prescription as being the most important factor for all players to cope with, rather than some of the macro-economic issues typically raised as the industry's immediate challenges.
In theory, the UK mortgage market should be moving back to equilibrium pricing where new and existing borrowers pay the same. This is what happens in every other mortgage market around the world and what happened in the UK prior to the most recent recession. It's hard to knock the theory. There must surely be remortgage saturation at some point where all the inert customers have taken advantage of the new business offers. But it's all taking a lot longer than many experts predicted. Moreover, lenders can't force the pace (witness the loss of market share experienced by Nationwide when it attempted to do this).
So, while a reduction in the amount of new business subsidy will be a feature of the market over the next few years, it won't necessarily reduce competition. It may simply reduce the threshold which triggers competition. In the US, for example, borrowers are willing to remortgage to save one quarter of 1%, sometimes less on a fee-free deal.
Fierce product competition is likely to be a feature of the market in the foreseeable future. As competition has intensified, everybody has an opinion on what is a good and bad product. Unfortunately, because a lot of this thinking is shallow, products which can do a lot of good are criticised, whereas products that can do a lot of harm are sometimes praised. That is the danger of non-experts (in the media, in the regulatory authorities or elsewhere) getting prescriptive about product design.
A good example of a product that has been all but outlawed is the large cashback or front end giveaway secured by a redemption charge for the first three or five years. Lenders didn't make those products up and force them on customers. They evolved because customers wanted them. Certain customers need help with budgeting. As long as the redemption charge is made absolutely clear on the offer, this is a judgement that the customer should be able to make.
Competition is such that no major lender strays outside a narrow band of market rates for existing borrowers irrespective of whether redemption penalties are outstanding or not. To do so would be reputational suicide. These products can therefore do a lot of good. But very few of these products are available because commentators have taken it upon themselves to assume that customers shouldn't have that particular choice, criticising any lenders who offer them.
In contrast, flexible and CAT mortgages have been promoted as being good even though customers pay quite a bit more than if they went for the best new business incentive they could get. This is a waste of money in the case of flexible mortgages if the flexible features are not used, and recent research indicates that up to 50% of borrowers don't use the flexibility they think they're getting in return for less of a new business incentive. CAT mortgages are even worse, with customers hardly able to contain their indifference.
Another area where the non-experts get their knickers in a twist is in relation to borrowers' ability to repay. Guessing somebody's nominal ability to afford the repayments tells you very little about whether they will actually pay. The current situation is that most lenders tell borrowers they can't afford 5 x income today, but the level of repayment accompanying 5 x income is the equivalent of 3 x income a few interest rates ago, when we told them they could afford it.
In fact, borrowers' attitude to credit is the most important factor in predicting future delinquency, i.e. do they have existing credit and have they performed on it? If they do and they have, you can easily dispense with nominal income checks because you will have secured the most important underwriting factor. This is the responsible underwriting call for most borrowers. Those who insist that lenders slow down the mortgage process to gather paper-based information are doing the market a disservice.
While I have no doubt that product design will continue to get more sophisticated, this process is hampered by commentators who think they know best about what customers should have. Choice and transparent terms should be the overriding first principles.
What I imagine most in the market will agree on is that service in the mortgage industry is not good enough and has not coped well with the massive year-on-year increase in new lending. The main reason is the old-fashioned paper chase that characterises mortgage processing. All this paper has to be gathered which causes delays and service blow-ups. The only way the mortgage industry can cope with the sort of growth expected in the future and offer decent service is if automated decisioning substitutes paper gathering.
A customer should be able to go to a broker (and in due course even onto a website), have appropriate details keyed in and then receive a point-of-sale offer subject to no further referencing and contingent only upon the valuation report. Credit searching and scoring are sufficiently predictive to ensure that any given portfolio of loans performs more or less as you expect it to. We're going to try and crack this.
If we can also crack the database-versus-personal valuation issue, that document delivered at point-of-sale could then be the mortgage offer itself. With technology capable of delivering that, it is a mystery why the government is continuing with seller's packs. These will deliver at some expense an array of information that purchasers will not or should not trust without independent verification, while slowing down the supply of second-hand homes to market.
As well as automated decisioning, lenders who are seeking relationships with large intermediaries need to consider remote processing, where the lenders put the systems and people in place to enable significant introducers of business to control the process right up to completion. Whatever problems lenders may have in servicing at any given time, the intermediaries and their customers benefiting from a remote processing package do not suffer.
GMAC-RFC was the first company to implement remote processing into the UK mortgage market when we introduced correspondent lending in 1998.
New groupings to the fore
I've already suggested that the big intermediaries will get bigger and the smaller ones will either exit or club together. Packagers, networks and mortgage clubs will continue to have a role to play, particularly in remote processing, local distribution, product design, training and compliance. Hopefully we can remove from packagers most of the pre-offer time-wasting paper gathering to make their businesses more focussed and profitable.
There are, of course, those who disagree with this view. One lender is so sure of its position that it feels able to insult the packaging industry as a whole while patronising a small group with a seal of approval. It may create a bit of noise while it lasts, but I doubt it adds much to anyone's serious distribution planning.
Networks, clubs and, perhaps, new types of groupings will be key to helping smaller intermediaries and a lot of this is what good packagers do best. We are therefore looking to focus our help on the bigger intermediaries while ensuring that we have value-added packages for all.
In short, the UK mortgage market has been a major success story, turning the worst ever recession of the early 1990s into the massive economic influence the housing and mortgage markets are today. Challenges exist on all fronts and those who get on with implementing the best thought-out strategic decisions will come through. Big lungs don't necessarily mean big ideas, so look out for those making good decisions. They won't necessarily be the people making the loudest noise.