A buying opportunity or warning of debt crisis to come?
Building credit
Stock Market Turmoil
Investors are being urged to keep their nerve amid a turbulent stock market, with optimists seeing the slide in the FTSE 100 in the last couple of weeks as nothing more than an overdue "correction" and an opportunity to buy shares . But the less confident are getting cold feet as the end of the tax year approaches, with many still to decide where or even whether to invest their 2006-7 individual savings account (ISA) allowance.
The fall in the FTSE 100 share index last week to its lowest point since the
previous May is a result of ripples spreading out from the gyrations of the Dow
Jones Industrial Average across the Atlantic. After a choppy few days, the
London stock market index ended the week down on fears that the Federal Reserve
would fail to cut interest rates later this week.
The weakening of the US economy, which is creaking under the costs of the war in Iraq, has been has amply demonstrated by events in the sub-prime mortgage market, and the evidence shows we are not immune from the effects over here.
Last week trading in the shares of the second biggest US sub-prime lender, New Century Financial, was suspended by the New York Stock Exchange because of liquidity problems. Around 20 sub-prime lenders - who make one in 20 loans to US housebuyers - have already gone bust. Others lenders, such as Countrywide, Ameriquest Mortgage, HSBC Holdings and Fremont General, have also admitted that they are having trouble with their loan portfolios. New Century's share price has plummeted 95% so far this year, while Fremont General shares have fallen by 58%.
So what's the sub-prime crisis all about?
Sub-prime mortgage loans are those made to people with poor credit ratings. As
house prices have risen over the past decade, people with a poor history of
repaying their loans have been allowed to take on increasing amounts of credit.
This was because the lenders knew the loan was backed by a property - an asset
with a seemingly ever-rising value. Lenders have also taken increased risks and
offered mortgage loans to people without proof of income, with an uncertain
earning stream, and often with no deposit.
During fat years, lenders like sub-prime borrowers because they can charge them 2 to 5 percentage points more than they charge for prime loans.
Moreover, the mortgage loans are often bundled together and sold to third parties, or packaged into securities for sale to investors - a process described in Michael Lewis's book Liar's Poker - so the people making the loan get their profit in terms of fees, and pass on the actual risk.
But the higher interest rate comes with a downside. When the lean years come, these mortgage loans - which are of their essence made to people who are more likely to default - become still harder for the borrower to repay, because of their above-average interest rate, and therefore in many cases may not be repaid at all.
The problem is that any hiccup in the US economy can cause the delicate ecosystem to collapse. Borrowers start to default, and lenders repossess homes and sell them cheaply to recover their money. Meanwhile, other discomfited borrowers, or simply ordinary sellers trying to move house, find prices depressed by the glut of repossessions, and a downward spiral takes hold. One consumer group said it believed that 20% of the $1.5 trillion (!) or so in sub-prime loas funded over the last two years will eventually end up in repossession, and estimated that as many as 1.5 million Americans could lose their homes.
UK banks with exposure in the US have not escaped the carnage, Barclays has just foreclosed on a loan of £464 million to New Century Financial, but it said that its relationship with the lender did not pose a significant risk. HSBC recently announced that it was putting $10.5 billion aside to cover loans likely to go bad, mostly from its Household Financial unit in the US.
It can't happen here - or can it?
While most analysts do not believe that the US crisis will have a major impact
in the UK - or at least they are saying they don't - this might not always be
the case.
It is not just that UK banks have exposure in the US. US banks have joined the sub-prime jamboree over here. Britons have plunged into sub-prime like it's going out of style, often for no better reason than they can't be bothered to gather their payslips together to prove their income.
Among the Americans with a foothold in the UK, US investment bank Lehman Brothers is now offering a new range of buy to let products through Alliance & Leicester. Meanwhile, Lehman's Southern Pacific Mortgages and Rooftop Mortgages, backed by. Bear, Stearns and Crown Mortgage, are both heavily invested in the UK sub-prime and "heavy adverse" sectors.
So, will the UK's borrowing chickens come home to roost? Data from the Bank of England suggest that they might well do. So-called "specialist" lending in the UK has risen from 6% of all mortgages in 1996 to 26% last year, reaching £281bn.
At the same time, over the last few months, interest rates have been creeping up. The Council of Mortgage Lenders says it does not see any halt to the upward trend in house prices, but it has noted that the fear of higher interest rates has led to a record number of first time buyers choosing a fixed-rate loan.
Banks and building societies have been steadily increasing their exposure to the sub-prime sector in pursuit of juicy profits. The FSA, in its 2007 Risk Outlook, warned, "Like the banks, some building societies have also moved into new, higher-risk areas of business, such as commercial and sub-prime lending...
"For some building societies these higher-risk activities are relatively unfamiliar areas of business... Overall, credit quality in the building society sector still appears to be relatively good. However, the equivalent figures for building society subsidiaries (which hold a significant proportion of the sub-prime, buy-to-let and other non-standard lending of the sector) are currently at more than five times the building-society-only number."
A recent Bank of England survey estimated that nearly 6 million people felt they were currently struggling with their finances, while the number of households struggling to repay their mortgage debt had risen to 7.7%.
Repossessions in the UK have crept up to the highest level since the early 1990s. During the fourth quarter of 2006, 30,349 mortgage possession actions were started, 2% lower than in the fourth quarter of 2005. However, in the previous quarter, 34,626 mortgage possession actions were initiated by banks and other lenders, a huge 15% increase over the third quarter of 2005.
Debt charity Credit Action estimates that almost 300 people are becoming insolvent each day as the number of UK personal insolvencies continues to increase, with 29,804 individuals entering into bankruptcy or an IVA (Individual Voluntary Arrangement) during the final quarter of 2006. The figures represent an increase of 7.1% on the previous quarter, and are 60% up on the previous year.
Steve
Treharne, head of personal insolvency at KPMG, said,"You could
more than fill the new Wembley Stadium with those who have formally become
insolvent in 2006."
Cash-strapped borrowers will have their fingers very firmly crossed that interest rates will at least remain stable in the next few months, and don't rise further so that those self-same fingers don't get very badly burned.
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