Bad News For Homeowners And Lenders!

The Crosby report -- a review of the UK mortgage market -- came out on Tuesday morning. It makes grim reading for property owners and investors.

According to figures released on Tuesday by the Bank of England, the future looks increasingly bleak for British homeowners and lenders.

Property sales tumble again

The Bank of England revealed that a mere 36,000 homebuyer mortgages were approved in June. This figure has fallen for fourteen months in a row and is now the lowest since the bank began producing this monthly series in 1993.

Furthermore, the next set of figures from the Council of Mortgage Lenders will probably be the worst on record since mid-1974. So, forget the last property crash, because things are as bad as they were in the early Seventies! (Many thanks to property guru and Fool hero globalarbtrader for analysing these data in this excellent post.)

What's up with mortgage lending?

The big problem is that the market for residential mortgage-backed securities (RMBS) is effectively dead. This involves lenders packaging up bundles of mortgages and selling them on to investors in the form of bonds, a process known as `securitisation'. Until last year, (mostly overseas) investors such as fund managers, insurance companies and other banks were very keen on the high yields (income) paid by these bonds.

Then the credit crunch happened, confidence was lost, and buyers of RMBS went on strike. As a result, one of the key props for the property market was pulled away, leaving banks badly short of funds to lend to companies and individuals. (For the record, UK banks have issued fifty times as much RMBS as building societies. This explains why banks, not building societies, are in line for most of the mortgage agony!)

Desperately seeking solutions: the Crosby report

Having promised `no more return to boom and bust' while Chancellor, Prime Minister Gordon Brown is desperate to avoid a full-blown property crash on his watch. Hence, in April, Chancellor Alistair Darling asked Sir James Crosby, deputy chairman of the Financial Services Authority and former chairman of HBOS, to conduct a review of the outlook for mortgage financing.

This morning saw the publication of Crosby's interim analysis into mortgage finance (the final report is expected in October). In forty pages, the report explains that there are no quick fixes to be found, and the situation is unlikely to improve in the immediate future. Indeed, it warns that it will take years for banks to adjust to this new era of lower leverage, and levels of new lending will remain low well into 2010.

The Crosby report suggests the creation of one or more `gold standards' for issuers of these securities. This could increase transparency and simplicity. Another option would be to set up an exchange to allow these bonds to be priced and traded in a similar fashion to shares. However, improved market efficiencies alone would not be enough to reproduce previous levels of demand for RMBS.

Another proposal would be to broaden the Bank of England's Special Liquidity Scheme, which allows lenders to exchange existing RMBS for more liquid government bonds. However, extending this £50 billion scheme to include new issues of RMBS, while improving liquidity, could expose the Bank to financial and legal risks. Another non-starter, perhaps?

The new reality: lower lending and higher rates

At present, mortgage-backed securities simply aren't attractive enough to investors, who have had their fingers burned by the collapse of existing bonds. One way to improve the appeal of these packages of mortgages would be to bump up their yield. However, this would involve a significant rise in mortgage rates, which would have to go up by about a quarter (25%) to, say, 7.5% a year.

Of course, higher funding costs for mortgage lenders mean higher prices or lower availability for borrowers. This would be a disaster for mortgage borrowers and the wider property market, so big leaps in mortgage rates are unlikely to happen without a serious property slump.

Another option would be to improve the quality of mortgages that are bundled into bonds. For example, lenders may decide to securitise only prime mortgages from borrowers with deposits of, say, 25% or more. Alas, this would prevent loans to first-time buyers, subprime buyers and buy-to-let investors from being sold on.

Thus, improving the asset quality of RMBS would mean excluding borrowers who, until this year, accounted for a large slice of the overall market. These `fringe' borrowers would be forced to pay much higher interest rates, reflecting their raised risk profile. Again, pinning our hopes solely on home-movers would still leave the property market firmly in the doldrums.

Let's leave the government out of this!

Happily, the Crosby report expresses caution about proposals to set up a government-sponsored agency to guarantee mortgage-backed securities. Given the near-collapse and Federal rescue of Freddie Mac and Fannie Mae (which guarantee over $5 trillion of US mortgages, or almost half of all home loans), I'm relieved that this is one American model which won't make it across the Atlantic. After all, why should taxpayers take the risks, after bank shareholders have taken all the gains?

As Sir James remarks at the end of his letter to the chancellor, "...I should stress that I may yet recommend that the Government should not intervene in the market, on the grounds that such intervention would create more problems than it would solve."

So, it seems certain that the mortgage market will be left to heal itself, and it will be several years before mortgage securitisation can resume at anything like its former levels. In other words, we can look forward to more of the same from the credit crunch, with no let-up this year or next.

The end of millennial madness

In my view, the credit crunch is no short-term difficulty that can be solved with a quick fix. As Sir James remarks, "...a significant and prolonged shortage of mortgage finance must take its toll of both [the housing market and consumer spending]." Indeed, this may well be the worst financial crisis the UK has faced since the dark days of the Seventies.

Hence, I stick by my prediction that house prices will fall around three-tenths (30%) from their peak last year. Thanks to a global re-pricing of risk, falling asset prices and reduced liquidity, the UK will soon see double-digit yearly drops in property values, which will continue into, and even beyond, 2010. This will lead to rising job losses and, possibly, a sharp fall in economic output, leading to a recession.

So, get your personal finances in order now, before it's too late to batten down the hatches...

More: Get a market-beating mortgage via the Fool | Use This Mortgage To Crack The Credit Crunch | Take The Money And Run