Are We Heading For A Sub-Prime Mortgage Crisis?

Find out whether the US housing market crash is going to happen over here.

Everywhere I looked this morning, I saw little green men.

You probably think I'm crazy. But that's because you're adding two and two together and coming up with aliens and spaceships and hallucinations of intergalactic doom - when, in fact, I am referring to a rather more mundane topic: pedestrian crossings.

The danger of drawing conclusions from inconclusive evidence and erroneous assumptions in this way was well demonstrated by the Panorama programme on the UK sub-prime mortgage market, which I watched - grinding my teeth - on Monday night.

Here's a quick re-cap for those of you who missed it:

Reckless mortgaging lending in the USA has jeopardised house prices over there, leading to a global financial crisis (and the problems with Northern Rock).
The sub-prime mortgage market in the UK is similarly out of control. Sub-prime lenders have little incentive to vet borrowers' ability to repay the mortgage, because they sell on or `securitize' the mortgage debt. For this reason, they are lending to people who live on benefits and have No Income, No Job and No Assets.
These so-called `Ninja' mortgages could lead to a house price crash of similar proportions to the USA, where prices recently saw their steepest decline in 16 years.

Sounds scary, doesn't it? But before you sell up your house in a panic to escape from a group of teenage mutant ninja mortgages, take comfort from the following facts:

Only a tiny proportion of sub-prime mortgages are Ninja mortgages, according to the Council of Mortgage Lenders, and anyway sub-prime mortgages make up only 8% of the UK mortgage market (while they made up around 25% of the US mortgage market).
Less than 2% of all sub-prime borrowers had their homes repossessed in 2006. That means 98% of sub-prime borrowers (ie borrowers with a problematic credit history) are managing to keep up their mortgage repayments.
Lenders are regulated by the FSA and must only lend to a borrower who can afford to repay the loan.
Most sub-prime lenders only offer mortgages through intermediaries. You have recourse to the Financial Ombudsman if you can prove that you were sold a mortgage by a broker which you cannot afford to pay back.
The fall-out from the US sub-prime crisis means sub-prime lenders are tightening their lending criteria, as they are finding it hard to securitize their debts. Sub-prime borrowers now have to meet stricter affordability requirements than in previous years.

Phew! Now that's a relief. But there are other, more important reasons why homeowners do not need to worry about a UK sub-prime mortgage crisis.

Why a sub-prime crisis won't happen over here

In my view, there are some key differences between the UK and US housing market and the wider economy, which mean that the kind of problems that developed in the States are unlikely to occur over here.

First of all, let's look at interest rates. Between 2004 and 2006, interest rates in the US rose 4.25%, from 1% up to 5.25%. As 80% of US sub-prime mortgages were lent on variable rates - which move up and down with interest rates - this created huge problems for sub-prime borrowers, whose payments increased dramatically over a short period.

Many sub-prime borrowers were also allowed to `under-pay' in the first couple of years of the deal, so the interest rolled over and the debt built up even more quickly, a practice which does not happen in the UK. Similarly, there is virtually no lending in the UK to sub-prime borrowers who do not have a 10% deposit, unlike the US.

By contrast, UK interest rates have moved up a measly 1.25% over the past two years and, historically, are still relatively low. What's more, 85% of sub-prime mortgages in the UK are offered on fixed rates, so a borrower's monthly payments do not increase when interest rates rise.

There's no doubt that - mainly because of the US sub-prime crisis - sub-prime mortgages are becoming more expensive and sadly, most sub-prime borrowers are going to face payment shock when they come off their current deals. But in the UK, unlike the US, lenders look at whether sub-prime borrowers can afford to pay the final rate (usually the SVR), when deciding whether or not to lend. This is likely to be around 2% higher than the initial, discounted rate. So in theory, sub-prime borrowers should still be able to meet their repayments, even if rates have gone up around 2%.

Having said that, I do think the number of repossessions is likely to rise next year and this will dampen demand in the housing market.

Dampen, but not destroy. Fundamentally, the UK housing market suffers from a huge shortage in the supply of housing - unlike the US, where there is currently an oversupply.

This lack of supply is partly the reason why house prices have risen at an astronomical rate in the past few years. Most sub-prime homeowners have built up a sizeable chunk of equity in their homes, and many can use this equity to get rid of their debt and then cut their monthly outgoings significantly by renting instead.

It's not exactly the kind of situation that makes you go: "Cowabunga - we're invincible!" but I think there is certainly no need to panic. Remember, sub-prime mortgages make up just 8% of the overall mortgage market, the vast majority of sub-prime borrowers have steady jobs and, at the moment at least, 98% are managing to meet their repayments.

Of course, I might be wrong. We may well be heading straight for a UK sub-prime crisis on the scale witnessed in the USA. And I know that some Fools - especially Cliff D'Arcy - are much more bearish about prospects for the UK housing market than me. But in my view, a sub-prime-fuelled housing market crash in the UK is extremely unlikely -- in fact, just about as likely as a Martian invasion.

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