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Why The Flight From Risk Could Soon Spread To Housing

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The way the City chooses to describe various financial instruments can be quite instructive.

If a company has a bad credit record with a significant chance of defaulting on its debts, then its debt is described as “junk”. But if an individual is seen as a poor credit risk, the loans they are offered are described as “sub-prime”.

No doubt lenders would have a tougher time selling “junk mortgages” than the rather less judgemental-sounding “sub-prime” loans.

But whatever you want to call them, risky mortgages are the biggest growth area in the UK home loan market today. At the same time, repossessions and mortgage arrears are creeping higher, and global interest rates are rising.

That doesn't sound like a healthy mix to us...

As we mentioned in yesterday’s Money Morning, lenders have been falling over themselves to dish out mortgages to the UK's “sub-prime” market. And the City watchdog is starting to get a little bit worried.

Yesterday’s FT headline was “Fears over surge in high-risk mortgages”. The Financial Services Authority (FSA) is concerned about “a sharp surge in mortgage lending by investment banks and brokers to risky customers with poor credit records.”

Merrill Lynch-owned Mortgages Plc reckons that sub-prime mortgage lending accounted for about £25bn to £30bn last year. That’s about 10% of the total mortgage market – and significantly higher than the £20bn loaned to buy-to-let investors.

You would think that with rising bankruptcies, repossessions and record levels of UK consumer debt, banks and building societies would be trying to rein in borrowing. And in fact, lenders are making it more difficult to take out unsecured credit, like personal loans and credit cards.

But at the same time, they are diving into the sub-prime mortgage market as if everything was rosy. In fact, the latest ‘credit-impaired’ product launch from Leeds Building Society is aimed at people who are buying shared ownership properties.

For those who don’t know, buying a home via shared ownership involves purchasing a 25% (or larger) share of a property from a housing association. The rest is then rented from the association at a subsidised rate. The part-owners can buy further shares in the property as and when they feel able.

“It is clear that if a customer has impaired credit and needs shared ownership, they have very little opportunity to own their own home…This new mortgage…allows clients to borrow 100% of their share of the property”, enthused Leeds product development manager Stuart Fearn.

Let’s get this straight. The ideal customer for this mortgage needs a government subsidy to be able to afford a house; has no deposit saved up; and on top of this, can’t get a mortgage anywhere else because of their bad track record on repaying debts. If that’s not sub-prime, we’re not sure what is.

So why are lenders all jumping on this seemingly rickety bandwagon? One reason of course is that secured debt represents far less risk for the bank or building society than unsecured debt.

If you default on your credit card, there’s not much they can do except avoid lending to you again. But if you default on a loan secured against your home, then the lender gets to take your house.

Profit margins are also higher on sub-prime loans. Sub-prime lenders have something of a captive audience, so they get to charge higher rates, which compensates partly for the risk.

But another reason is revealed in the FT article – hedge funds.

Let us explain. Investment banks are getting into the mortgage market because they can earn fees by packaging up all those individual mortgages and selling them on as residential mortgage-backed bonds.

The more credit risk these bonds carry, the better the yield. And high yield is exactly what hedge funds are looking for. Because mortgage arrears are still low by historical standards, “the bonds have performed well”, says the FT. So that increases hedge fund demand even further.

But it’s the phrase, “low by historical standards”, that’s the problem. As the FSA said: “The credit scoring techniques have so far proved robust but most have only been developed in the last decade, under relatively favourable credit conditions… There is a possibility that the current rates do not correctly price the risk of a downturn.”

Just a possibility? Repossessions and arrears are rising, and bankruptcies are already at record highs. Unemployment is ticking higher, and global interest rates are also rising – which will put pressure on our own Bank of England to hike rates.

We’d say it’s a raging certainty that the risks of sub-prime mortgage debt – just as with almost every other asset class across the globe – have been underpriced.

If demand for these sub-prime bonds collapses, mortgage lenders will rapidly have to tighten their lending criteria. That would result in the fastest-growing corner of the mortgage market become the fastest-shrinking.

What would that do to house prices? Well, we can't see into the future - but take a look at the recent stock market plunge if you want a reminder of what happens when investors start to worry about risk again.

Edited by munimula

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