How to rescue the UK mortgage market

Analysis
By Steve Schifferes
Economics reporter, BBC News

Many surveys have suggested that the housing market is slowing

UK mortgages could become more expensive and harder to obtain unless there is further help for stricken credit markets, an influential government advisor has said.

David Miles, chief economist at Morgan Stanley and a Treasury advisor on the mortgage market, says that UK banks need to refinance £250bn worth of mortgage loans that have been financed in wholesale money markets.

He argues that if markets remain frozen, the Bank of England - or a special government agency - will need to lend £60bn to £80bn to the banks this year to prevent mortgage finance freezing up.

See which UK banks depend most on money markets

And he warns that, without such help, banks will be severely limited in their ability to issue new mortgages, and will have to charge higher rates in order to attract additional funding.

This, in turn, could lead to steeper declines in house prices, which would make the UK economic slowdown much deeper.

Exposure

The UK banking sector is not as exposed as banks in the US to the problems in the credit markets.

But nevertheless, Morgan Stanley estimates that 28% of mortgages issued in the UK were financed by banks securitising their mortgage book and selling them to other investors (as opposed to around 70% to 80% in the US).

It says that around one-third of these mortgage packages will need to be refinanced this year, and that so far credit markets remain closed to new issuance - because of continuing fear by investors of buying bad mortgage debts.

The result could be that UK mortgage lenders would have to either pay very high interest rates to borrow money from other wholesale investors, or pay higher interest rates to retail savers to attract more deposits.

The banks have already been squeezed because their profit margins on mortgage lending has dropped substantially in the last few years.

Either way, UK banks would then have to raise mortgage rates sharply in order to cover the higher costs of borrowing - regardless of whether the Bank of England lowered base rates.

The Council of Mortgage Lenders acknowledges that "there is a potential shortfall" in the wholesale funding and says it has urged the authorities "to intervene more aggressively" in money markets to restore normal market conditions.

'Market failure'

Mr Miles argues that the drying up of lending to UK banks is an example of "market failure", where credit markets are over-reacting to fears of a meltdown in US sub-prime mortgages.

Therefore there is a case for government intervention, perhaps by creating an independent agency which could provide short-term funding to the banks while the credit markets are frozen.

The proposal bears some resemblance to US agencies such as Fannie Mae and Freddie Mac which buy up mortgage debt from lenders and have helped expand the mortgage market.

Risks

But there would be risks. Intervention on such a large scale could make it more difficult for the Bank of England to keep money market rates in line with its own targets and might be inflationary.

Should the Bank of England lend another £80bn to the banks?

And the government may be reluctant to authorise another huge bank bailout when it is still not clear how much of its £55bn liability for Northern Rock will ever be repaid.

Even Mr Miles acknowledges that it still not clear how much UK mortgage lending is now shaky, and suggests that up to one-quarter of all recent loans might have been granted under too-generous conditions or without sufficient checks.

But Mr Miles says that the risks for the UK economy are so great that doing nothing should not be the preferred option.

He forecasts that if a mortgage squeeze causes consumer spending to dry up, UK economic growth could fall to 0.5% next year, and the government's budget deficit could double to £68bn.

And house prices, already high by historic standards, could fall sharply.

See UK house prices in relation to average incomes

Homeowners at risk

Mr Miles has argued that more consumers should switch to long-term fixed rate mortgages.

Good mortgage deals could become a lot harder to find

He says that most homeowners have focused too much on how actions by the Bank of England will affect their mortgage payments, and have not realised that they could face higher rates due to independent actions by their lenders.

He says that lenders, whose profit margins on mortgages have been squeezed in recent years by competition, will seek to widen the spread between lending and borrowing.

In the longer term, he says that the government should help the market develop index-linked mortgages whose payments were based on real interest rates (taking into account inflation) and the value of the property.

However, so far in the UK there has been little appetite for long-term fixed mortgages, although inflation-linked government bonds have now become well-established.

MORTGAGE LENDING AT RISK

2006 data

Bank	Mortgage loans (£bn)	Securitised (£bn)	Securitised (%)
HBOS	219.0	72.7	33
Abbey	101.7	29.1	29
Lloyds TSB	95.3	14.9	16
Northern Rock	77.3	47.2	61
RBS	69.7	15.7	23
Barclays	61.7	12.6	20
HSBC	37.4	3.7	10
Alliance & Leicester	38.0	3.4	9
Bradford & Bingley	31.1	6.7	22
Total	731.2	206.0	28
Source: IFS/Morgan Stanley

Securitised loans are funded by borrowing on money markets - not from depositors

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