In May, when we last updated our market forecasts, we predicted a 7% correction in house prices this year. Clearly, that forecast now underestimates the extent to which property values are set to adjust by the end of 2008. However, there is now even more uncertainty than there was in May – not only about the future availability and cost of mortgage funding, but as a result of widespread turmoil in financial markets and the impact this will have on consumer sentiment, household finances and the broader economy. It is therefore a particularly difficult time to attempt to revise our forecasts.
Fluctuating interest rates
When we updated them in May, we based our forecasts on an assumption that the Bank of England’s special liquidity scheme (SLS) would begin to have some modest beneficial effects on the availability of mortgage credit in the second half of this year. And in the late summer, there were tentative signs of an improvement in conditions, with a fall in mortgage rates for mainstream, lower risk customers.
The more recent financial market turmoil, however, sparked another surge in inter-bank lending rates. By Tuesday of last week, the overnight London inter-bank offered rate (libor) had risen to 6.7%, 1.65% higher than it had been at the end of the preceding week. On Wednesday, following the Bank’s announcement of an extension of the SLS, overnight libor declined sharply and was just 0.25% higher than it had been the Friday before. And by the end of the week, it was nearly a quarter-point below Bank rate!
Perhaps of more significance for borrowers, however, is three-month libor, to which some tracker mortgages are linked. This rate has not been as volatile as overnight money, but its rise has been more sustained. By the end of last week, the three-month rate had risen to 6%, and its spread above bank rate – a full 1% – was the highest since last December. Going forward, both lenders and borrowers will be keen to see what the impact of the Bank’s decision to extend the SLS will have on three-month libor.
In our May forecasts, we noted that lending for house purchase had weakened and predicted that that would continue in the coming months. In fact, gross lending for house purchase has been weak but broadly flat since then. Between March and July – the latest month for which we have detailed statistics – monthly lending for house purchase has totalled between £7 billion and £8 billion, although it remains significantly lower than a year ago. Looking ahead, mortgage approvals data remains weak, and the number of future house purchases will be affected by consumer sentiment and the outlook for property prices.
In May, we observed that remortgaging was subject to different pressures. Funding shortages and a general tightening of lending criteria have continued to constrain this section of the market. But demand has been sustained by the numbers of borrowers whose existing fixed-rate mortgages have come to an end and the policy of some lenders to shrink in 2008. Remortgaging has continued at broadly the same levels as in 2007, although in August it was weaker than expected. It is too early to say what impact the different forces affecting remortgaging will have on future business levels.
So, if our current market predictions have understated the extent of the house price correction – and we think it is futile to update them at this stage of the year – what are other commentators and industry experts saying?
In a recent interview with the BBC’s Robert Peston, Nationwide Building Society chief executive Graham Beale predicted that signs of a housing market recovery were unlikely before 2010. “I think that next year we are going to see a similar pattern to what’s happened this year…we are going to see further falls in house prices.” And he went on to say that the average decline in house prices by 2010 – peak to trough – could be as high as 25%.
“There is definitely a connection between what’s going on in the US and what goes on in the UK,” he continued, “and it really comes down to market confidence, and we are talking about global market confidence because clearly, with the massive disruption in the US, banks have stopped lending to one another. And we need that fluidity back in the market.”
His view of the housing market echoed that of Andy Hornby, chief executive of HBOS, who – also in an interview with Robert Peston – said there was a consensus that house prices would fall by 20% during 2008 and 2009.
He predicted that wholesale market funding would remain constricted until US house prices begin to rise again, which could take 18 months. UK banks raised two-thirds of their wholesale funding overseas, much of it from the US, he said. And US money market investors would not restore the flow of funding to institutions in the UK until US house prices begin to recover.
“We are looking at a period when we are seeing house price deflation which is stronger that the early ‘90s,” he said. “We are looking at 18 months now before we are expecting to see significant improvement in markets. It will be 18 months before US house prices have started to rise again, which is likely to give confidence to the system and get banks lending again. US house prices are a key lead indicator to the unblocking of wholesale funding markets worldwide.”
The Bank’s view
That view was endorsed last week by Spencer Dale, the Bank of England monetary policy committee member who is also the Bank’s chief economist. “The deterioration in the housing market is…likely to impact banks’ balance sheets, leading them to tighten further the supply of credit,” he said.
“This type of so-called adverse feedback loop – in which a deterioration in the housing market and in the wider economy impinges on banks’ balance sheets and their ability to lend, which then in turn feeds back on to economic activity – already appears to be operating to some extent.”
He forecast a “painful process of adjustment” for households and businesses, and particularly for businesses like builders and estate agents that depend directly on the strength of the housing market.
We have already presented our argument that there is a role for the Bank in helping restore confidence in wholesale funding markets.
In April, we welcomed the Bank’s decision to launch the special liquidity scheme (SLS), and have argued for a continuing flexible approach allowing it to respond to changing market conditions. Last week’s decision by the Bank to extend the SLS until the end of January was therefore welcome, both for the help it will provide for firms and as a show of flexibility in response to difficult and fast-moving market conditions.
A call for action
Last Friday, the Financial Times also urged the Bank – and other central banks – to show continuing flexibility in response to changing credit market conditions. Its leader column argued that there was a crucial role for central banks when liquidity was needed, but constrained by “a generalised panic in the core of the world’s financial system.”
It argued: “In essence, the world is witnessing an extreme shift in liquidity preference. People want to hold cash or securities only in the most secure and most accessible form, namely government liabilities.
“The government, which is the beneficiary of this shift in liquidity preference, must respond by engaging in a recycling operation on an enormous – indeed unlimited – scale. It must convince markets that sound businesses will not be allowed to disappear for lack of funding.
“Such operations must be conducted on a global scale, with necessary swap arrangements among the world’s principal central banks also being open-ended. It must now offer funds at a relatively lengthy maturity, as well, or at least with a commitment to rolling funding over for as long as panic conditions last.
“This is not a time for niceties. When credit – or trust – has vanished, the only creditworthy institutions left on the planet – triple A-rated big governments – have to act. Central banks are lenders of last resort because governments are insurers of last resort. That is, quite simply, what they exist to do.”
It is therefore not a surprise that the US government is now looking to co-ordinate a global response by governments, to protect consumers from a worse outcome than the cost of the interventions announced so far. The challenge for the UK government is to decide what steps to take in response to our own market dislocation. The report from the Crosby review will be completed this month, and we expect early targeted action to follow.