Compared to other European countries, the UK housing market remains a relatively robust place to invest
The residential mortgage backed securities (RMBS) market has got a bad name for itself in recent years. Having been implicated in the credit crunch and the collapse of several major Western banks, investors have understandably been keen to avoid bundles of mortgage debt.
The sub-prime debt fiasco, which started in the US, is well documented. Europe also had its fair share of house-price bubbles.
In particular, the UK, Ireland and Spain experienced massive house-price appreciation. UK prices rose by almost 250% over the decade to 2006, while Spain and Ireland experienced similar increases, benefitting from low interest rates that would probably have been higher had they not been euro members. However, European mortgages have outperformed with 96% of all AAA securities remaining AAA while only 65% of US mortgages retained their AAA rating.
Looking at Ireland, at the height of the boom, around three quarters of lending by the country’s banks (a total of e420bn) was bound up in property, construction and land purchases. The property and construction sectors amounted to more than a fifth of economic output. By comparison, in Spain, which has suffered its own cataclysmic property boom and bust, these sectors amounted to less than 10% of economic activity at their peak.
Brutal crash
The crash, when it came, was brutal. The global liquidity crisis put a stop to the loose credit and cheap money that had characterised markets in the previous few years. A glut of property swamped the market – official estimates indicate a third of all homes in Ireland were built during the speculative boom of the last 10 years. Thousands of homes were left uncompleted and unsold with the result that prices plummeted.
Ireland was one of the first European nations to respond with austerity measures and is now 18 months into its programme of cuts. Significant steps have been taken to bolster the country’s credit rating and get the economy back on track. To cut the fiscal deficit, six percentage points of GDP have been wiped from this year’s budget. Yet the deficit still stands at 12% of GDP.
Unlike Greece, the Irish electorate has begrudgingly accepted the need for these austerity measures. But budget cuts of the amount the country now faces are not going to stimulate growth.
Concerns
Throughout Europe, similar measures are required and if Ireland’s experience offers a window on the future, then we all need to be concerned. The country’s economy has continued to struggle and is mired in recession. Gross National Product, which includes multi-national profits, shrank by 11.3% last year. At its peak, 13% of Ireland’s labour force was employed in the construction sector. A negative feedback loop has been created, with weakness in the housing market leading to rising unemployment, which in turn adds to the negative pressure on demand for housing. Unemployment in Ireland rose to 13.7% in May. Against this background, house prices are now down more than 34% from their peak and the rate of decline is showing no signs of slowing.
What is really important to RMBS investors, though, is not really the price of the underlying asset, but the willingness and ability of mortgage holders to pay back the debt. This can be measured by loan-to-value and debt-to-income ratios. Other key drivers are interest rates, unemployment and consumer confidence. Potential default and recovery prospects are also important, along with the length of time for which the mortgage has been held and the strength of the issuing bank. In all three countries these indicators are getting worse, but the UK market is showing slightly better results.
Robust
The UK housing market remains relatively robust compared to other European countries. Prices underwent a correction as the effects of the credit crunch took hold, but falls have been less dramatic than elsewhere. In fact, recent figures from the Nationwide Building Society show prices are back within 10% of their October 2007 peak after a further 0.5% rise in May. The rebound in property prices over the past year has been fuelled by record low interest rates and limited supply.
These factors are likely to reverse in the short to medium-term and it is true we might be storing up problems for a later date, but other metrics indicate the UK at a better starting point than its peer group.
Activity remains muted and the market is still constrained by reduced availability of mortgage credit but unlike in many European countries, there is no substantial overhang of foreclosed or unsold properties in the UK.
Most importantly, UK households are in a comparatively good position to pay back their mortgages. Unemployment has risen significantly, but is still a long way short of the three million mark that many were forecasting last year.
The rate of growth in unemployment is slowing and appears likely to peak later this year. Our forecasts indicate employment may start to edge back up during the second half of 2010.
As in the rest of Europe, households are tightening their belts and face the prospect of a higher tax burden in the form of higher national insurance contributions and/or higher VAT. However, interest rates do not appear set to rise dramatically any time soon. With rates stuck at record low levels, mortgage payments remain affordable.
Confidence
In addition, consumer confidence has improved markedly from its weakest levels seen in the depths of the financial crisis. This is helping underpin economic growth, which although weak, is keeping the country out of recession.
These factors are underpinning the RMBS market in the UK. After recovering well from depths of despair in 2009 the market continued to produce positive returns in the first quarter of this year.
Looking forward we see credit issues taking the fore and the likely continued underperformance of both Irish and Spanish RMBS. Inflation will come through eventually and rising interest rates will hurt all borrowers, but we believe prime UK RMBS investments offer distinct advantages over European equivalents. We view this sector as defensive but also offering a comparatively attractive total return. Any contagion we see as an opportunity to add to UK prime exposure.
With so much change and uncertainty, for now it seems sensible to stay close to home.
Mary Boyle, senior investment analyst, ABS at SWIP
