September 25, 2007

Northern Wreck

U.S. subprime crisis hits Great Britain

The ongoing fallout from the subprime mortgage calamity in the United States may strike the United Kingdom quite hard, some observers believe. The Bank of England's (BoE) recent surprise agreement to provide emergency bailout funding for troubled U.K. mortgage lender Northern Rock may only be a harbinger of things to come.

While Britain has enjoyed unprecedented economic growth over the past decade, the twin pillars underlying that boom--its housing industry and its meteoric London-centered financial services sector--are now coming under severe pressure, says Andrew Clare, professor of asset management at Sir John Cass Business School, London. The credit crunch and reduced global liquidity arising from subprime weakness--which have generated losses in structured debt products linked to these high-risk loans--will likely lead to moderating house prices, higher lending rates from squeezed mortgage lenders and higher corporate borrowing costs, all of which may spill over to the wider British economy amidst an environment of higher interest rates and weak wage growth.

Indeed, the ITEM Club, an economic forecasting group of accounting giant Ernst & Young, warned that if the credit crisis deepens, in a worst-case scenario, Britain's annual gross domestic product (GDP) growth rate could be reduced by a full percentage point, down to 2.0%, next year.

Home prices in the United Kingdom have more than tripled over the past decade, at a rate far outstripping wage growth. According to U.K.'s Office for National Statistics (ONS), the price of housing rose 204% from April 1997 through April 2007, versus a 94% gain in average salaries. This surge in home prices, which fueled rising consumer spending and spurred stratospheric personal debt now reaching $2.7 trillion, was precipitated by a perfect storm of factors: strong economic growth, low interest rates, low inflation, low unemployment, easier access to cheap credit and limited supply.

But is Britain's buoyant housing market really facing a major correction?

In a recent survey, Rightmove plc, a U.K. residential property website, said the average asking price for a house fell by 2.6% in September. Similarly, the Royal Institution of Chartered Surveyors, the property consultant firm, noted the average British house price fell in August--the first such drop in almost two years.

But other surveys provide conflicting data. HBOS plc, Britain's top mortgage lender, reported that August home prices rose 11.6% year-over-year, representing the eighth straight monthly gain.

Part of the confusion arises from the disproportionate influence of London and the Southeast on national statistics. London housing prices have typically outpaced the rest of the country, fueled by higher incomes and the bonuses handed out to employees of London's financial services center. In much of the rest of Britain, housing prices appear to have leveled off, and, in a few areas, actually declining. Indeed, the Department of Communities and Local Government, a governmental agency, recently noted that annual house price inflation in London runs at around 19.1%--despite six straight interest rate hikes by the BoE since last summer.

Clare himself conceded that the chronic shortage of housing in Britain would impose a floor on any home price declines. "We are a small and densely populated island," he says. "Housing will always be limited here."

Moreover, although home repossessions climbed 30% year-over-year in the first half of 2007, according to the Council of Mortgage Lenders (CML), the absolute numbers remain well below the levels witnessed during the recessionary early 1990s.

Regardless of the near-term outlook on housing prices, British homeowners are facing some serious issues. "Mortgage holders that fixed their mortgage rates two years ago at around 4.5% are now faced with variable rates well above 7%, or are faced with new two-year, fixed rate deals of just under 6%," says Clare. "For many mortgage holders this will be a painful transition. Second, lenders themselves are beginning to apply more stringent terms on those wishing to re-mortgage and on new borrowers. This is the direct impact of the credit squeeze."

Indeed, one of the factors behind Northern Rock's woes lay with its inability to retrieve any more funding from other banks or money markets. U.K banks and lenders are facing increased borrowing costs because, among other things, there is significant uncertainty over how much exposure to U.S. subprime assets British financial institutions have. The London Interbank Offered Rate, or LIBOR--which is essentially the interest rate at which banks offer to lend unsecured funds to other banks in the wholesale money market--currently stands at nearly 6.90%, well above the BoE's 5.75% policy rate.

And these increased borrowing costs are already being passed on to mortgage customers--some of the U.K.'s largest lenders, Halifax, Abbey and Standard Life, recently hiked their mortgage lending rates. Another lender, Victoria Mortgages, which specialized in loans to Britons with poor credit, has collapsed.

Thus, first-time homebuyers must surmount rising costs. According to CML, average new buyers are now borrowing 3.39 times their annual income (a new all-time peak) and using 19.7% of their wages to repay just the interest on their mortgage loans.

It is unclear if the BoE will provide any immediate relief to British homeowners by easing rates at its next meeting in October. Inflation data that showed that United Kingdom's annual CPI rate for August 2007 came in at 1.8% (just below the BoE's 2.0% target), following a 1.9% figure for July, seems to argue against any further rate hikes. Annual CPI was as high as 3.1% in March 2007 and has ranged between 2.4% and 3% over the past year. However, the BoE's Monetary Policy Committee is determined to keep inflation under the 2.0% target, suggesting a rate cut may not be in the works anytime soon.

The BoE now has a less plausible case in raising rates, says Robert Quinn, S&P's European equity strategist, "but my feeling is that they will adopt a wait and see policy. Inflation pressures still exist on the upside, especially on food prices and energy. The July figure was the beneficiary of early sales on furniture that will probably be reversed so an extra months' worth of data will offer a lot more clarity. Of course, stronger-than-expected pressures have surfaced on the real economy due to the prolonged credit crunch that not many of us foresaw."

"With reduced short-term inflation, The Bank of England definitely has more flexibility," says Robin Creswell, managing principal at Payden & Rygel Global Ltd. "The Bank can avert its attention from its first priority, inflation, to its next priorities--making sure the economy remains robust and financial system stays liquid and afloat."

Creswell notes that while opinion has been almost unanimous that interest rates will remain unchanged at the BoE's October meeting, "events are moving so quickly that it's quite conceivable that we could see a quarter-point cut at that meeting."

The City of London is now the world's largest financial services center. Its resurgence was driven by such financial innovations as credit derivatives trading, hedge funds, private equity, leveraged buyouts, foreign IPOs and debt finance, all of which come under threat from the global liquidity squeeze.

Capital Economics Ltd., a London-based consulting firm, estimates that financial services accounts for at least 10% of the British economy. Any weakness in the health of London's financial behemoth, Clare opines, would not only reduce employment, cut bonus payments, seriously weaken Britain's housing market, but also hurt the country's overall economic growth. "With equity markets under pressure, and with the cessation of corporate and private equity activity, the strong profit growth of the past three years in the U.K.'s financial sector is unlikely to continue," Clare says.

Underscoring the importance of the financial services sector to Britain, Clare indicates that since 1998, nearly all of the growth seen in U.K. private sector employment came from financial and business services. Elsewhere in the private sector, job growth has been stagnant.

Wage growth in the public sector has fallen to its lowest level in almost a decade. ONS data revealed that public sector pay grew 2.7% year-over-year for the three months through July, the lowest reading since May 1998. By comparison, pay for the private sector grew 3.7% for the same period. In response, British trade unions are threatening a series of strikes this winter if Prime Minister Gordon Brown does not raise the government's 2% pay-hike limit for civil servants, government workers, teachers and postal workers.

Northern Rock, which according to BBC owns about 18.9% of U.K.'s new lending business, has seen its shares plummet more than 60% since the start of the year. Clare notes that the BoE's bailout agreement indicates that Northern Rock's underlying mortgage books are of high quality, since the BoE requires bedrock collateral before providing such funding.

However, ignoring assurances from both the company and the BoE that Northern Rock is financially solvent, thousands of panicked customers have withdrawn their deposits.

Despite the Northern Rock bailout, BoE Governor Mervyn King has warned that it is not the central bank's responsibility to rescue financial institutions that have taken on undue risks by lending recklessly.

Meanwhile, King has been heavily criticized by some bankers and politicians for not intervening earlier in the credit crisis, contrasting his actions with those of the U.S. Federal Reserve and European Central Bank which inundated their financial systems with cash to shore up their credit markets. Defending himself in testimony before the Treasury Select Committee, King blamed regulatory laws in both the U.K. and European Union for preventing the BoE from dealing with the Northern Rock emergency earlier the way he wanted.

Alec Young, S&P's equity strategist, says that although uncertainty regarding the ultimate magnitude of U.K. housing weakness coupled with lingering fears over how many U.S. subprime tainted securities lie on British financials companies' balance sheets has caused the U.K. cost of capital to rise, "it remains historically low, and we do not think the increase is sufficient to trigger either a U.K. recession or a cyclical peak in the country's corporate profit growth."

While the S&P Europe 350 index has rebounded from its August 16 lows, Young notes, "the pace of the gains would have been greater if not for ongoing credit jitters in the Financials sector, the index's largest with a 29% weighting." The U.K. represents roughly 30% of the S&P Europe 350 index and British banks, brokers and insurers feature prominently in the index's Financial sector.

S&P forecasts 2.3% U.K. GDP growth in 2008 with the consensus forecasting a 7.9% increase in 2008 U.K. EPS growth. Young adds that U.K. stocks currently trade at only 11.8 times estimated 2008 earnings, making valuations "among the lowest in the world, by our analysis. As such, we remain positive on U.K. equities."

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