US and UK housing market in a fix

This week’s cover of Business Week asks the question ‘How toxic is your mortgage’. The article centres on the recent usage and promotion of ARMs to buyers in the USA as a way to cheap deals. Unfortunately many customers are now finding that what was originally a promise to help them get a foot hold on the property market has become a liability, threatening to lose them their homes and leave them in debt.

Much of this ‘mis-selling’ is also mirrored in the UK though there seems to be less worry from both consumer watchdogs and government about the practices.

According to Business Week the ARM’s taken out in 2004 and 2005 are now turning into a massive liability for owners that will affect the market itself.

The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created. With its temptingly low minimum payments, the option ARM brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted, especially in the hottest markets. Suddenly, almost anyone could afford a home — or so they thought. The option ARM’s low payments are only temporary. And the less a borrower chooses to pay now, the more is tacked onto the balance.

The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules — often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent homebuyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

At the same time in the UK lenders have been struggling to fid ways to encourage borrowers to borrow more money. With house prices increases in the UK exceed even the stratospheric rises in the US, there is a shortage of first time buyers able to afford the loans. In the UK loans are normally variable, so unlike the USA they will generally move in pace with the Central Banks rate. As the rates have been very low over the last few years in the UK, the ability to sell short term fixed mortgages has been something the lenders have promoted, with many offering short term loans of as little as 2 percent for two years. The problem with these loans is that they are only fixed for a short period, and lock the customer into the variable rate for an extended period after the fixed period ends.

With the UK central bank rate now sitting at 4.75 percent, with the likelihood of an further increase to 5 percent next month, many customers are now coming out of the ‘fixed’ rate period and finding that the repayments they agreed to some 2-3 years ago have doubled, and in some cases increased by more even more as the rate the customers pay (called the standard variable rate) has risen to 6.75 percent for most lenders.

As in the USA the borrowers were lent amounts of money based on the ability to repay the loans calculated at the ‘offer rate’ and not the eventual repayment rate. Many lenders in the UK have, and are continuing to compound the problem, by offering huge multiples of earnings – beyond the usual 3.5 times annual salary – or in many cases for first time buyers, they are even offering 110 percent loans (i.e. offering to lend more than the value of the property).

With property prices in the US slowing down, or falling, the debt/equity ratio’s are beginning to spiral in the wrong direction – with the likelihood that they can’t be repaid and the number of loan defaults and repossessions set to increase rapidly in the winter months.

In the UK this pattern has been held off as prices still continue to grow, though at a slower pace. Expectations that the Bank of England will increase rates to 5 percent next month will hit the British borrowers with the double-whammy of higher repayments and a potentially falling market, as it responds to the increased cost in the winter period.

Overall the outlook is gloomier than before, as with all bubbles it’s going to be those least able to afford the loss that will have to carry the burden. We think that governments in both countries should take action to discourage the irresponsible behavior of lenders at the moment.