The effect of the sub-prime crisis on UK mortgages

It is a confusing time in the mortgage market. Some mortgage rates have fallen, while some are forecasting that others will rise.

This, and recent stock market turmoil, has been sparked off by a crisis in the US sub-prime mortgage market, and it came at the same time as good news arrived in the UK with the inflation rate dropping below 2%.

The result has been a tightening of lending criteria and a rise in borrowing costs for those with poor credit histories and a reduction in some fixed rate mortgages.

A sub-prime mortgage is a mortgage given to those with poor credit histories, or the self-employed with unusual income streams who cannot get a home loan from a mainstream lender. Borrowers have to pay a premium to reflect the fact that they are higher risk. Sub-prime mortgage lenders (sometimes called specialist lenders) also provide self-certification (self-cert) mortgages for those who find it difficult to prove their income.

In the US the sub-prime mortgage was said to be a great success when interest rates were low and house prices were rising. However, when prices started to fall and interest rates started to rise, problems began to surface. The lending criteria had been relaxed so much that many borrowers were now unable to afford their repayments and as they couldn’t sell because of lower house prices, millions began to default on mortgages.

The problems in the wider financial markets have been caused because the mortgage debts were sold off as derivatives, bundled together to represent a lesser risk if things were to go wrong. The problem is that something did go wrong – and the bundling didn’t help. In fact, the lending has gone far and wide, and many banks have decided to check their lending criteria, not just to mortgage consumers, but to other institutions and other businesses. This has caused a dramatic loss of confidence in the future success of businesses, many of whom are reliant of funding from banks, and thus a selling spree on financial markets worldwide.

The obvious immediate effect for UK homeowners is that those with poor credit history are facing a rocky road ahead. The market has moved in recent years so that virtually anybody could get a mortgage as long they weren’t bankrupt. This may no longer be the case in the aftermath of the US problems, and this could affect up to 10% of the UK mortgage market. Many lenders have already raised rates or withdrawn mortgages, including Victoria, GMAC-RFC, Unity Homeloands, Infinity Mortgages and DB Mortgages.

Regular borrowers have not yet suffered from the sub-prime fallout. In fact, it has been quite the opposite in some cases. Nationwide, Abbey, Alliance & Leicester and Coventry Building Society have all cut two-year fixed rates. They have done this as a result of the fall in inflation in July – down to 1.9%, below the government’s 2% target. This has improved the chances of the Bank leaving the base rate at 5.75%. The fall in inflation has led to a reduction in two and three years Swap rates (Swap rate is the rate at which banks borrow money, and it has an influence on fixed rate mortgage borrowing). On August 21 the two-year Swap rate was down to 6.1% from 6.3% earlier in the month.

One high street lender which has been particularly badly hit by the recent problems has been Northern Rock. It grew its mortgage business rapidly ion the past few years by borrowing cash, becoming the UK’s eighth largest bank in the process. The borrowed money leaves it on shaky foundations, and its share price has fallen by half in 2007.

Lenders who can draw on their deposits for mortgages still have to borrow cash to fund their loans and many of them sell on their debt. With the sub-prime crisis striking fears into all lenders, the cheap and easy borrowing that has been helping the stock market and property boom will come to an abrupt end. The financial world will want to place itself on a much firming footing in the future. Experts call it ‘repricing of risk’. At the same time homeowners have had to suffer five rate rises in the past year. What goes on in money markets in the US, Japan and even the UK stock exchange may seem a long way from a cottage in the country with a mortgage on it, but the likelihood is that mortgage lenders will eventually have to pass on the cost of their lending errors to mortgage customers.

There can be little doubt that this combination of higher borrowing costs and tightened lending criteria will bring a halt to double-digit house price inflation that we have seen for so long in the UK, especially as recent reports from Halifax and Nationwide have already reported the start of a slowdown.