20 December 2012
The Funding for Lending Scheme (FLS) is likely to be a key factor influencing short-term market developments. Coming alongside wider improvements in funding conditions since mid-year, the FLS appears to be making an early positive contribution to mortgage pricing and credit availability. Our central view is that this will continue, and give rise to a discernible, although not dramatic, improvement in lending activity through 2013.
The prospect of household real incomes stabilising, and then recovering slowly, should help to underpin housing and mortgage activity, by the time the stimulus from the FLS fades when drawdowns under the scheme cease from early 2014.
Assuming that the jobs market continues to be relatively stable, and that lenders retain the flexibility to determine where forbearance is appropriate, we envisage arrears and possessions remaining close to current levels throughout the forecast period.
While our central forecast is for a gentle underlying improvement in activity over the next two years, there are several key market risks and these are predominantly on the downside. The biggest concern continues to be that of a disorderly break-up of the Eurozone, although the possibility of this appears to have reduced somewhat over the past year. A tougher line from macro-prudential regulators on capital requirements could also dilute the positive effects that we expect to see from the FLS.
Table 1: CML market forecasts
|Residential property transactions, UK, 000s||859||886||886
|Gross advances, £bn||143||135||141
|Net advances, £bn||12||8||9
|Number of mortgages in arrears, 2.5% or more of outstanding balance at end period:||199,600||175,800
|Number of possessions in period:||48,900||38,500||37,300
The UK has emerged from its mild double dip recession, but continues to experience a drawn out and anaemic economic recovery.
Chart 1: OBR economic growth forecasts, GDP % change
The Office for Budget Responsibility (OBR) estimates that our economy shrank by 0.1% this year, and has revised down its short- and medium-term growth forecasts, largely on the back of weaker prospects for the world economy. The OBR now expects GDP to grow by 1.2% next year followed by a 2.0% increase in 2014. This is broadly in line with private forecasters and also the latest collective judgement of the Monetary Policy Committee, and forms the starting point for our central forecast.
Although short-term growth prospects appear modest, it is important to note that some of the long-standing headwinds to UK growth should gradually abate.
In particular, while the Eurozone crisis continues to cast a shadow over economic prospects, there are grounds for being more optimistic than a year ago. Eurozone policy-makers have made progress on delivering fiscal and economic reform and designing new institutional arrangements. And summer’s announcement from the European Central Bank, that it was willing to provide unlimited support to lower the sovereign funding costs of member states that committed to undertake necessary reforms, has had a transforming and lasting beneficial effect across funding markets.
Eurozone risks still persist and, were the Eurozone to fracture, this would have dire consequences across major economies, including the UK. Although we cannot insulate ourselves fully, given our strong economic ties, the UK authorities have introduced measures that guard against some of the worst financial contagion effects.
In June, the Bank of England activated its Extended Collateral Term Repo (ECTR) facility. Although it has been little used over the past few months, ECTR has reassured firms, the regulator and financial markets more generally that the central bank will provide UK banks with whatever liquidity they need in times of financial stress. The Chancellor George Osborne has also given the Financial Policy Committee (FPC), responsible for macro-prudential policy, an additional objective of supporting the economic policy of the Government, including its objectives for growth and employment. Prompted by the FPC, these actions have in recent months encouraged the FSA to soften its guidance on liquidity requirements.
Meanwhile, the messaging by the regulatory authorities around capital adequacy has fluctuated somewhat, and although the recommendation from the latest FPC meeting suggests that attitudes have hardened again recently, the implications for residential mortgage lending appetite are unclear at the time of writing.
But the most important policy development for the UK economy has been the launch in August of the Funding for Lending Scheme (FLS).
The coalition government’s adherence to its deficit reduction plans leaves the Chancellor with little scope to use fiscal policy to support economic growth. Looking beyond the special factors that distorted the headline numbers in the recent Autumn Statement, the underlying stance was broadly neutral in fiscal terms. In consequence, the Chancellor continues to rely on monetary policy to bolster economic prospects.
The minutes of recent Monetary Policy Committee meetings show that the Bank of England has considered the merits of base rate reductions and further quantitative easing (QE), but appears to have “parked” these options, at least for the time being, while it evaluates the impact of the FLS.
As we describe later on, we see the FLS playing an important role in shaping the near-term profile of housing and mortgage market activity.
Elsewhere, another positive domestic economic development through 2012 has been the surprising buoyancy of the labour market. In the three months to October, adult employment was half a million more than a year earlier, with the gains also extending to full-time employment. While there is an apparent disconnect between strong labour market conditions and weak output - and so a concern that employment could yet fall substantially or fail to increase materially alongside any economic recovery - the near-term implications are positive. While uprating to benefits underpinned much of the surprisingly strong growth in real incomes in Q2, jobs growth also made a positive contribution.
This is important, given that the household sector has been under financial pressure over a protracted period and that a notable feature of the UK’s lacklustre recovery so far has been the conspicuous absence of consumption.
Assuming that the jobs market remains reasonably stable, and that pay settlements remain well-anchored near the 2% level, the anticipated (albeit slow) unwinding of inflationary pressures from the second half of 2013 should open up the prospect of a modest cumulative boost to household incomes. This in turn should help to lift consumer confidence out of the doldrums and have a positive impact on consumer spending and borrowing appetite, with some obvious benefit for housing and mortgage market activity.
Housing and mortgage markets
The wider economic picture continues to represent a challenging backdrop for the UK housing and mortgage markets.
Supporting the housing market is an integral part of the government’s wider economic growth agenda. It has supplemented its 2011 housing strategy with some fresh measures to boost house-building. Reflecting its fiscal straitjacket, the government has only made available relatively small amounts of additional finance to stimulate the beleaguered house-building sector. However, this did include £280m to extend its FirstBuy scheme through to March 2014, potentially helping a further 16,500 households on to the property ladder.
But much of the focus of public policy has been to create a catalyst to attract private finance, by leveraging the government’s high credit standing among investors. In the housing space, the government has been developing a debt guarantee scheme to encourage investment in build for rent (in response to Sir Adrian Montague’s review of the barriers to investment in private rented homes) and affordable homes. The aim is to begin offering such guarantees from early 2013.
Elsewhere, the authorities are pressing on with new-build indemnities (NewBuy in England, MI New Home in Scotland and a recently announced Welsh scheme) - to increase the supply of higher LTV mortgage finance for new-build homes - and its reinvigorated Right-to-Buy policy. As with FirstBuy after its launch, initial take-up under NewBuy was relatively slow, but there is now broader participation and volumes have recently begun increasing.
All of these initiatives, alongside others from local authorities and lenders themselves, provide some valuable upside potential for transactions and mortgage lending. Although they are likely to be incremental rather than transformative in nature, an important positive for the wider market is that there now seems to be less risk that such measures will be undermined by wider funding developments.
Funding and the FLS
Increased funding costs associated with earlier financial strains in the Eurozone area began to show through into higher mortgage rates during the closing months of 2011. By early this year there was a danger of credit becoming materially more expensive and scarce.
This in turn threatened to stymie the modest pick-up in housing market activity that had started in the second half of 2011.
By mid-year, the prevailing market view was that UK bank lending overall was more likely to contract rather than increase over the short-term, in part reflecting the plans of some major UK banks to shrink their balance sheets in the post-financial crisis environment. This prompted the authorities to launch the funding for lending scheme (FLS) last August. In essence, the FLS offers relatively cheap four-year funds to participating firms over an 18-month drawdown window. As the Bank has made clear, the scheme has been designed not only to encourage more new lending, but also to provide incentives for slower contraction in lending on the part of those firms that might previously have planned to shrink their balance sheets.
Whereas the FLS was conceived by the UK authorities to mitigate the worst impacts of a potential fresh credit crunch, its launch has in fact coincided with a much more positive external funding environment (thanks largely to the European Central Bank actions mentioned earlier). This more benign context, in our view, means that the FLS now has the potential to underpin a modest pick-up in mortgage lending activity.
Chart 2: Gross mortgage advances, £million
The Bank of England's latest Inflation Report provides a useful blueprint for monitoring the effectiveness of the FLS.
The scheme has attracted significant lender interest. To date, 35 firms, representing about 80% of total lending to the real economy - and a similar proportion of residential mortgage lending - have signed up to the FLS.
Since the FLS was launched, funding conditions for UK banks have improved substantially. The Q3 credit conditions survey highlighted a very strong improvement in credit availability. Although global factors have been at play, with ECB actions playing an important role, funding costs for UK banks have fallen by more than elsewhere, suggesting that the FLS has already begun to have a positive effect. As well as the obvious direct impact, the FLS should also act indirectly, as the reduced funding needs of participating firms should lower wholesale and retail funding costs more broadly. As relatively few participating firms have drawn down FLS funds so far, it seems reasonable to anticipate further benefits accumulating into 2013.
While it is not possible to separate out FLS impacts from the more general improvement in funding costs, the FLS is likely to have made an early positive impact.
An important development for the market is that the upward pressure on new mortgage rates - evident during the first half - has shown signs of abating in recent months. This is particularly true for fixed rates, which are the predominant product chosen by borrowers.
Chart 3: Average mortgage rates, new lending, % pa
While competition initially focussed on lower risk business, there are indications of a developing risk appetite from some lenders, with greater availability and lower mortgage pricing at higher LTVs also emerging. This improvement in credit availability appears to have bolstered expectations in the mortgage market, and may have also contributed to recent reported improvements in consumer confidence.
A key test, however, will be the extent to which greater borrower appetite materialises in response to better credit availability.
While it is early days for the FLS, and the Bank has cautioned against expecting to see higher activity as a result of the scheme until 2013, we believe that a degree of guarded optimism with respect to mortgage lending is warranted.
Remortgage activity has been pretty subdued for some while, with low back book rates limiting the rationale for borrowers to refinance onto new deals, and generally flat house prices doing little to improve the refinancing options for households with limited equity. In the past few months, however, there have been signs of a pick-up in activity, in response to increases in standard variable rates by some lenders earlier this year and more attractive refinancing deals. While this recovery is from low levels, we think that it is realistic for the 2012 dip in remortgage lending to be reversed next year, and for activity to match or even slightly exceed the £47 billion level seen in 2011.
Chart 4: Recent trends in mortgage lending, £million
Conditions in the housing market are less easy to gauge, and the process is not helped by the numerous factors – such as the earlier stamp duty holiday for first-time buyers, the Queen's jubilee celebrations and the London Olympics - which have distorted the monthly pattern of house purchase activity. We have been pleasantly surprised by the resilience of the housing market this year, although our sense is that activity was somewhat front-loaded into the first half, and that the underlying picture since then has been more stable. Nevertheless, seasonally adjusted approvals have strengthened in recent months, according to the Bank of England. Taken together with evidence from RICS and other surveys, suggesting that buyer (and seller) interest has picked up, the inference is that there is a reasonably robust base on which to build.
Macro-economic developments, and particularly those affecting the jobs market and wider inflationary backdrop, will also be important, but, as we have mentioned already, there are grounds to be hopeful that these will be modestly supportive factors. Taken overall, our central forecast is that the FLS will help underpin a further modest recovery in house purchase activity during 2013.
Improved mortgage credit availability looks set to benefit both home-buyers and private landlords.
The number of first-time buyers is likely to exceed 200,000 in 2012 and just touch its highest level since 2007, and this may well be surpassed (although again by a small margin) in 2013.
Buy to let, meanwhile, has seen activity levels build up progressively from fairly modest levels. The combination of strong demographics, limited new housing supply and the affordability pressures facing potential home-buyers, has pushed rents higher, providing a strong platform for a further expansion in landlord activity.
As with other time-limited measures, the FLS has the potential to bring forward some activity into 2013, resulting in a possible modest dip the following year. However, we anticipate a prospective modest but durable recovery in household incomes to have a largely offsetting impact, underpinning borrower demand and activity at levels which broadly match or are a little higher in 2014 compared with this year.
Arrears & possessions
It has been a welcome surprise to see the relatively strong performance of mortgage loans over the past year, especially as there is continuing evidence of financial hardship for a significant minority of households.
Chart 5: Number of mortgage arrears, by percentage of total balance in arrears, end period
The number of mortgages in arrears, on our preferred percentage of balance basis, has essentially been flat this year, whereas we had foreseen a gentle increase as a result of ongoing pressure on household finances. Lower than expected mortgage rates for existing borrowers, lender forbearance that is appropriate and helpful (the sort recently praised by Andrew Bailey, the FSA's head of prudential business unit), and unexpectedly benign labour market conditions, together explain much of the better performance.
While the future jobs picture is not easy to gauge, the FLS should help to ensure that mortgage rates persist at lower rates for longer. The recent Autumn Statement also confirmed that the temporary concessions relating to the £200,000 capital limit and 13-week waiting period for benefit claimants seeking help with mortgage interest payments will continue for another two years - an important part of the current safety net arrangements.
Some borrowers may also take advantage of attractively priced fixed rate products currently to insulate themselves from the higher market rates that are likely downstream (even though few economic forecasters expect material increases in official interest rates before 2015-16).
So, even after the FLS window closes from early 2014, our expectation is that arrears rates and indeed possessions will continue at elevated levels, but within narrow parameters close to current levels through our forecast period.
Our central expectation is for a discernible but modest improvement in activity levels next year, on the back of better funding market conditions and a still subdued, but slowly improving, UK economy.
The FLS is a significant influence on the overall profile of our market forecasts. Better credit availability and lower mortgage rates should help to stimulate stronger activity through 2013, but not dramatically so, given the headwinds that continue to hold back consumer spending and the wider economic recovery.
We see household finances stabilising through 2013, as consumer inflationary pressures recede. A gentle recovery in real incomes then supports more widely based domestic economic growth and this in turn helps to offset any negative impact that may be associated with the expiry of the FLS.
Better credit availability offers some clear upside potential for housing and mortgage lending activity in 2013 , but in most other respects the short-term risks to activity levels are weighted in a downwards direction. As well as the ongoing downside risks associated with the eurozone, our forecasts depend crucially on the continuing resilience of UK employment. Recent comments from UK regulators about the capital requirements of major banks have also added some unhelpful uncertainty to how banks feel able to respond to incentives to lend.
Overall, however, 2013 should be a year in which housing transaction numbers and mortgage lending both show a modest but tangible increase.
- Name: Bob Pannell