Market commentary

20 August 2008

As Mervyn King pointed out, the housing and mortgage markets are going through an adjustment process. The question is how far the authorities will leave the correction to market forces and whether they will look to step in at a time when the wider economy is at risk of recession.

The Governor has made clear his objection to any long-term assistance with funding. The interim Crosby review highlighted a number of possible courses of action, including leaving the markets to adjust without intervention. After the mixed signals given out by the government over a possible stamp duty holiday, we hope that the authorities will act soon with timely, well targetted and decisive measures.

A market correction

Sir James Crosby's interim review of mortgage finance gave a succinct summary of the difficulties faced by the market. The shortage of mortgage finance, which Sir James believes could last through to 2010, has now become intertwined with demand. Buyer enquiries have declined each month for the last year, and consumer confidence has weakened.

The question the authorities must face is how best to deal with the correction, and what actions may be warranted to prevent it becoming painfully protracted.

Mervyn King made clear his belief that the adjustment process is necessary and best left to market forces. And those forces will determine the new level for house prices, "not the government, not us".

So what steps could be taken?

The interim Crosby review raised a number of possible courses of action to address the current difficulties, but offered no concrete suggestions. It also reserved the option of doing nothing. While the case for action can be made to counter significant risks to the wider economy, there is a danger that any action could distort the market and delay any subsequent recovery.

One option mooted was for the government to guarantee mortgage backed securities, either directly or implicitly through a US-style agency. But the implicit guarantee scheme was not considered appropriate for the UK, unsurprising given the current problems faced on the other side of the Atlantic. Mervyn King came out even more clearly against government guarantees of any sort, observing that the authorities don't offer such terms to any other area of private sector borrowing.

Sir James also outlined schemes to encourage new issuance of RMBS, such as that proposed by the CML. This would extend the current Special Liquidity Scheme to enable participants to swap securities backed by newly issued mortgages - at present only mortgages originated before the start of this year qualify. The tone of the Governor's recent comments indicate a reticence for extending the SLS. The Bank clearly objects to the authorities directly funding the securitisation market in the long term, but there might be a little room for manoeuvre in its short term operations.

The Review also highlighted a number of market led international schemes already taking place to improve the functioning of the securitisation markets, largely through improving transparency and standardising products. These are long term initiatives aimed at making the funding markets more efficient and are unlikely to have a significant impact in the near-term.

The MPC's dilemma

Against this backdrop, the immediate interest rate dilemma faced by the Bank of England has become even more acute. The recent Inflation Report highlighted how many of the risks previously identified by the Bank have materialised. Economic growth has slowed sharply and inflation has continued to rise - it is expected to peak at around 5% in the coming months, more than double the 2% target. While the Bank's central scenario is for the economy to virtually stagnate in the coming quarters, a recession was not ruled out.

Chart: Interest rate expectations

Source:Bank of England
Notes: The market expectations curve relates to commercial bank liabilities

The financial markets interpreted the Report as signalling quite sharp rate cuts as we move into next year, in the belief that a slowing economy will drag inflation lower next year once the current spike passes through. This has allowed several lenders to further cut the rates on fixed rate products.

However, as the Bank itself notes, the margin around any economic forecasts in the current environment is especially wide. The Governor made clear the MPC's determination to take whatever action is required to bring inflation back to target. Expectations for rate cuts could reverse quite sharply if the upside risks to inflation materialise.

No easy way out, but an opportunity for decisive action

We are currently going through an adjustment process. Even if conditions were to improve quickly, we would not see a return to the market of recent years. It is important for the authorities to consider the wider implications of this adjustment process.

Some will face a difficult time. The CML's figures for mortgage arrears and possessions in the first half of the year show a deterioration, very much in line with expectations. A further deterioration over the second half is inevitable in the current climate.

The recent messages from the authorities have been mixed and there is some confusion over what is on the table. The Crosby review raised several options but offered little on what action the final report will recommend, and also left hanging the possibility of no action. The Bank has raised objections to certain measures and signaled its preference for allowing the correction to be left to the market. Meanwhile, the government has created further confusion with the mishandled rumours of a stamp duty holiday.

The CML would like to see a joined up message from the authorities. We would like to see decisive and effective action taken promptly, before the Pre-Budget report.