How hedge funds affect house prices

One reason that house prices have remained stable, even in the face of rising interest rates, is that lenders have in fact been making it easier for people to take out mortgages. Why? The answer might surprise you...

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The way the City chooses to describe various financial instruments can be quite instructive.

If a company has a bad credit record with a significant chance of defaulting on its debts, then its debt is described as "junk". But if an individual is seen as a poor credit risk, the loans they are offered are described as "sub-prime".

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No doubt lenders would have a tougher time selling "junk mortgages" than the rather less judgemental-sounding "sub-prime" loans.

But whatever you want to call them, risky mortgages are the biggest growth area in the UK home loan market today. At the same time, repossessions and mortgage arrears are creeping higher, and global interest rates are rising.

That doesn't sound like a healthy mix to us...

As we mentioned in yesterday's Money Morning, lenders have been falling over themselves to dish out mortgages to the UK's "sub-prime" market. And the City watchdog is starting to get a little bit worried.

Yesterday's FT headline was "Fears over surge in high-risk mortgages". The Financial Services Authority (FSA) is concerned about "a sharp surge in mortgage lending by investment banks and brokers to risky customers with poor credit records."

Merrill Lynch-owned Mortgages Plc reckons that sub-prime mortgage lending accounted for about £25bn to £30bn last year. That's about 10% of the total mortgage market and significantly higher than the £20bn loaned to buy-to-let investors.

You would think that with rising bankruptcies, repossessions and record levels of UK consumer debt, banks and building societies would be trying to rein in borrowing. And in fact, lenders are making it more difficult to take out unsecured credit, like personal loans and credit cards.

But at the same time, they are diving into the sub-prime mortgage market as if everything was rosy. In fact, the latest credit-impaired' product launch from Leeds Building Society is aimed at people who are buying shared ownership properties.

For those who don't know, buying a home via shared ownership involves purchasing a 25% (or larger) share of a property from a housing association. The rest is then rented from the association at a subsidised rate. The part-owners can buy further shares in the property as and when they feel able.

"It is clear that if a customer has impaired credit and needs shared ownership, they have very little opportunity to own their own homeThis new mortgageallows clients to borrow 100% of their share of the property", enthused Leeds product development manager Stuart Fearn.

Let's get this straight. The ideal customer for this mortgage needs a government subsidy to be able to afford a house; has no deposit saved up; and on top of this, can't get a mortgage anywhere else because of their bad track record on repaying debts. If that's not sub-prime, we're not sure what is.

So why are lenders all jumping on this seemingly rickety bandwagon? One reason of course is that secured debt represents far less risk for the bank or building society than unsecured debt.

If you default on your credit card, there's not much they can do except avoid lending to you again. But if you default on a loan secured against your home, then the lender gets to take your house.

Profit margins are also higher on sub-prime loans. Sub-prime lenders have something of a captive audience, so they get to charge higher rates, which compensates partly for the risk.

But another reason is revealed in the FT article hedge funds.

Let us explain. Investment banks are getting into the mortgage market because they can earn fees by packaging up all those individual mortgages and selling them on as residential mortgage-backed bonds.

The more credit risk these bonds carry, the better the yield. And high yield is exactly what hedge funds are looking for. Because mortgage arrears are still low by historical standards, "the bonds have performed well", says the FT. So that increases hedge fund demand even further.

But it's the phrase, "low by historical standards", that's the problem. As the FSA said: "The credit scoring techniques have so far proved robust but most have only been developed in the last decade, under relatively favourable credit conditions There is a possibility that the current rates do not correctly price the risk of a downturn."

Just a possibility? Repossessions and arrears are rising, and bankruptcies are already at record highs. Unemployment is ticking higher, and global interest rates are also rising which will put pressure on our own Bank of England to hike rates.

We'd say it's a raging certainty that the risks of sub-prime mortgage debt just as with almost every other asset class across the globe have been underpriced.

If demand for these sub-prime bonds collapses, mortgage lenders will rapidly have to tighten their lending criteria. That would result in the fastest-growing corner of the mortgage market become the fastest-shrinking.

What would that do to house prices? Well, we can't see into the future - but take a look at the recent stock market plunge if you want a reminder of what happens when investors start to worry about risk again.

Turning to the wider markets...

The FTSE 100 ended higher, up 26 points at 5,678 on Wednesday. The main risers were media stocks, with Pearson rising 2% to 706.5p on rumours that the publisher is considering a tie-up between the FT and the Wall Street Journal. For a full market report, see: London market close

Over in continental Europe, the Paris Cac 40 rose 2 points to 4,774, while the German Dax fell 2 to close at 5,456.

Across the Atlantic, US stocks made gains, though volume was light ahead of the Federal Reserve's interest rate decision (which arrives at around 7:15pm this evening, UK time). The Dow Jones Industrial Average rose 48 to 10,973, while the S&P 500 closed 6 points higher at 1,246. The tech-heavy Nasdaq gained 11 to 2,111.

Over in Asia, the Nikkei 225 gained 235 points to 15,121, recovering from yesterday's heavy sell-off. Exporters were helped by the improved sentiment shown by US investors during trading on Wall Street.

This morning, oil was mixed. A barrel of crude was trading higher in New York at around $72.55 a barrel, but Brent crude was a little lower, easing back to around $71.60.

Meanwhile, spot gold was little changed, trading at around $581 an ounce. Silver was also flat, at around $10.22 an ounce.

And in the UK this morning, the bidding frenzy continues. Hotel and leisure club operator De Vere Group has accepted an improved £745.4m offer from AHG Venice. AHG is now offering 850p a share, compared to an initial 825p.

And our two recommended articles for today...

Six places that are on Jim Rogers' radar right now

- Legendary investor Jim Rogers has made his money by buying into places that most people have barely even heard of, let alone considered investing in. At a recent conference, the Daily Wealth's Tom Dyson heard him talk about the six regions he is most interested in right now - to find out what they are, click here: Six places that are on Jim Rogers' radar right now

Why Peak Oil has no impact on oil prices - yet

- An increasingly common explanation for soaring oil prices is the phenomenon of Peak Oil - the idea that we are rapidly reaching the point of no return in terms of oil production. But how can this be true, with vast potential reserves in Canada's oil sands and in oil shale in the US? As Justice Litle points out in the Daily Reckoning, the problem isn't so much the amount of oil in the ground - it's getting it out. To find out why neither oil shale nor Peak Oil will have any impact on the oil price for the forseeable future, click here: Why Peak Oil has no impact on oil prices - yet

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.