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How to survive Britain's debt crisis

Many consumers will be counting the cost of financing their Christmas spending with credit cards and overdrafts this month. So how can you protect yourself - and profit - from Britain's debt dependency?

This article was first published on 6/10/06

Datamonitor research shows Britons owe more money than consumers in every other European country. So what's going on, asks John Stepek

UK consumers are the most indebted in Europe. It's a label we're all becoming very familiar with some would say rather too familiar. The latest report confirming our profligacy came from research group Datamonitor. The typical UK consumer now owes more than £3,170 on credit cards, overdrafts and personal loans twice as much as his European counterpart, who owes just £1,588. And that's not including our mortgage debt, which comes to about another £21,000. But we're used to these stories by now. It doesn't seem that long ago that the papers were running headlines about the UK debt mountain climbing above the £1trn mark for the first time. Now we owe more than £1trn on our mortgages alone, while consumer credit clocks in at just over £210bn.

It's tempting to fall into the trap of thinking that because we've lived this long with the debt mountain that it will always be the same. But the signs of strain are already beginning to tell. Bankruptcies are at record levels and still climbing, while mortgage repossessions and arrears are both picking up sharply.

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Take the old metaphor about boiling a frog if you heat a pan of cold water slowly enough, the frog doesn't notice the temperature changing until it's too late and it boils to death. Well, now the water around us is starting to bubble. And it's high time we paid attention.

How has the UK got into so much debt?

There are lots of theories about why the UK is the spendthrift of Europe. Hamish McRae in the Independent is just one of many commentators who cite the sophistication of our credit sector, which makes it easier and more attractive for us to borrow money. "Britons borrow because it is much easier to do so than it is for most Continental Europeans; the spread on mortgages is lowerwhile personal loans and credit cards are easier to obtain."

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But it goes deeper than that. Even in recent history, Britain has benefited from greater political and economic stability than most of the rest of Western Europe. For example, in the past 20 years alone, Germany, where consumer credit is noticeably lagging, has had to go through the upheaval of reunification. The two drastically different economies of West and East Germany were welded together, causing all manner of problems, including a government-subsidised construction boom that turned to bust in the mid-1990s, leaving Germany among the few countries in the world where property prices have changed very little in the past decade. Then there was the other big upheaval of joining the euro. So it's no surprise that their consumers are more wary of debt than those in the UK they have more recent memories of hard times.

However, the main factor in any discussion of British debt has to be the property market. So much of our perception about our own worth is tied up in housing. In many European countries, long-term renting is perfectly normal, but here in the UK people who rent are seen as being in some way disadvantaged. Perhaps they are too poor to buy, or simply too stupid to realise that they are merely paying off someone else's mortgage.

Low interest rates and our financial system's constant hunt for more ways to sell mortgages, have enabled people to borrow more heavily, which has sent house prices soaring most measures suggest they have doubled in the past five years. This in turn has made homeowners feel rich the so-called "wealth effect". Mortgage equity withdrawal (MEW) money withdrawn from property without being spent on another property or home improvements has picked up again this year after a sharp slowdown in 2005. People took more than £24bn out of their homes in the first half of the year up about 50% on last year.

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A family with a £100,000 mortgage hears that the property next door sold for £200,000. "We're rich!" they think. So when they see that £5,000 holiday or that £1,000 plasma TV they think, "Why not? We've made £100k on the house! Let's treat ourselves."

And as property prices continue to rise particularly with the tech crash and general worries over pensions still fresh in investors' minds people have looked to housing as a way to fund their retirement too. The number of buy-to-let mortgages reached record levels in the first half of this year. The market now accounts for nearly one in ten of all outstanding mortgages. 

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Does debt really matter?

But does rising debt really matter if it's underwritten by rising house prices? Unfortunately, yes it does. The trouble is that, for homeowners, this new-found property wealth is an illusion. The only way to withdraw cash from your home is to sell it. But then you have to find somewhere else to live, so you need to use the money to buy or rent another property. And for those on the property ladder, higher prices make it more difficult to move to a bigger, better house.

Therefore, so-called "mortgage equity withdrawal", where a bank agrees to lend you money on the basis that your property is now worth more than the debts you have secured against it, is really just a loan. You might get a better interest rate and a larger credit limit than on the typical credit card, but it's no different except that the lender gets to keep the house if you don't pay up.

For those investing in second or third homes, of course, house-price gains are real enough once they've locked them in. But it's only when you come to sell a home that you find out how much it's really worth. As Bank of England Governor Mervyn King said: "House prices are a matter of opinion, whereas debt is real."

As for using property as a pension, this carries its own particular risks. Traditional saving and investment through stocks and shares, for example, don't involve borrowing lots of money. Investing in rental property, on the other hand, is a leveraged bet on house prices.

And regardless of what you believe about the property market, one thing is hard to deny property is expensive, whichever way you look at it. And the rush to jump on the buy-to-let bandwagon looks very much like a bubble.

One example that sums up the general mood was a recent case study in The Daily Telegraph. It featured a pair of amateur landlords buying a two-bedroom flat in Bournemouth. They happily acknowledged that the rental payments would fail to cover mortgage and maintenance costs, and that the flat would cost them £50 to £100 a month. Why did they buy it? "Because it's such a good investment," was the reply.

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This is like buying a share and then paying the company an annual dividend for the privilege of holding onto it. If such a thing happened in the stock- market (and something similar actually did, in Japan, at the peak of the Nikkei bubble) there would be no doubt that we were in a stockmarket bubble. But of course, as always, the property pundits keep arguing that "this time it's different".

Will it all come tumbling down?

The main problem with debt is that it has to be paid back. If you borrow from the future to fund current consumption, you are effectively taking a gamble that you will be able to pay back that money when the creditor needs it.

The more money you borrow, the bigger the risk that you won't be able to pay it back. And given that households now have a record level of debt, they have left themselves very vulnerable to sudden changes in circumstance like losing a job, getting divorced or having a baby. In that case, the only option might be to renege on the debt.

Some people are already having to do that. Even though interest rates are at historically low levels and employment is high, the number of bankruptcies stands at record levels and is still rising. It's likely to breach the 100,000 mark for the first time ever this year. In the second quarter alone, 26,021 people became insolvent, an increase of 66% on the same period last year.

Banks pin a lot of the blame on Individual Voluntary Arrangements (IVAs). These allow working individuals with unmanageable unsecured debts subject to certain conditions to reach agreement with their creditors to pay off a proportion of their debts over a set period, usually five years. In exchange, the rest of the debt is written off and the person's credit rating is left unimpaired.

Since bankruptcy rules were relaxed in April 2004, IVAs have been heavily promoted by companies specialising in insolvency, and the banks, needless to say, haven't been impressed. In fact, they have tightened up sharply on their credit-card lending policies. This has, however, made no difference to overall lending because, at the same time, borrowing against your home has become easier.

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But it's not just unsecured lending that banks should be concerned about. The mortgage market is also showing growing signs of distress. Home repossessions are soaring, albeit from a low base during the second quarter of this year, 33,180 mortgage possession actions (the first step in the repossession process) were entered, up 17% on the previous year. According to the Council of Mortgage Lenders, 280,000 mortgages are one month or more in arrears a 4% increase on last year, while the number of homes repossessed in the first half of the year was 8,140, the most for more than five years.

The last peak in bankruptcies came in the wake of the early 1990s recession. But this wave of insolvency, and the sharp rise in repossessions, is happening against a relatively benign economic backdrop. If macro-economic conditions deteriorate, conditions for indebted Britons are likely to get far worse. Plus a long list of potential hazards is just around the corner. UK interest rates are still firmly on the upward path. Unemployment is continuing to tick up. And abroad, the US economy is running into problems with its own housing market. Any slowdown in US growth will have a knock-on effect on the global economy, which would of course have an impact on the UK.

UK debt crisis: what should you do about it?

In investment terms, there are several sectors we suggest you avoid. Retail is the most obvious. Last year, a dozen high-street retailers went to the wall, according to research group Verdict. It expects underlying sales on the high street to grow by less than 0.1% a year between now and 2010. This means that much of the success of individual shops is now built on stealing sales from others, rather than sharing in an ever-growing pie. If consumers are forced to rein in their spending, then shops will be fighting over even smaller pieces of pie. That doesn't bode well for profit margins or for share prices.

The banking sector also doesn't look like a great bet. But worse still is the sub-prime lending sector. These lenders have seen business boom in recent years as more people have been rejected by mainstream lenders. But these are also the people who suffer first in a downturn.

Another striking statistic that partly explains why we owe so much money is that British people now spend more each year on eating out and takeaways than we do on cooking at home. That trend will reverse sharply when the debt squeeze is on. So avoid the restaurant sector: at some point, all of those personal finance articles reminding us that a daily latte costs us in the region of £500 to £1,000 a year will stick in people's minds and the purveyors of takeaway food will be in trouble.

And at times of uncertainty in the markets, it's not a bad idea to keep more of your money in cash than perhaps you normally would. Rising interest rates mean that the rates on tax-free Isa accounts are improving and, of course, this keeps money available for any opportunities that present themselves when the downturn arrives.

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But it's not all bad news for stocks. Some companies will benefit from the debt crisis find out which ones in the box below.

Which stocks could gain from rising debt?

The trend for rising bankruptcies is continuing apace and plenty of companies are lining up to take advantage. Insolvency practitioners such as Debt Free Direct (DFD), ClearDebt (CLEA), Debts.co.uk (DETS) and Debtmatters (DEBT) have flocked to Aim. These companies make their money by arranging IVAs for people in debt. The firms are valued for rapid growth, but there's a good reason for that. Debt Free Direct, which trades on a p/e of 28, had a record month in August, handling 607 IVA cases. The company now expects annual profits to be 10% ahead of forecasts.

And the sector looks set to benefit from another IVA innovation, the Simple IVA, which the Government is expected to introduce later this year. A standard IVA needs the consent of creditors representing at least 75% of the applicant's debt. But the Simple IVA would cut this to 51% for debts below £75,000. However, it is important to keep an eye out for regulatory risk. IVAs are an easy scapegoat for banks trying to explain rising bad debts to shareholders, and the sector has called for changes in the way they are marketed. Concerns have also been raised that IVAs are being recommended to people for whom straightforward bankruptcy is more suitable. So while growth looks set to continue in this area, it is worth watching out for a possible crackdown.

Another group already benefiting from rising debts are pawnbrokers. There are two main listed firms in the sector. Acquisitive Albemarle & Bond (ABM), had "another very successful year" in the 12 months to 30 June, which saw profits rise 18% to £6.6m. Meanwhile, recently floated H&T (HAT), made £0.4m pre-tax profit in the first half, compared to a £0.5m loss last year. The group also offers a range of "alternative" financial products such as pre-paid debit cards.

What can you do to protect yourself from the debt crisis?

So what should you do if you're worried about your own share of the debt burden? "I'm about to buy another property with an 85% mortgage and I'll get the deposit on credit card," writes Alice Douglas in The Independent. Needless to say, Ms Douglas, who already has "about £30,000" on her credit cards, is doing exactly the opposite of what we suggest MoneyWeek readers should be doing right now.

The first step should be to pay off your credit card debts. There is no point in having savings if you have credit-card debt as well unless you are being charged 0% interest, which will generally only last for a set period. You might as well put it all to paying off your debt. And don't ever use store cards they charge by far the highest rates of interest.

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Look at switching your mortgage to see if you can cut the amount of interest you are paying, but don't forget to take into account costs such as legal fees and account-closing costs from your current provider. And if you're on a variable rate, it could well be time to consider going for a fix. If you're undecided about whether to go for a fix or a variable rate, think about how you would make your mortgage payments if interest rates were, say, 2% higher in a year's time. That's not a prediction but stranger things have happened, and with something as important as the roof over your head, it's worth making sure you will be able to afford repayments even in the event of nasty surprises.

If you have more than one property, take a good long look at your portfolio. Rental yields in many parts of the country have fallen sharply average net yields across the country were just 3.6% last year, according to Investment Property Databank. Could it be worth offloading some of the non-performing properties and using them to pay off some of your other debts?

As for where to put your money, the biggest worry when a debt bubble collapses is to avoid risky investments. As Bill Bonner puts it, it's a time to "worry about the return of your investments, not the return on your investments".

So as well as high-interest savings accounts, investors might want to look at holding some gold, traditionally a good store of value. Other potential stockmarket investments include high-yielding, defensive stocks such as utilities.

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