Stand by for a British subprime crunch

Although fewer UK mortgage buyers are considered risky compared with the US, many are in for a shock as the market corrects here.

Unless you've spent August on a desert island, you'll know about the subprime mortgage crisis in the US. What started off as a problem in an obscure corner of the US housing market has spiralled into a housing and credit market slump that may pose the greatest threat to the financial system since the 1998 crash of the Long-Term Capital Management hedge fund. Rising interest rates and dodgy lending practices have hurried along a housing slump and may even lead to a US recession. Numbers out this week showed that the S&P/Case Shiller US National Home Price Index fell 3.2% last quarter from the same period a year earlier. That's the worst number since the index was created in 1987. Of the 20 cities included in the survey, 15 saw a price fall. That's not good news for US home owners, particularly as the data only runs up to the end of July before the subprime crisis really kicked off.

Only a few months ago, the American authorities were talking of the problem being contained', and claiming the housing market bottoming out'. It clearly hasn't. We would do well to learn from this complacency. Here in the UK, commentators claim that we have no significant subprime problems and that a similar crash couldn't happen here. We think they are wrong. It could and it probably will. Here's why.

What exactly is a subprime loan?

Eight percent of UK borrowers have been identified by the Financial Services Authority as being subprime', or high credit-risk debtors. That's a pretty significant number, but it's a lot lower than the 20% or so seen in the US and that's why so many analysts think we don't have a problem. The trouble is, this figure is a massive underestimate it isn't just those who have defaulted on loans in the past who are at risk of doing so now. What about all those other borrowers with previously good credit histories who have been allowed to self-certify their income, or include discretionary bonuses in the calculation of their earnings? Suddenly we're talking about accountants, lawyers, bankers and hedge-fund managers who have been able in many cases to justify a mortgage of, say, £800,000 on an income of £100,000 and the promise of future bonus payments.

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Then there are those who have signed up to mortgages of five or even six times their income, with banks like Northern Rock. Not to mention the large number of borrowers who signed up for deals such as the Bradford and Bingley max 130, allowing them to borrow 130% of the value of their property, putting them immediately into negative equity before they even cross the threshold of their new home. How many of these over-borrowers and self-certifiers are out there? No one really knows and that's the frightening part. The FSA has said in the past that around 6% of mortgages are self-certification, while the Council of Mortgage Lenders has claimed it's as low as 1%. Yet, in a BBC survey last year, a well-known mortgage broker boasted that nearly one third of his new mortgage business was self-certification and reckoned that was "fairly typical".

Worse, even if you are a convert to the "it's different this time" theory and you believe that in today's low interest-rate world a loan of five or six times your salary is sensible, what if the salary figure itself is actually a myth? Recently the Institute of Payroll Professionals pointed to scores of websites that offer fake payslips, allowing individuals to take on so-called "liar loans" based on incomes that simply do not exist.

There is a general opinion that UK lending standards are much tighter than in the US. But they may not be. Take the FSA's own report into the UK subprime market issued just last month. Having looked at numerous lenders, representing more than half the market, the regulator concluded that not one of them had "adequately covered" responsible lending when briefing their heavily commissioned sales advisers. A full half failed to carry out any suitability checks (the key one being whether the customer can actually afford the loan) before selling mortgages. And for anyone who thinks that Ninja loans (no income, no job, no assets) couldn't happen here, think again. The FSA reckoned that more than half of subprime customers had self-certified their mortgages anyway, so in effect responsibility for demonstrating affordability had switched from the lender to the borrower. The FSA's conclusion? "Poor sales practices" could lead to "serious wider consequences".

Subprime is already being squeezed

The impact of the recent credit crunch, "one of the worst liquidity crises in 55 years", as one lender put it, is being felt globally. Debt is suddenly very hard to get hold of no matter how big or creditworthy you are. UK subprime lenders, such as GMAC-RFU and Infinity Mortgages, have responded by either raising lending rates or pulling certain products altogether. Victoria Mortgages' managing director Alex Forrester has simply said: "We are not offering any mortgages at the moment", while others have hiked the interest rates charged by between 0.5% and a whopping 2.5%, according to mortgage broker Charcoal.

And the rot doesn't stop there the credit crunch is also forcing price hikes at some household names, too. Last week, Northern Rock said it was to raise mortgage rates across its entire range of products in response to the "rising cost of funding in the market". That includes a rise of 1.25% this week, specifically targeting subprime borrowers. Even the world's largest building society, the Nationwide, hinted darkly that as a result of events in the wholesale credit market, "pricing of loans could be affected".

Interest rates are likely to rise again

Any borrowers hoping for leniency from the Bank of England are likely to be badly disappointed as another rise in the base rate to 6% is still on the cards in the UK, probably this side of Christmas. This is thanks both to robust growth figures the Office for National Statistics reported a year-on-year rate of 3% last week and inflation. July's surprisingly low 1.9% seems unlikely to last, amid high prices for commodities like oil and wheat (up 80% since April to an all-time high this month). This was made more likely this week, after the ONS revealed that the deflator applied to GDP basically a downward adjustment that strips out inflation rose from 3.1% to 3.8%, the highest since 1996 and a sure sign that prices are still trending strongly upward.

A further rate rise would be the final blow for the estimated 125,000 households who are already behind with their mortgage payments, according to Bloomberg. But those 125,000 may soon turn out to be the tip of the iceberg. Hundreds of thousands more have been shielded from the past five rate rises (taking the base rate from 4.5% to its current level of 5.75%) by two to three year fixed-rate mortgage deals years taken out in late 2005 and early 2006. These "teaser rate" borrowers, who fall outside any official definition of subprime, are the UK property market's big time bomb. Around 750,000 people, who have so far paid their mortgages on time at artificially low rates, will face hikes in interest payments of around one third before Christmas, according to The Times. Ratings agency Fitch expects trouble, too its Delinquency Index has risen 7.7% in the past three months, compared with the previous three, and it expects arrears to keep rising. The likely impact on the rate of repossessions already up 30% in the first quarter of 2007 compared to the last quarter of 2006 could be eye-watering.

UK house prices must fall

As James Ferguson points out in Buy-to-let: the market's Achilles heel, UK house prices are hugely overvalued. Any further rise in property prices in a country where the average home costs up to 11 times the average income in some regions, will simply pile more pressure on buyers who will have to take on even higher levels of debt just as it is becoming more expensive. This can only lead to rising defaults. This is just one reason why prices are set to come back down to earth with a bang. In a recent report, Fitch declared the UK as one of three economies, along with New Zealand and Denmark, which were most vulnerable to a housing correction. Just a few months ago the IMF warned that UK residential property was overvalued "by any conventional measure".

Meanwhile, insiders are bailing out of the market. It is no coincidence that John Hunt, the founder of one of the country's most aggressive estate agencies (and mortgage finance companies, since Alexander Hall is part of the same group) Foxtons, sold the business months before the founder of, Simon Nixon, floated a firm that generates substantial sales from offering comparisons of once-cheap mortgage deals.

The truth is that UK borrowers were stretched to the limit even before the international debt markets effectively closed for business this summer. The sad reality is a big chunk of the bottom rung of the housing ladder is made up of borrowers who can't afford to be on it, or amateur buy-to-let investors who shouldn't be on it. Further up the ladder you have bankers and hedge fund managers wondering what will happen when the next £250,000 bonus that was supposed to pay down some of their mortgage doesn't show up in their pay packets this Christmas (estimates of the drop in 2007 City bonuses quoted in the FT range from 10% to 15%). That's assuming they are still around to collect it in the light of recent warnings of big job losses from the likes of UBS.

Already property consultancy Knight Frank warned in the FT that "if there is a downturn in City profits and employment levels, you couldn't be surprised if central London prices fall". Meanwhile, one London estate agent told the newspaper that fear in the City "had prompted several deals to fall through". As the vital cheap debt prop is taken away the whole house of cards will tumble. Expect to see a lot more deals collapsing in the near future.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.