2 years ago few people had heard of Libor, the London Interbank Offered Rate, let alone knew what it was. Most people still won’t be able to define Libor but as a result of the credit crunch many people will at least be familiar with the term, as mainstream news bulletins took to reporting daily changes in 3 month Libor after Lehman’s bankruptcy.
The definition used for the calculation of Libor for the purposes of any Libor linked product is the British Bankers’ Association (BBA) fixing of Libor at 11.00.a.m. each day, based on the average of the rates at which inter-bank deposits are offered to the contributing banks for various terms and in all the major currencies. Not all of the contributing banks provide rates for every currency.
Libor, particularly 3m Libor, is a widely used benchmark for short-term interest rates and, as outlined above, is in theory is the rate of interest at which prime banks borrow funds from each other for terms from overnight to 1 year. However, over the past year it became known as the rate at which banks don’t lend to each other!
All of the contributing banks are major banks and prior to the credit crunch the rates supplied on any one day by these banks would be similar. However, the lack of trust in even major banks after Lehman’s collapse resulted in much wider variations in the rates at which even these banks could borrow from one another. Questions were even asked as to whether some of the banks were massaging the rates supplied to the BBA to avoid admitting the real rates they were being quoted to borrow from their peers.
Readers will be most familiar with the Sterling 3m Libor rate, which is not only the Libor rate most commonly quoted but also the rate used for nearly all mortgages which track Libor. A mortgage linked to 3m Libor is in effect a serious of 3 month fixed rates, with the rate reset at the beginning of each 3 month period.
Because most tracker mortgages are linked to Bank Rate rather than Libor, whereas the funds lenders borrow in the money markets will normally linked to Libor, as far as their mortgage lending is concerned the important point for lenders is not the actual rate of Libor but the spread between Bank Rate and Libor, particularly 3 month Libor.
Movements in 3m Libor anticipate Bank Rate changes expected by the market and prior to the credit crunch 3m Libor averaged about 0.16% above Bank Rate. This margin rocketed to well over 1% at times over the last year but 3m Libor has today fallen back to only 0.05% above Bank Rate, which is a good indication that conditions in the money market are improving.
However, much of the money borrowed by banks and building societies to support their mortgage lending is not borrowed for just the short Libor term but by way of a Floating Rate Note (FRN), a Residential Mortgage Backed Security (RMBS) or a Covered Bond for a longer period, typically 5 – 15 years, with the interest rate set for the whole term at a fixed margin above or below Libor. The actual margin depends on market conditions, the status of the borrower and, for mortgage backed securities and covered bonds, the quality of the security offered.
All three markets closed for new issues following Lehman’s bankruptcy and the FRN and RMBS markets have only just reopened. Over the last few weeks Barclays, Nationwide and Lloyds have all raised money by issuing sterling senior unsecured FRNs for 10-12 years. Nationwide, for example, raised £700m for 10 years, but had to pay 1.85% over 3m Libor, compared to 0.1% over Libor last time it raised money in this way, which was in 2005 This is a clear indication of how much the market has changed, despite Libor rates above Bank Rate returning to pre credit crunch levels.
Lloyds had to concede an even bigger margin over Libor, which says a lot for the trust the market has in our Government’s commitment to playing fair with those institutions which choose to lend new money to our nationalised and part nationalised banks! Barclays, on the other hand, were able to borrow a little cheaper than Nationwide.
Only this week Lloyds has raised about £4bn at 3m Libor + 1.8% in the first European issue of a residential mortgage backed security since Lehman’s bankruptcy.
The perception most people have is that Libor is the cost of funds to banks and building societies. However, as can be seen from the fact that Nationwide have had to pay 1.85% over Libor to borrow new money, it is not that simple. The cost to lenders of borrowing in the money market is a combination of the margin over or below Libor they have to pay plus the rate of Libor itself. Most lenders will still have FRNs issued on much finer margins before the credit crunch and the more they have still outstanding in these issues the lower will be their average cost of funds.
The return of Libor rates to normal margins over Bank Rate and the re-opening of the FRN and RMBS markets are both encouraging signs for the mortgage market. These issues made sense for the lenders concerned, despite the high margin over Libor, because they still provided funds cheaper than the 3% or so they have to pay to be competitive in the instant access retail savings market, or more for 1-5 year fixed rate bonds.
Now that some lenders can again raise funds in the money markets at an acceptable rate, we should begin to see more competition in the mortgage market emerging as these lenders will now be better able to take advantage of the historically high gross margins available in the residential mortgage market. This suggests that current margins above the cost of funds, both for variable rate and fixed rate mortgages, are close to a peak.
Also, with house prices almost certainly going to show an increase in 2009 (my current forecast based on the Nationwide index is an increase of 6-7%) but most lenders budgeting in their 2008 accounts for a fall this year of around 15% and further falls next year, plus repossessions well below forecast levels, provisions for bad debts on residential mortgage lending in lenders’ 2009 accounts should be well down on last year’s provisions, although commercial lending may be a different story.
This all suggests that conditions in the residential mortgage market should start to improve in the near future, although the extremely onerous Basel 2 capital adequacy rules mean that the spread between the cost of high and low LTV mortgages will continue to far wider than prior to 1 January 2008, which is when the current rules came into force.
Liberal Democrat Shadow Chancellor Vince Cable opened his speech at the party conference yesterday by saying "If there were ever a time for the Liberal Democrats, this is it." On that basis I presume he doesn’t expect the LibDems to ever form a Government.
He correctly identified that the next General Election will be fought over the economy and then predictably tried to rubbish the two main parties’ credentials in this area. After speaking of the “enormous economic challenges” facing the country he said: “One (option) is to trust the people who led us in to the present mess to get us out of it: but this would be a triumph of hope over experience.” It is hard to disagree with that statement.
But his criticism of the Conservatives was that their “life time experience of business is confined to managing their Bullingdon Club bar accounts.” He claimed that LibDems, on the other hand, were better able to sort out the economy because “These are big jobs for people who’ve been tested in the real world of work.” This presumably wasn’t meant to be a joke but it is hard to think of many LibDems who have “been tested in the real world of work”, notwithstanding the fact that Vince did have a proper job before becoming an MP, and I am not referring to his ballroom dancing!
The two announcements which have grabbed most of the headlines are to impose a so called Mansion Tax on owners of properties worth more than £1m and to increase the earnings threshold before income tax becomes payable to £10,000.
Cable said “It is wrong that people on the minimum wage should be dragged into tax.” The minimum wage for employees over the age of 22 increases to £5.80 per hour in 9 days time and so assuming someone on minimum wage works a 40 hour week and gets holiday pay they would earn £12,064 p.a. In fact anyone working at least 33½ hours a week would earn over £10,000 p.a. For someone who is meant to be an economist Mr Cable’s command of basic arithmetic appears to be somewhat lacking.
Now for the Mansion Tax. The proposal is to impose a tax of 0.5% p.a. “on property values over £1m.” This is being interpreted as a tax on residential property but what Mr Cable actually said implies commercial property would also be included. If that is not the intention he is guilty of very sloppy wording in a speech which was no doubt pored over by several people before the final version was agreed.
As the LibDems have no chance of winning an election any time soon they can indulge themselves in the luxury of announcing policies without having bothered to think through all the implications. A cost benefit analysis would be a basic step. What percentage of the cash raised would be wasted in extra bureaucracy? I suspect it would be disproportionately large, just like the London congestion charge, where road works appear to be a far bigger cause of congestion than vehicles.
Until recently the LibDems wanted to abolish Council Tax and replace it with a local income tax. Now they want to introduce a tax which is in essence an extension of Council Tax. It reminds me of the old Schedule A property tax, which was abolished many years ago because it was a bad tax.
Vince Cable has not stated how valuations would be obtained or how he would deal with fluctuating property prices. We know from problems with mortgage valuations that automated valuations can sometimes be way out – we have had examples where the real value established by a physical valuation has been 50% more than an automated valuation.
Nick Clegg claimed it would be “relatively easy” to establish value using Land Registry documents. How naive! Using the Land Registry figures for properties which last changed hands several years ago would be prone to significant error. Furthermore it has been pointed out that such a tax would come under the devolved powers of the Scottish Parliament and the Welsh Assembly and hence either or both could refuse to implement this new tax. More egg on face as it appears Mr Cable has overlooked this minor legislative impediment.
The only positive thing I can say about this tax is that at least the proposal is to apply it to the amount of the property value in excess of £1m, not to the total value of properties worth more than £1m. In that respect it is much fairer than the tiered system of stamp duty land tax Gordon Brown has imposed on us.
The new Government will have to increase tax revenue after the election as it is impossible to believe the budget deficit can be contained solely by spending cuts, despite the huge scope to cut waste in Government expenditure. Vince Cable has not properly thought through this proposal but if property taxes are increased in such a way as to generate revenue on an annual basis the obvious way to do it would be to increase the number of Council Tax bands. One can argue about whether council tax is a fair tax but as long as we have it I think there is a case for adding a couple more bands at the top end. After the initial cost of new valuations the additional cost of collection would be nil.
Stamp duty land tax is also in desperate need of reform to remove the unfairness and no go areas for property prices a little above the current thresholds. Such a reform could combine a fairer system, less tax on most cheaper properties but higher tax for properties above, say, £1m. A fairer tax could be something along these lines:
0 - £150,000: Nil
£150,001 – £300,000 2.5% on the amount in excess over £150,000.
£300,001 - £500,000: 5% on the amount in excess over £300,000.
£500,001 upwards 6% on the amount in excess over £500,000.
These percentages may not raise the amount needed but the principle is one which an incoming Conservative Government should adopt. Using the above percentages the amount of tax payable compared with the current system would be:
Total tax payable at £250,000 would be £2,500, the same as at present but it would be less for amounts between £175,000 and £250,000.
Total tax payable at £300,000 would be £3,750, compared to £9,000 at present.
Total tax payable at £500,000 would be £13,750, compared to £15,000 at present.
Total tax payable at £750,000 would be £28,750, compared to £30,000 at present.
Total tax payable at £1m would be £43,750, compared to £40,000 at present.
Total tax payable at £2m would be £103,750, compared to £80,000 at present.
Total tax payable at £5m would be £283,750, compared to £200,000 at present.
Total tax payable at £10m would be £583,750, compared to £400,000 at present.
Many properties purchased for sums in excess of £2m are commercial and hence implementing a change along these lines would not only make the tax fairer but would in effect also transfer some of the burden from the householder to business.
A report today from the Ernst & Young ITEM Club calls the current increase in house prices, which it refers to as “stabilisation,” a false dawn and forecasts that property values will not return to their 2007 peak for at least another five years. It says that “while data is showing that the housing market is now beginning to stabilise, the recent rise in house prices cannot be sustained beyond the spring of 2010.”
It adds “Price rises largely reflect the acute shortage of available properties, with many homeowners either trapped in negative equity or reluctant to sell for fear of locking in the losses of the past two years. A small number of cash-rich buyers have supported prices, but the supply of these funds is limited, which means prices are likely to dip again in the first half of next year."
“Mortgage lending remains depressed and with 56% of owner occupiers having a mortgage, it would be difficult to make a case for a sustained pickup in prices without a recovery in mortgage lending. However, this would still appear to be some way off. Banks are continuing to restrict the amount of money that they are willing to lend, with them looking to strengthen, rather than expand, their balance sheets."
ITEM suggests that prices are likely to stagnate for the next two years, before picking up again gradually from 2011 as the wider economy strengthens and credit conditions ease. But it will take more than five years for prices to return to their late-2007 peaks.
It adds, "The combination of rising joblessness and weak earnings growth is bad news for the housing market. The threat of unemployment encourages consumers to save more and to pay down debt, rather than add to their existing burden. The uncertainty also discourages consumers from committing to big decisions such as buying a house. The weakness of earnings growth has also meant that, despite the sharp drop in house prices, affordability has not improved to any great extent. The scarcity of mortgage supply and tough lending criteria is making it particularly difficult for first time buyers to enter the market."
I concur with much of what the ITEM Club says but draw a different conclusion as to how the property market will react over the next 2 or 3 years.
Prices bottomed out in March accordingly to the Nationwide index and since then have risen by 4.7%. As this recovers about 25% of the fall in prices I would suggest describing this as “stabilisation” underscores the extent to which prices have increased. Although the recovery is certainly based on low, albeit rising, turnover, I expect turnover to remain low (by pre credit crunch standards) for at least 2 or 3 years for 3 principle reasons:
Around 3.5m people with residential mortgages (out of a total of 10m) can't move unless they sell up and rent because, even though most are paying their current mortgage satisfactorily, they can't meet lenders' requirements for a new mortgage, even one of the same size. This is either because they are in negative equity, have too little equity to provide a deposit for the new property plus the expenses of moving, have adverse credit or need to self certify their income. (Sub prime mortgages have virtually disappeared and the availability of Self Cert mortgages is not much better). However, the number of people affected in this way will reduce as property prices increase.Some people who have a very cheap mortgage which is not portable, e.g. a low SVR or possibly a lifetime tracker, might choose not to move simply because they would have to pay a much higher rate for a new mortgage if they did move. FTBs will continue to struggle to find the bigger deposits now required unless they can get help from the Bank of Mum and Dad.
Thus the number of potential sellers will be severely restricted for some time as well as the number of buyers. Although repossessions are increasing they are doing so, mainly as a result of low interest rates and Government action, at a slower rate than most people envisaged when the credit crunch started.
Thus I think the arguments for being cautious about price rises because they are based on low turnover fall down because turnover will continue to be low. Some opportunist sellers will come out of the woodwork when they think prices have risen enough but others will hold on as long as they expect prices to keep rising, particularly BTL investors who have reverted to lifetime tracker rates of around Bank Rate + 2%.
Increasing unemployment and lack of mortgage availability is undoubtedly a problem, but prices have risen since March despite this and there are signs that mortgage availability will show a modest improvement next year, although unemployment is some way from peaking.
Furthermore, on a medium term view, the fact that housing completions this year will probably be only about 50-60,000, and not much higher next year, compared to the Government's estimate that about 240,000 new dwellings are needed each year, must have an impact on prices.
In my view the key to house prices will continue to be interest rates and affordability. Our economy is in such a mess that interest rates are likely to stay low for at least 2 years, although not necessarily with Bank Rate as low as 0.5% for the whole of that period.
Thus I expect house prices to continue rising next year, although there may be a blip early in 2010 after the stamp duty threshold increases from £125,000 to £175,000, which will bring some purchases forward to this year.
House prices will fall back again when interest rates rise sufficiently to make affordability a problem, although I expect lenders’ gross margins to narrow somewhat as rates rise and this will mitigate the impact of higher rates.
Rates
Bank Of England rate - 0.5% - kept on hold (next decision 10th September) ECB rate kept on hold at 1% - (next decision 8th October) A meeting of the Bank for International Settlements (BIS), which consists of the world's central banks, have backed new measures to strengthen supervision of the global banking industry, and pledged to increase bank's capital requirements. The plans should "substantially reduce the probability and severity of economic and financial stress," the BIS said. However they did not set out a timeline for implementation of the proposals. The measures will be outlined in detail by year-end and be introduced in a way "that does not impede the recovery of the real economy."The BIS, established in 1930 in the aftermath of the Great Depression, consists of 55 member central banks and is based in Basel. The meeting, on Sunday, was held by members of the Basel Committee on Banking Supervision. "The agreements reached today among 27 major countries of the world are essential as they set the new standards for banking regulation and supervision at the global level," said Jean-Claude Trichet, the head of the European Central Bank chief who presided the meeting. In addition to holding on to more capital, the BIS agreed to boost the standards for so-called "tier one" capital requirements - which essentially means the quality of the assets that banks have on their books in relation to their deposits. Banks The much heralded G20 meeting of finance ministers has agreed a series of measures to try to regulate the global banking system, including new controls that rewards long-term performance rather than short-term risk-taking. However the meeting did not agree on specific limits on the amounts individual bankers get paid. Britain, the US and Canada opposed the idea, but the Financial Stability Board is to examine the issue. It will report back to the summit of G20 leaders in Pittsburgh, Pennsylvania later this month. The countries agreed on measures requiring banks to disclose the pay and bonuses of their highest-paid employees and to allow bonuses to be "clawed back" if decisions which seemed successful later go wrong. The FSB has also been asked to look at the desirability of new rules which would allow regulators to rule on whether the total pool of cash set aside by a bank for bonuses is excessive, given its long-term financial stability and strength. Ministers also pledged to continue financial support for the global economy until recovery from recession is secured. They said they would develop co-ordinated "exit strategies" to deal with ballooning public deficits once the recession is over. But they warned that although there were signs of recovery in the world economy, that recovery would not have happened without massive intervention from governments - and all bankers should take note that they owed their salvation to action by taxpayers. US SecTreas Tim Geithner said the momentum for financial reform needed to be kept up despite the signs of an upturn. "Actions (by the G20) have pulled the global economy back from the edge of the abyss. The financial system is system is showing signs of repair," he said. "However, we still face significant challenges ahead. Unemployment is unacceptably high. Conditions for a sustained recovery led by private demand are not yet established." UK Chancellor Alistair Darling said all bankers were obliged "to make sure that their pay practices are responsible". He said: "Above all we are determined to take action to stop banks or other financial institutions getting themselves into a situation where their pay-and-reward practices actually encourage people to take risks which bring their institutions into a situation where they could be brought down with catastrophic results." Discussing possible regulation of bonuses, the PM said: "If you have got an institution that is struggling or it's in the process of rebuilding itself the regulator could say that pool set aside for bonuses is really too big." Mr Darling added: "Critically now the job is to make sure that you translate those principals into practical propositions that actually bite and actually work. We need to have standards that are observed right across the world."Banking group RBS-NatWest - majority owned by the taxpayer - has broken ranks with the rest of the industry and decided to slash its overdraft charges, in a move which comes ahead of a decision of the new Supreme Court on whether or not the OFT can regulate these charges. From 1 October, RBS and NatWest customers will be charged only £5 for having a cheque bounced, down from £38. The fee for paying an item on an overdrawn account falls in half to £15. "This is good news for customers, not least because the fees for unarranged borrowing have been an area of ongoing concern for them," said the chief executive of the bank's UK operations, Brian Hartzer. "As we look ahead there are many issues to consider, but we thought it was time to move this particular customer concern forward by cutting our charges. "As it relates to past charges we are awaiting the outcome of the industry-wide bank charges test case," he added. At stake is annual income for the banks of more than £2bn a year, and many experts will be scrutinising the new structure of the bank's charges to see if the lost income is being made up elsewhere. The RBS-Natwest group declined to say how much income it would forego each year from its reduced fees, but a spokesman said its change of policy had been prompted by the arrival of the new chief executive Mr Hartzer and that there had been no pressure from the government to change the bank's overdraft fees. It is thought many other banks will now follow suit.The BSA has said that planned new regulation will make it difficult for them to compete with banks. Proposals from the FSA, include plans to limit riskier types of lending by building societies, thought to include high loan-to-value mortgages for borrowers with small deposits and buy-to-let mortgages. The BSA says these proposals would disadvantage the industry, and has made a formal submission to the FSA following a consultation period on the proposals. Adrian Coles, director general of the BSA, said the proposed regulation would have a "discriminatory and anti-competitive effect in the mortgage market". The FSA declined to comment. UK Mortgage / Housing Market Thousands of buy-to-let investors attempting to renege on contracts where property values have dropped below agreed off-plan sale prices face legal action from developers intent on holding them to the deal. New-build flats, which were popular as buy-to-let investments, have suffered price falls of up to 40 per cent. Buyers, most of whom have paid cash deposits of 10 per cent, are now struggling to obtain financing to complete the deal. "Many investors think that they can withdraw from a purchase for which they have exchanged contracts and simply sacrifice their deposit, but the legal position on this is quite clear," said Jeremy Raj, head of residential property at Wedlake Bell, the law firm. "The buyers are legally obliged to complete on the transaction."
