CML slashes repossession forecasts - are they right to?

The FT this morning carries the news that the CML has slashed its repossession forecasts for the year. Let me give you a brief precis of what it says:

The CML lowered its forecast for property repossessions in 2009 to 65,000 from its previous estimate of 75,000

The CML said:

Although the economic backdrop remains challenging, the vast majority of homeowners continue to meet their monthly payment obligations. The large cuts in interest rates have benefitted many, making it easier for households who suffer a loss of income to continue to pay their bills.

This is all very nice and, indeed, the CML may be correct that their original forecast was wrong. However, do not read into this message, as many undoubtedly will, that, to quote the song by Yazz, "The only way is up" for residential property prices - I think that there must be at best stagnation and at worst (or even better for those hoping to buy) further falls to come.

The fundamentals

The boom in residential property prices was caused by a number of different factors. The most important of these were:

• demand (especially within London and the South East)
• disposable income (bonuses)
• cheap lending
• belief that values could continue to grow
• lack of housing stock

Let's consider some of these fundamentals in turn and the outlook

1 Demand

Demand for property was very high towards the height of the boom. This demand was fuelled by:

• more people looking to buy their own home
• the buy-to-let market
• expectations of windfall profits
• immigration and migration to London and surrounding areas

Most of these factors no longer exist. The buy-to-let market is still available if you have the cash to invest and are prepared to take the risk. There is no longer an expectation of windfall profits as people will be happy just to make a reasonable profit and keep a roof over their heads. Large job losses in the financial and services sectors and general downsizing resulted in and will continue to result in a decrease in movement into the UK and we may even see emigration and certainly migration away from densly populated and expensive areas such as London.

2 Disposable Income

Apart from Tube workers who believe they have a right to inflation busting pay-rises whilst the rest of the world goes to hell, most people are facing stagnant pay (or pay cuts in real terms). At the top level of the market (the banking, legal and other professionals) where pay was boosted by bonuses for so many years the size of the important bonus (if it exists) is significantly lower. Therefore, in terms of ability to pay monthly interest and/or repayment sums the amount that can be paid is less. Further the lack of job security means that the inflexible nature of owning a property with a mortgage is less attractive to, otherwise, mobile individuals.

Put in simplistic terms, there is significantly less money out there even before you consider the availability of debt.

3 Cheap lending

Not sure I even need to spell this one out. However there are actually two factors to this. First there is the fact that prior to the credit crunch the margins banks imposed on their mortgage deals were paper thin. Tracker rates below base rate were available. The reason for this was that with the magic of securitisation banks did not expect to hold on to their loan book for long so what did they care if the initial rates were 'loss-making'.

However, the Government and the Bank of England (along with other world economic leaders) have forestalled an immediate crisis caused by a sudden jump in the cost of borrowing by cutting interest rates drastically (0.5% in the UK). For those on base rate tracker deals this has resulted in them paying almost nothing (some are literally paying nothing). For those on fixed rate deals, when those deals have ended they have come on to a standard variable rate on average between 4% and 5% (about the level their fix was at in 2007). The CML has expressly stated that this is a major factor in their expectations being revised.

But interest rates cannot stay this low for too long. Predictions of deflation and very low inflation (below the BoE target of 2%) have thus far proven false. CPI is still above the target rate of 2% although the BoE have justified avoiding any rises on the basis that deflationary risks outweigh inflationary ones. This is probably correct in the immediate short term but as inflation begins to creep in (petrol prices are up significantly and at the end of the year VAT reverts to 17.5%) how long will the BoE be able to sit back and not act?

When the BoE does react (and even if it is not for a year from now) those homeowners who have been sitting on standard variable rates are in for a rather nasty surprise. Those rates will go up quickly (and quite possible faster than the base rate). Many who bought or refinanced in 2007 will find themselves in difficulty. New mortgage deals will not be open to them as the equity in their homes is likely to fall below the 25% level required to get a decent affordable deal and those fixed rate deals will continue to increase in expense. Meanwhile the interest payments will seem unaffordable as incomes stagnate and the cost of living rises.

In such circumstances will a bank avoid repossessing whilst there is potentially some profit in a sale which would cover its expenses when waiting will mean triggering a real loss on its books as values potentially fall and arrears mount? Will borrowers avoid selling to realise a small amount of equity whilst the arrears begin to rise and renting is a realistic option?

Conclusions

There is some inevitability that interest rates will rise again. Many suggest this might happen sooner than expected. When this does homeowners, loaded up with debt from the boom years which they are unable to refinance at affordable rates, will be forced to consider selling or defaulting. This will result in more properties coming on to the market on a distressed basis and this will further depress prices.

House prices in London and the South East may have cooled off but they have not really fallen. That fall will happen unless someone can wave a magic wand to make the debt disappear. As someone looking to buy I selfishly hope that magic wand does not work!

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Addendum: Check out the FT on Fitch's report that 10% of borrowers are now in negative equity. If you classed negative equity at 90% LTV (on basis that you cannot borrow 90% today) I wonder how many then fall into the trap?