Bank of England worried about a self-reinforcing feedback loop" that could bring down the UK ec

The Bank of England is concerned that the UK mortgage market cannot withstand an "adverse shock."

  • It has created a diagram of a "self-reinforcing feedback loop" that could bring down the UK economy.

  • The Bank recommends a technical tightening of borrowing requirements for new mortgages.

  • For now, this is merely a scenario, not the Bank's expectation.

Click here to read the original article at Business Insider.

The Bank of England's most recent Financial Stability Report contains an extended section on the frothy UK mortgage market. British property values have been so high recently that many wonder whether a new house-price bubble is happening.

The bank is worried too. It has recommended a tightening of lending rules to help fend this off. And the mere fact that that the BoE is discussing it at length is interesting in itself.

The scariest bit is this diagram of what a potential spiral of doom would look like in the event of an "adverse shock" to the economy. The bank doesn't say what such an adverse shock might be, but the BoE's report contains a separate chapter on financial stability during Brexit in 2019.

The UK economy is very sensitive to a rise in interest rates. "80% of new mortgage lending in 2016 was either on a fixed rate for a period of less than five years or on a floating rate," the bank says. And "mortgages are the largest loan exposure for UK lenders." The bank will next make a rate decision in August.

It's not just that mortgages are at risk of being defaulted upon in a downturn; it's that buyers might create contagion by defaulting on other consumer debt payments - cars, credit cars - in hopeless attempts to keep houses they either cannot afford or are "under water" when the property market sinks.

Scroll down for a quick look through the bank's visual data on what it describes as a "self-reinforcing feedback loop" that, if triggered, would cause another 2008-style crisis in the UK.

The context: British people are still carrying high levels of household debt. It's not as bad as it was before the 2008 crisis, but it is heading back up there.
Bank of England.
All that mortgage debt is being driven by rising house prices. Rising prices mean buyers' mortgages need to be much bigger, and a great multiple of their incomes, than at any time in the last 40 years (except for 2008).

Bank of England.

"The average house price for first-time buyers increased from around £50,000 in 1997 to over £200,000 in 2016. Over the same period, the size of a typical deposit for a first-time buyer increased from less than £5,000 to over £30,000," the BoE says.

Prices - and therefore mortgages - will not decline soon because the UK has halved the number of houses it builds annually. With supply constricted, prices rise, and mortgage debt follows.

Bank of England.

A couple of new types of mortgage products have entered this booming market. £0 fee mortgages are now 45% of all UK mortgages. Zero fee mortgages are more attractive to poorer buyers because they require no upfront costs.

Bank of England.

And the percentage of mortgages taken by investors who rent the houses they buy remains high, at a plateau. The buy-to-let segment was tempered by a change in tax law last year. Nonetheless, all those post-crash BTL mortgages are still out there ...

"The share of households in the private rental sector rose from around 10% in 2002 to 20% in 2016" because of BTL mortgages, the bank says.

All of this is fine as long as house prices keep going up - because buyers who get into trouble can always sell their way out of it. But the bigger your mortgage as a multiple of your income, the riskier your mortgage is.

Bank of England.

The sketchiest end of the market are the mortgages with a high debt-service ratio (DSR), calculated as total mortgage payments as a percentage of income. The higher the debt service percentage, the more likely buyers are to be in arrears on their payments. DSRs are rising over time simply because prices - and the mortgages needed to cover them - are rising over time, too.

This is the bank's worst-case scenario: It shows what happens if unemployment in the UK went up to 8% (it's currently under 5%). The result would be double the number of households who suddenly have high debt service ratios - the most fragile mortgages out there. The estimate is represented by the yellow diamond:

Bank of England.

Put that all together and you create a potential spiral of doom: "Self-reinforcing feedback loops between levels of mortgage lending and house prices can amplify risks to both borrowers and lenders," the bank says.

Bank of England.

A "feedback loop between house prices and credit also arises in a downturn. An economic slowdown can reduce house prices. Due to the role of housing as collateral, lower house prices reduce the demand for, and supply of, credit. Expectations of further price reductions, which can result in sales of houses at heavily discounted prices (‘fire sales’), can further amplify house price falls, reinforcing the adverse feedback loop. The resulting deterioration in borrowers’ and lenders’ resilience will intensify a downturn."

The new recommendation

The bank has recommended that lenders use a new, tighter calculation when considering whether new buyers for mortgages are financially able to handle a 3 point change in interest rates: "The new Recommendation states that lenders should test affordability by considering a 3 percentage point increase in their current reversion rate (for many lenders this is the standard variable rate, or ‘SVR’), while the previous Recommendation stated that lenders should consider a 3 percentage point increase in Bank Rate."

This article was written by Jim Edwards and originally published by Business Insider. Domus Financial Services is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to invest. All investments can fall in value as well as rise and you could get back less than you invested.

Search By Tags
Follow Us
  • Facebook Basic Square
  • Twitter Basic Square
  • Google+ Basic Square