Wednesday, May 7, 2008

The sub prime myth

I heard it again today. A friend, who should know better, stupidly claimed that UK housing crash was somehow related to the ongoing sub prime mess in the US.

When I hear this rubbish, I get mad, It is wrong and misleading. It also obscures the deeper observation that our housing crash is domestically produced. We made this mess ourselves and without any help from abroad.

The link between the UK housing crash and sub prime crisis just does not add up. At the height of the US housing bubble, the total number of adjustable rate mortgages topped out at around $1 trillion. Furthermore, the really toxic stuff - the mortgages originated in 2006 and 2007 - was only a fraction of that amount. Even assuming some really dreadful default rates, it is hard to imagine that the US sub prime crisis is going to cost more than $400 billion.

What does a loss like $400 billion mean? To give the number some perspective, the US stock market has a capitalization of around $16 trillion. A $400 billion sub prime loss would be equivalent to about 2 percent fall in the US stock market. That is the kind of loss that might make a headline or two in the financial press, but it is hardly the kind of financial sector shock that would generate a credit contraction in the UK lasting eight months.

Of course, I know that some UK banks held sub prime MBS and that some of those losses are significant. I also know that some people will be uncomfortable with comparing stock market losses with banking losses. Nevertheless, it is very hard to make any direct links between what happened here to what went on over there.

The best connection I've heard so far runs along the lines that bankers the world over started taking stupid pills, forgot about risk, and went mad on real estate. However, that is an argument based on correlation not causation.

There is a much simpler explanation for our housing crash. After years of irrational lending, last summer UK banks suddenly lost confidence in UK households. After years of pumping in billions of pounds of credit, the banks because queasy and wanted to stop.

The evidence for this sudden loss of confidence is there in the most recent bank lending data, issued by the Bank of England earlier this week.

First, in order to get an understanding of the data, it is important to grasp the importance of lending to individuals to UK banks. As of the end of March this year, loans to individuals accounted for around 38 percent of the outstanding stock. Lending to other financial corporations accounted for a similar percentage, while lending to the rest of the economy took up the remaining 23 percent. So, lending to individuals forms a huge part of bank lending activity, and most of that lending takes the form of mortgages.

So what has happened to bank lending in the first three months of the year? The banks have kept on lending to financial corporations and the rest of the economy, but they have pulled back dramatically from lending to individuals. This is, of course, the counterpart to the well-publicized observation that mortgage approvals have collapsed.

Breaking the lending data down further reveals another interesting observation. There is still some mortgage lending going on, but unsecured bank lending has virtually collapsed. If you don't have a house to use as collateral, the only unsecured consumer lending today is via a credit card.

Why have the banks suddenly lost confidence in their reliable old punter - the UK household? One day, the banks woke up, stopped taking the stupid pills, and realised that UK households were choking with debt. The threat of a housing crash was looming large, and panic took hold. Suddenly, the board room screamed from on high "stop the lending". The memo was circulated, lending standards were tightened, and the days of easy credit were over.

It was as if someone came into the room and switched off the TV. House prices needed the credit like a chat show needs C list celebrities. No credit means no show. Now, house prices are tumbling, estate agents are going out of business, and everyone else is wondering why did we ever think house prices could keep on growing at 20 percent a year.

So, don't look to sub prime for an explanation for the UK house crisis. Think local and think high street banks. Imagine a noxious blend of stupidity and greed, that is suddenly replaced with fear. Then you will understand our housing crash.


  1. Alice, as always, the numbers are so compelling. I have you down as a maths teacher. Am I far off?

  2. It is astounding just how quickly sentiment changes. Housing shortage one day, housing crash the next.


    More evidence of bank panic.

  4. It feels as if I'm always arguing, so I'll start with an agreement.

    US Subprime defaults will have remarkably little direct impact on the UK. US Subprime defaults, however, are absolutely crucial - since they exposed the stupidity of the way securitised debt is managed internationally.

    US Subprime is the economic threat that affects the global economy - and, I agree, it is recoverable - even if, rather than the $400bn initially suggested, it actually costs the more recent $1tn estimate.

    The threat in the UK goes far beyond this. Funding for UK mortgages followed the US model (forget about who borrowed - they were mere pawns - on both sides of the Atlantic.)

    We've debated M4 expansion - which we found at ~12% or in the (*very* approximate) order of £100bn per year. Securitisation of debt took off in around 1997 - and has been growing at a massive rate for a decade. In 2006 £192bn was issued - and 2007 looked set to eclipse this by a significant margin - until midsummer. £172.6bn was still issued - but slowed significantly in the fourth quarter.

    These figures suggest that debt has been able to grow at about treble the rate of deposits - for the last couple of years at least. Is it any surprise at all that mortgages and debt and house prices are growing far faster than wages?

    US Subprime was the retail face of securitised debt in the USA. It is worth noting that up-until Summer 2007, over half of all European securitisation of debt was on assets in the UK. With key players being the likes of JP Morgan (Yes, the same people who have taken on Blair as a well-paid consultant) and Merrill Lynch... are you absolutely sure our problems aren't one and the same as US subprime? The demand came from the same globally traded "investments".

  5. P.S. Vodka Drinker... It is not *AT ALL* surprising to me how quickly the sentiment is changing with respect to mortgages. What you need to realise is that mortgages (tied up prettily by investment banks) have been traded as if they were stocks and shares in a new industry. There's been a bubble - just as there was a Tech bubble in the late 1990s. The bubble has burst... nobody with any sense wants to invest in mortgages any more... it is inconceivable that mortgage debt will return above the risk-free rate - so investment today is the epitome of stupidity.

    The effect on house prices is of secondary importance... except that, while house prices rose, there profits were all but guaranteed... and as soon as they start to fall, default risk makes the entire industry unprofitable.

  6. "there profits" => "the profits" - Doah! :-$

  7. Shocking how quickly the banks abandoned consumers. They love you one day, and ignore you the next.

  8. Asteve - I expected some kind of slowdown in housing. The crash in the last few months has taken me at least by surprised. I tell you straight - I never expected it.

    The idea that mortgages could be sold like shares is a new one for me. I am sure you are right, but it just makes me feel as if I am behind the curve all the time.

  9. slightly OT...Property Ladder tonight is a cracker...some idiot who's leveraged up on London property over the last 5-6 years, with a couple of million quid of interest-only loans...only JUST covering outgoings with rental income at the moment...he's going to get properly f*cked soon i reckon, if he (hopefully) did the old trick of getting 2y mortgage and just assume he can roll it.

    Was on Channel 4 8-9, so you'll get it on 4+1 just now. Brilliant. I even know the areas well that he is in, and trust me it is all offered just now in the market!!

  10. Allow me the opportunity to chip in. I think Alice and asteve have both got it right in this sense:

    1. The UK bubble was blown up because UK borrowers were in an investment mania. You can't blame that on US subprime.


    2. The end investors (buyers of MBS) were global and thus the collapse of US subprime cut away the market for selling UK mortgage debt too.

    The reason the UK got the property crash so quickly was the MBS investors learned all their lessons in the US and didn't pussy foot around as the UK bubble burst.


  11. Alice,

    Did you see Savills is reporting a steep decline in volumes for high end London houses?

    I think we all know the pattern:
    1) Declining volumes then
    2) Stagnant prices then
    3) Waterfall moment and pandemonium

    Looks like London wasn't immune after all. Who'd of thought it?


  12. US subprime was the immediate cause but not the basic cause, in the same sense that the assassination of Archduke Ferdinand was the immediate cause of the Great War but the basic cause was the wider trend of imperialist ambitions and secret treaties between the great powers.

    By summer 2007 the UK housing market was a powder keg, with all sorts of procyclical factors lined up ready to kick it off. Between 2004 and 2007 there had been a huge boom in securitisation. By mid 2007 RMBS money accounted for 38% of residential mortgage lending, as compared to less than 5% in 2003.

    A large part of this RMBS mortgage money came from US financial institutions. The recoil of the banking sector from MBS generally I think was the trigger in the UK housing downturn, but the basic factors were obviously the huge amount of speculative demand which had built up over the last 5-10 years and was supporting house prices at their peak levels.


  13. ...
    Nothing beside remains. Round the decay
    Of that colossal wreck, boundless and bare
    The lone and level sands stretch far away.

  14. Is that pete or lord shelley?

  15. notice how gordon brown ALWAYS blames the subprime market in America for the current housing/economic woes over here...

    watch out for it - he ALWAYS does it.

  16. Yes john trenchard I agree.
    Gordon Brown took credit for his "miracle economy" when houses were going up in price but quickly distances himself when houses go down and voters feel poorer.
    The man is a bafoon to say the very least - full of empty words.
    I cringe every time that idiot says he is helping "Britains hard working families"...when it is these very people he is royally shafting !
    As far Darling, well he is just stupid - the fall guy when it all goes belly up !