Mortgage guarantee could sow the seeds of trouble

The UK government awarded hard-working medical staff a meagre 1% pay rise in the most recent budget, all the while splashing out on yet another indirect subsidy for house prices: the mortgage guarantee.

Despite what politicians say, the reason behind the continuous stimulus thrown at the housing market is not that of helping the young buy their first property. In fact, just the opposite may be true.

The new mortgage guarantee scheme is due to start sometime in April 2021 and run for 20 months (at least that’s the initial plan; like with other subsidies, once granted it will be very hard to revoke without crashing the fragile UK housing market).

Under the scheme, the government guarantees to the banks willing to lend 95% of the value of a property (costing up to £600,000) that it will compensate them for a portion of the net losses suffered in the event of repossession.

The guarantee will apply down to 80% of the purchase value of the guaranteed property, and any lender participating in the scheme must have a five-year fixed-rate product as part of its range of mortgages offered under the scheme.

It is not for the first time that the government has used a mortgage guarantee scheme to prop up house prices (or rather, in its own words, “to support a new generation in realising the dream of home ownership”).

“The intention is to mirror the successful scheme that operated along similar lines between 2013 –2016, and that reinvigorated the market for lending at up to 95% LTV (loan to value) until the pandemic,” the government mortgage guarantee scheme outline states.

It was not just the market for lending that that scheme (together with others destined to push up residential prices, such as Help to Buy) reinvigorated. It was the entire housing market.

House price inflation guarantee

Banks in the UK had pulled back low-deposit mortgages because of fears that the precarious employment situation and, later, the pandemic would push more borrowers into default.

This was a sensible attitude, protecting both the banks and the borrowers, who could see their entire savings wiped out, as well as remain saddled with debt and without a roof over their head if they find themselves jobless and in negative equity.

But now, Lloyds Banking Group, NatWest, Santander, HSBC and Barclays, Britain’s biggest banks, have all signed up to take part in the government’s mortgage guarantee scheme.

Before the announcement of the new government mortgage guarantee scheme, the number of 95% LTV deals available was five – down from 405 a year ago, according to the Financial Times.

This number will probably jump back up again with the same speed as house prices, if not even faster. However, the policy increases risk for the long term.

The UK housing market has become “too big to fail”, as one property developer recently told the Financial Times with glee.

It is not for the first time that we hear this declaration, either. As far back as in 2015, the Motley Fool published an article saying the same thing.

It is useful to make a comparison with other countries to see who else is in a similar position. The chart below, with data from the Bank from International Settlements (BIS), shows that UK house prices have in fact lagged those in advanced economies in aggregate.

Looking at the house prices trend, the UK has recently most closely followed two of the most volatile property markets, Canada and Australia, even though the peaks and troughs have not been as large.

US house prices have been remarkably stable, particularly considering the depth of the Covid-19 crisis in the country; eurozone home prices have been fairly stable as well.

One explanation for this could be that the residential property markets in these various regions are quite different.

In the US, for example, borrowers have the right in many states to just return the property’s keys to the bank that granted them the mortgage and walk away debt-free.

In the eurozone, where generally tenants have more rights than in the UK, renting a property is not seen as not “having made it” in life; people are more relaxed about owning property and house prices have been less volatile as there has been relatively less speculation.

An additional — and more worrying — explanation could be the level of personal debt.

Another set of data from the BIS shows that the countries with the biggest fluctuations in house prices are also the ones with the highest percentage of household debt to gross domestic product.

Among the advanced economies, UK has the third-largest household debt, after Australia and Canada. The debt has not reached 100% of GDP in the UK as it did in the other two countries but, at almost 90% in the third quarter of last year, it is not far.

Again, the US looks better than the UK on this indicator, at 78% of GDP.

The eurozone, usually given as an example of runaway government debt, looks like a model of restraint when it comes to households: their debt has remained remarkably stable, below 60% of GDP in the past five years.

The two charts seem to suggest that in Australia, Canada and the UK the governments (and central banks) have repeatedly chosen to stimulate domestic demand by encouraging people to get deep into debt to make what for many is the biggest purchase of their life: a home.

Over the short term, this works. It pushes up home prices, vindicating the homebuyers’ decision to dive into the market. It also pushes up demand for additional goods and services, such as those needed for home renovation.

However, over the long term, the widely fluctuating house prices, coupled with the high household debt as a percentage of GDP, do not bode well for these countries.

Any economic shock that the government and central bank would not be able to deter could send them into a deep crisis. And the government mortgage guarantee scheme would be cold comfort in such a scenario.