Aggressive rate cuts over the past week - the Bank of England's (BofE) 150 basis points easing along with the European Central Bank's 50 basis points cut - are likely to improve loan affordability in existing household credit.
However, the cuts might not be enough to curb the downward cycle in highly levered European housing markets, experts said.
Since mortgages in highly levered markets like the U.K. and Spain are predominantly hardlinked to Libor or base rates, market analysts said that the benefit of rate cuts will be substantially realized. However, they will do little to improve the marginal bid for housing. The rate cuts will also not ease the constraints on mortgage market liquidity across Europe, nor will they address the downward house price adjustments seen in these markets over the past year, analysts said.
HBOS's latest housing figures show a decline of 13.7% on a three-month year-over-year comparison for house prices in the U.K. The bottom is still far from sight, with estimates varying between a further decline of 20% to 50%. And the further the decline in house prices, the higher the risk of negative equity for U.K. borrowers. Fitch Ratings analysts said they expect a peak-to-trough U.K. house price decline of around 30% over the next three years. Merrill Lynch said in a report that it expects 25% peak-to-trough decline in U.K. house prices in the current downturn.
According to Fitch, this would bring the house price to household disposable income ratio broadly in line with its long-term average, and would represent a decline similar in real terms to that witnessed in the early 1990s, which saw nominal house prices decrease by 18-20% from their 1989 peak.
"Earlier this year, markets still expected a much more moderate U.K. house price decline of 5% to 10%, but with the ongoing turmoil in financial markets, the downside turns out to be much worse," Unicredit analysts said. "To date, prices are falling at a historical pace and are already down 13% to 15% year-over-year, depending on the index taken into consideration on a yearly basis."
This tense housing environment is likely have a negative impact on mortgage performance and the performance of U.K. RMBS. Severe delinquencies on U.K. mortgage loans have already risen more than 30 basis points since last year, reported Deutsche Bank analysts. As an increasing number of borrowers end up with negative equity, analysts said it is likely that the willingness to fulfill loan obligations on-time will shrink further and lead to increasing defaults. The BofE recently published its financial stability report, where it showed loan-to-value ratios increasing in selected U.K. house price decline scenarios.
The good news is that despite an increase in mortgage delinquencies, triple-A RMBS performance is expected to remain sound. According to Unicredit, in a moderate scenario that sees mortgage arrears double from their current levels to 2.8% over the next three years before steadily falling back, credit losses on U.K. prime RMBS would cumulate to roughly £9.4 billion ($14.3 billion) after 25 years.
In a more severe scenario, in which arrears were to increase more abruptly over the next years to 4.4%, losses would accumulate to around £12 billion. According to the BofE, under such a scenario only a fraction of double-A rated tranches would be exhausted. For triple-As to be impacted, loss severity rates would have to reach very high levels of around 85% and 65%, which is the most severe scenario.
The rate cut will also do little to support price action in the structured finance markets. Deutsche Bank reported that the continued heavy selling of U.S. ABS has taken a further toll on prices, painting a very weak backdrop for the European securitization market. Spread differentials between (non-guaranteed) financial credit and senior securitized bonds continue to widen beyond the record 350 to 400 basis points reached in recent weeks, while the cash-CDS negative basis in vanilla ABS is also at unprecedented levels.
"We remain of the view that the period between now and the beginning of next year is likely to be one of the worst for securitization (cash) market technicals, and therefore arguably one of the most compelling buying opportunity windows," Deutsche Bank analysts said.
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