The end of an era - the 100% mortgage is no more

Banks have taken a serious dent to their confidence over the past nine months or so. However, they’re rapidly discovering the bright side to the credit crunch – it’s the perfect opportunity to rebuild their profit margins.

As James Ferguson recently pointed out in his investment newsletter, Model Investor, mortgage lenders have been surviving on absolutely tiny profit margins, as they competed to offer the cheapest deals to consumers. That need to compete has gone now – nobody wants anything but the safest business.

So that means they can feel free to jack up their profit margins. And that in turn means that the impact of the credit crunch is being magnified when it comes to consumers.

Here’s why. When money was free and easy, banks would borrow money at say 5.0%, then lend it out at little more than that – say 5.2%. They had to – with around 15,000 mortgage products on the market, buyers had plenty of other options open to them.

But now that mortgages are harder to come by, people can’t be fussy. They’re desperate to find one bank willing to lend to them, let alone a selection. So even though it’s costing banks more to borrow money, they’re able to widen their profit margins substantially – say to more like 1% or more.

That’s not to mention the rapid rise in arrangement fees. I read at the weekend that one lender is now charging arrangement fees to take out its standard variable rate mortgage, something that was unheard of up until now.

Some commentators have been talking of how this is a return to a more ‘normal’ mortgage market, and it is. The days of easy credit were abnormally slack, and caused abnormal house price growth, which in turn fed upon itself, encouraging more people to make bad investment decisions, and more builders to build inappropriate flats in city centres.

The housing market is now ‘reverting to the mean’ after a long period of defying gravity. The trouble is, when things fall after rising for so long, they don’t just stop when they return to the historical average. They overshoot on the way down.

So just as credit was ridiculously cheap for a while, so it will become ridiculously expensive. And just as house prices were ridiculously overvalued, so one day, they will become ridiculously undervalued.

It’s hard to say exactly how far that process will go. But you can be sure that the level of falls we see will be much more in line with the gloomier predictions, than those still hoping for 5%, or even 10%. Wildcards include the recent changes to capital gains tax, which could well see many buy-to-let investors piling in to sell now, to lock in gains at the lower rate of 18% while they still have them.

Some individuals will feel the pain of falling house prices even more keenly. Anthony Hilton had a very good piece in yesterday’s Evening Standard where he pointed out that it’s hard to understand just how brutal a house price crash can be if you haven’t lived through one. He cited the example of one £1.3m home in London which fell as far as £650,000 in value.

Most of those homeowners and buy-to-let investors who bought into the market in the past five years were probably living at home with their parents during the last crash in the early 1990s. Many of them will be among the 75,000 households or so which Experian reckons will end up in negative equity this year.

Inevitably, the clamouring is starting for the government to ‘do something’. But what can – or should – the government do? All through the boom, the bulls were claiming that the super-sized house price growth was based on fundamentals, and had nothing to do with slack lending practices. If they’re right, then prices shouldn’t fall very far before the fundamentals pick them back up again.

If they were wrong, then house price gains were a bubble based on rampant speculation. Those bubbles need to be allowed to pop, so that people don’t keep throwing good money after bad.

Of course, the reality is that many of the bulls knew this was a bubble. They just thought it was too big to blow. More than a few people used to argue that “the government will never let the housing boom end. It’s too important to voters.”

They will soon be reminded that there are few things less worthy of your faith than governments. For all its efforts, the Federal Reserve still hasn’t prevented US house prices from diving by more than 10%. Our leaders can’t hope to do any better.

Turning to the wider markets…