The ticking debt bomb?

This blog originally appeared on Public Finance

When the financial crisis first hit, politicians of all parties talked up the notion of ‘rebalancing’ the economy, moving away from a growth model dependent on financial services, house price increases and consumption and towards one based on the real economy and on trade. Five years on and, with little sign of a sustained economic recovery, the chancellor appeared to wind the clock back in his last Budget.

The new Help to Buy scheme is designed to give a shot in the arm to the housing market, making it easier for households who are currently considered too risky by lenders to get onto and move up the housing ladder.

So, is borrowing making a comeback? Despite predictions back in 2008, the debt bomb hasn’t yet exploded. Arrears and home possessions did increase, but they have peaked below expected levels and have been coming down for the last year or so. But rather than having been defused, it’s more likely that the bomb is merely lying dormant, as today’s report from the Financial Conduct Authority on the prevalence of interest-only mortgages reminds us.

It makes for chilling reading. Half of the 2.6 million interest-only mortgage borrowers holding products that are due to mature before the end of the decade are expected to have a shortfall in their investments, leaving some facing the prospect of having to sell their home in order to make up the difference. One-in-ten are thought to have no repayment strategy at all in place. Given that these products mainly relate to the endowment mortgages sold during the 1990s and taken out by higher income individuals who are now approaching retirement, the FCA hopes that remedial action might still be possible. However, the current economic environment means that some will find it difficult to fill their investment holes. Perhaps more worryingly, the extent of the debt problem is likely to stretch way beyond the interest-only issue.

Our Deconstructing Debt project has highlighted the fact that credit loosening during the 1990s and 2000s, fuelled by artificially low interest rates, risky lending practices and increased demand for credit in the face of spiralling house prices, mean that many of today’s mortgage holders are perilously close to the edge.

Defaults have been subdued by a confluence of four factors: monetary loosening, a relatively small house price correction, the resilience of employment and lender forbearance. Yet all of these mitigating factors are subject to some uncertainty and potential unravelling in the coming years. Most worryingly of all, repayment-to-income ratios are as high now as they were in the late-1990s when the Bank of England’s base rate was more than ten times its current level. As the chart below shows, one-in-four low to middle income mortgage holders were allocating more than one-quarter of their gross income on repayments at the end of 2011, comparable to the proportion in 2009. However, while the base rate currently sits at just 0.5 per cent, it was above 7 per cent in the earlier period.

Source:    Author’s analysis of CLG, English Housing Survey

Taking all borrowing together (secured and unsecured), some 3.6 million households can be described as ‘debt loaded’; spending more than one-quarter of their income on repayments despite the current low cost of borrowing. While most of these households are continuing to function without getting into arrears, they are displaying high levels of debt stress. Three-quarters (77 per cent) of debt loaded households are concerned about their level of debt, with one-quarter (27 per cent) saying they are ‘very’ concerned. And this concern has grown over time, with half (49 per cent) of the debt loaded saying they’re more concerned now than they were two years ago.

Developments in each of the four mitigating areas – and in the economy more generally – will be crucial in the coming months and years. In an ideal scenario, sustainable economic recovery will boost employment and wages, with household incomes rising in line with borrowing costs. Forbearance agreements could then be unwound, with mortgagors once again able to repay at market rates.

However, with low to middle income households projected to be no better off in 2020 than they were in 2000, it is quite possible that even at this slow pace interest rates will increase before the incomes of the most overstretched households do. And it may not take especially substantial movements in the cost of borrowing for repayment problems to arise: one estimate suggests that default risks would be “meaningfully heightened” if mortgage rates were to rise from their current level of 3.7 per cent to around 5 per cent. Similarly, Bank of England analysis suggests that an increase of this sort of magnitude would require around one-quarter of existing mortgagors to take “special action”.

And all of this matters not just for the households affected but for the wider economy too, with many households having to cut back on spending in the face of this debt overhang. Analysis by the Bank of England suggests that families saying their income had fallen and that their access to credit was restricted during the course of 2012 would spend around 75p of each additional £1 of income on average. By contrast, those reporting an increase in income over the year were spending just 14p of each extra £1. At some tipping point then, the micro debt issue becomes a macro one. The debt bomb is still ticking: expect it to make a lot more headlines in the coming months.