- How panic in Europe could hurt UK house prices
- Recommended article: An unloved small-cap property company
- Yesterday's close: FTSE 100 down 4.7% at 5,041... Gold down 2.37% to $1,740.13/oz... £/$ - 1.5343
From David Stevenson, across the river from the City
Dear Golden Jann,
 It’s probably safe to say that markets didn’t think much of Operation Twist.
Yesterday was brutal. The FTSE 100 plunged 4.7%, while French shares fell 5.2% and the German Dax lost 5%.
The similarities to 2008 and the Lehman Brothers collapse are growing by the minute. Shares, commodities, gold – everything fell as investors ran to the ‘safety’ of the US dollar.
And in the background, there’s another Lehman-era disaster brewing. One that could hit a market very much closer to most British people’s hearts.
The UK housing market…
The latest issue of MoneyWeek magazine is out now
 Inside this week's issue:
Watch your step
John Stepek chairs our panel of experts and asks them where they would – and would not – put their money now.
Other featured stories:
● Paul Hill: Two bargain European stocks to buy now
● Anthony Bolton: Why everyone should own some gold
● Should Britain pull out of the EU?
The Bank of England may lose control of interest rates
British house prices have been remarkably resilient following the global economic crisis. Sure, in ‘real’ (inflation-adjusted) terms, they’ve fallen a fair bit from the peak, outside London. But they remain hugely expensive on a historic basis.
What’s kept them propped up? Bulls will go on and on about supply and demand. But in reality, it all comes down to interest rates. With the Bank of England slashing the bank rate to 0.5%, many homeowners have seen the cost of their mortgages plunge to unheard-of lows. That’s enabled people to hang on to homes they might otherwise have been forced to sell.
Surely with the current carnage in the markets, we can at least rely on interest rates to stay low? Certainly the Bank of England has no plans to hike rates any time soon. Indeed, a fresh bout of quantitative easing seems far more likely.
But it’s not just down to the Bank. The cost of home loans may be bottoming out. And it all stems from what’s going wrong in the European banking system. Let me explain.
Counterparty risk is making a comeback
We wrote recently about counterparty risk. In short, it’s the risk that you make a deal with someone, and they then fail to hold up their end. Like backing a winner at the races, and then finding the bookie has done a runner when you go to collect your winnings.
Counterparty risk becomes a serious problem when banks start to get worried about lending to each other. And that’s what’s happening in Europe right now. Small wonder. The International Monetary Fund (IMF) has just warned that European banks are sitting on a staggering €300bn of losses from the eurozone sovereign debt crisis. Would you want to lend to anyone who might be exposed to that sort of loss?
As the IMF says, this is putting the financial system in its greatest danger for years. For one thing, these losses will prove very nasty news for Europe’s economy. Interbank lending is already falling. If the carnage in other markets continues, it’ll probably freeze up even more.
That’ll make credit even harder for businesses and households to get hold of. And this is where the interest rate risk we were talking about earlier comes in. This chart makes the point (it looks complex, but bear with me – it really isn’t).
Source: Bloomberg
The purple line is the key. This is the gap in ten-year swap rates – which you can read about here – between Germany and the eurozone overall.
What does that mean? Germany is seen as the safest country in the EU. So the higher the purple line goes, the more worried markets are about the state of the rest of eurozone. As jitters over Greece, Portugal, Ireland, Spain and Italy have grown, the Germany/euro swap rate gap has climbed steadily. In fact it has now risen to the levels it reached when Lehman went bust.
And here’s the nub of the problem – this also affects the UK.
The blue line on the chart is the three-month London interbank rate (LIBOR) at which banks lend sterling to each other for three-month periods. During the last two months in particular – as you can see clearly on the chart – it has been pulled higher by the purple line. That’s despite the fact that the Bank of England rate (the black line) hasn’t budged from 0.5%.
Why now could be a good time to fix your mortgage
In other words, almost every day, UK banks are being forced to pay more to borrow in the money markets.
And if banks have to pay more to borrow money, they’ll have to charge the likes of you and I more to borrow as well.
Already, building societies are only lending what they can attract as retail deposits. They aren’t borrowing in the wholesale money markets at all, Ray Boulger of John Charcol tells Lorna Bourke at Citywire.
“If, or when, Greece defaults and comes out of the euro, banks will be wary of lending to each other and there’ll be a shortage of mortgage finance”, he says. Lenders will push up mortgage costs – “first because they can, and second to stop being swamped with business.”
Mortgage lending is already tight. If it tightens any further, then that’ll make it even harder for the housing market to defy gravity.
As Mark Johnston of Mortgage News notes, "two-thirds of UK home owners have a variable rate mortgage, meaning 8m households would pay more when interest rates rise. A rate rise of just 1% would increase monthly repayments on an average £150,000 variable rate mortgage by £43 a month or £516 a year".
That could tip many already cash-strapped home owners over the financial edge. In turn this could lift repossessions and forced sales – and drive down house prices.
It also points to one clear conclusion for existing homeowners. If you currently have a floating rate mortgage, this could be a good time to take advantage of a cheap fixed rate product while you still can. We have more on this topic in the latest issue of MoneyWeek magazine, out today: Is now the time to fix your mortgage? If you’d like to become a subscriber and get your first three issues free, just click here.
Got a comment on this article? Leave a comment on the MoneyWeek website, here.
Until tomorrow,
David Stevenson
Associate editor, MoneyWeek
Our recommended article for today...
An unloved small-cap property company
- As an investment idea, owning shares in UK commercial property companies is admittedly on the contrarian side. But this small-cap property company is making a healthy return on its portfolio and has good prospects for the future, says Tom Bulford: An unloved small-cap property company.
And for yesterday's market update, see below...
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Market update
Click here for the latest stock market news and charts.
The FTSE 100 collapsed yesterday as investors grew increasingly worried about the health of the global economy. The index shed 4.7% to close at 5,041.
Miners saw the worst falls as metals prices crashed. Vedanta lost 13.3%, Antofagasta fell 12.7% and Kazakhmys lost 12.4%.
Energy stocks were also under fire. Essar Energy was the biggest faller in the sector, down 8.3%, while BG Group fell 6.2% and BP lost 5%.
Banks were hurting too, with Lloyds down 10.1% and Barclays 9.4% lower.
In Europe yesterday, the Paris CAC 40 fell 154 points to 2,781, and the German Xetra Dax was 138 points higher at 5,269.
In the US, the Dow Jones Industrial Average fell 3.5% to 10,733, the S&P 500 slipped 3.2% to 1,129, and the Nasdaq Composite was 3.3% lower at 2,455.
Overnight in Japan, markets were closed for a public holiday. And in China, the Shanghai Composite fell 0.4% to 2,433 and the CSI 300 lost 0.6% to 2,669.
Brent spot was trading at $108.18 early today, and in New York, crude oil was at $80.82. Spot gold was trading at $1,743 an ounce, silver was at $34.92 and platinum was at $1,698.
In the forex markets this morning, sterling was trading against the US dollar at 1.5419 and against the euro at 1.1413. The dollar was trading at 0.7402 against the euro and 76.27 against the Japanese yen.
And in the UK, the Confederation of British Industry (CBI) has said that a shortage of skills will curtail the growth of the country's creative industries. The sector is predicted to grow by 4% between 2009 and 2013, with the potential to employ 1.3 million people, the CBI said.
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