The world may by now be familiar with the ticking financial time-bomb represented by Option ARM mortgages.
According to Fitch up to $100bn of such mortgages — an adjustable-rate home loan that allows the borrower to choose whether to pay interest or principal — will recast from introductory, teaser rates to higher rates within the next two years, leading to significant payment shock for US home owners.
But just in case you thought the UK market would be spared anything quite as ghastly, it’s probably worth a re-introduction to the good old fashioned tracker mortgage.
In a recent note Variant Perception — the boutique research firm that brought us the now infamous “Are Spanish banks hiding their losses” report — sets out the tracker-mortgage risk in pretty glaring detail. The risk posed by tracker mortgages, by the way, are just one of a multitude of scary factors Variant see as potentially contributing to an overall emerging economy-style currency and debt crisis.
The problem with tracker mortgages, according to Variant, is that the market is still more focused on the temporary relief they’ve provided rather than than the impending pain of resets further down the line.
(For an explanation of recasts vs resets, see Tanta’s seminal post on the subject)
As VP explain (our emphasis):
How can one explain the apparent contradiction of financially-damaged consumers, but benign insolvency and repossession rates? Much has to do with exceptionally low interest rates. One of the most direct mechanisms through which the BoE rate cuts have fed through to the average overindebted borrower is tracker mortgages. These have rates that fix to some spread to the base rate. They have been very popular over the last few years.
Tracker loans at the peak accounted for almost 40% of all mortgage loans made. These have provided a huge lifeline for many homeowners who were finding it difficult (perhaps through losing their job or having to take a pay cut) to keep up with repayments on hefty mortgages when rates were much higher. In many cases the savings have been dramatic. It was not untypical for the rate on a £300,000 loan to drop from 5% to 1%, taking monthly payments of over £1200 to as low as £250.
And herein lies the rub. Most tracker deals, like option ARMs in the US, have a reasonably short term on the tracker rate before moving to the bank’s often penal SVR (Standard Variable Rate). We have estimated a reset schedule for tracker mortgages using 2.5 years as the average life of the loan before it shifts to the SVR. Trackers are now a lot less popular, mainly because banks offer fewer of them, and at much wider spreads over the base rate.
Referring to the chart above, we are about to hit another peak in tracker resets in Q3, Q4 2010. As borrowers come off trackers they will reset to the SVR rate, or they may choose to enter into a fixed rate deal or a new tracker (at a much less attractive rate). Either way the result is the same: a significantly higher rate, and significantly higher monthly repayments. Many borrowers who were able to coast through the recession thus far will start to struggle.
And here’s the chart referred to:
The resets should be all the more worrying since non-tracker rates are already drifting up despite the Bank of England’s low and long stance on rates.
Note, for example, the growing disconnect between the various fixed deals currently being offered on the UK market:
Which leads Variant to conclude:
This chart makes a key point. There is a growing disconnect between areas of the market that are ’subsidized’ (eg, tracker deals are an indirect subsidy as they are linked to the base rate, slashed by the BoE in order to help rejuvenate the economy), and those that are not, such as fixed rate deals. Fixed rates reflect the market’s perception of future credit and inflation risk, which are much higher than official rates. It is evident the market is still sick, and this is going to have increasingly detrimental effects on borrowers over the next 2 years and longer.
Related links:
The non tracker - FT Alphaville
Mortgage approvals edge higher – FT