With UK inflation trending above the Bank of England’s 2 per cent target (yet again), attention is now turning to the possibility of interest rate increases this year, and their potential impact on British mortgages and banking losses.
Just look at this note from Deutsche Bank’s Jason Napier and David Lock:
The UK banks have had a decent start to 2011, with stocks such as Barclays up 19% year to date, despite continued choppiness in relations between peripheral and non-peripheral Europe, and rising investor concerns around rising inflation and knock-on impact for banks of higher official interest rates and impairments. In addition to the usual run through of current housing marketing indicators, this note examines the importance of base rates to UK debt servicing costs and the impact on bank earnings of potentially higher retail loan losses.
It’s worth remembering that the low interest rates started by the BoE during the crisis effectively amounted to a dose of debt forgiveness for UK borrowers — thereby helping Britain’s banks weather, or decrease, non-performing loans. Once rates start to rise, however, pressure on both banks and borrowers could pick up again.
How much pressure for borrowers exactly?
Deutsche estimates lower rates have been benefiting the consumer by £26bn, and that each 25 basis point increase in rates costs consumers about £2bn in disposable income. So with 70 per cent of UK mortgages on variable rates, a 75bps rate hike over the course of 2011 (which Deutsche’s economists are forecasting) would end up costing borrowers about £6.2bn. Is this a lot of money in the wider scheme of stuff?
Here’s what the analysts say:
Well, to the negative side, a £6.2bn increase in debt costs would be the reversal of 24% of the fall in mortgage costs in this cycle (£44bn from £70bn in 3Q08), despite the obvious reality that a BoE rate at 1.25% is far from normal. For a customer on LBG’s Cheltenham & Gloucester SVR rate of 2.5%, a 1.25% increase in debt rate is a 50% increase in debt service cost. We expect some households will find the increase in funding costs difficult to bear.
To the more upbeat side, it is also true that the households facing higher debt costs were generally paying even more pre-crisis than this new rate to service their mortgages: we expect unemployment to remain the key driver of default. It is also worth pointing out that savers will see higher deposit rates in this scenario, giving a much-needed improvement in cash yields. At a UK level this will be some offset to the loss of consumer spending power from borrowers (though we think it axiomatic that the multiplier of spend/income is higher in the borrower sector than in the saver).
As for the banks themselves, here’s what Deutsche’s thinking:
- *Even if mortgage impairments are double what we expect them to be, the impact to EPS would be just 1%, 2% and 4% for Barclays, RBS and Lloyds respectively.
- *Using 2011 as the benchmark year, Lloyds is most susceptible to earnings downgrades in the event of hiked impairments – if they come in double our forecast in 2011, actual EPS will be 36% lower than forecast, compared with 25% at Barclays and 19% at RBS. Focussing on 2012 EPS, Barclays and LBG are similarly affected at around 20% of forecast earnings, with RBS better off at 11%.
- * For Barclays, however, note we have excluded gearing to US unsecured lending which are not susceptible to UK austerity and food price inflation dynamics.
- * On 2012 normalised earnings, the impact of higher impairment charges is reduced by around a third relative to 2011.
- * If we have overestimated impairment rates or the recovery in 2011 and 2012 is better than expected, we may see modest earnings upgrades of 5-9%.
Nevertheless, one to watch out for.
UK mortgages, and the bank lending blame game - FT Alphaville