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Dealing with Debt

The prospect of rising interest rates and the UK’s household debt problem

Katie Blacklock & Matthew Whittaker

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#ukdebt

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Despite economic improvement, UK has potentially large debt overhang that requires careful dismantling

• Household debt increased significantly in recent decades, particularly in the pre-crisis years

• Driven by rising demand (in part due to rapid house price growth) and easier supply (with a loosening of credit criteria)

• Entered the downturn with sizeable household debt burden which hasn’t been adequately dealt with

• A changing environment – and rate rises in particular – raises new challenges

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#ukdebt

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UK household borrowing increased rapidly pre-crisis, driven primarily by secured lending

Debt as a share of

household incomes rose sharply from

2002, reaching a peak of

170% immediately

prior to the financial crisis

Increase was

primarily driven by a

growth in secured lending

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Source: OECD & OBR

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Households have since gone through some de-leveraging, but the UK still stands out

Debt to income ratio has fallen in the UK, but

remains higher than in most

other countries at 140%

De-leveraging in the US has

taken the ratio below 120%

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Source: OECD & OBR

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And the OBR thinks that the period of de-leveraging has come to an end

Source: OECD & OBR

Projections from March

2014 suggest the UK debt to

income ratio will head back to its pre-crisis

peak by the start of 2019

As before, this is expected to

be driven by secured lending

associated with house

price increases

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Despite the UK’s exposure, the household debt fall-out post-crash has been relatively muted

Numbers of households in

arrears on their mortgage

and having their home taken into

possession rose sharply

after the financial crisis,

but did not reach the

levels anticipated

and have since fallen

Source: CML

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• The relatively small house price correction – But there are regional differences

• The surprising resilience of employment – But real wages have tumbled

• Loose monetary policy – But interest rates are set to rise again

• Lender forbearance & government support – Likely to unwind as house prices and interest rates rise

Thanks to four key factors, all of which are subject to some uncertainty

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But, despite historic low base rate, mortgage difficulties remain elevated

Given depth of recent

downturn and falls in

earnings and incomes,

falling borrowing costs have

provided only partial relief

for many mortgagors

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Source: Bank of England, NMG Survey 2013

8 #ukdebt

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And can’t necessarily rely on strong rebound in earnings during economic recovery

Typical earnings were

flat in real terms even before the

start of the downturn. They have

since fallen by around £2,000

a year, taking them back to a level last seen at the turn of

the century

And recovery in pay is set to

be slow at best

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Source: Modelling based on OBR, Economic and Fiscal Outlook

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Even under gradual rate rises and falling lender spreads, exposure to debt is set to increase

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If the base rate rises in line

with current expectations and lenders continue to

narrow their spreads, the

proportion of mortgagor households

spending more than one-third of their after-

tax income on repayments is set to double

by 2018 Source: Modelling based on DWP, Family Resources Survey

10

Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

1,130,000

13%

2,330,000

27%

Re-finan

cing

Very low equity households in

2014

Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

Highly geared households in 2018

(base rate at 2.9%)

760,000

9%

2,760,000

33%

At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

Re-finan

cing

Very low equity households in

2014

Other non-standard circumstances

in 2014

770,000

9%At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

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Potential ‘mortgage prisoners’ will find their options for re-financing limited

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Re-mortgaging options today

are likely to be limited for

those with less than 5% equity

in their home and for some other groups

We add those

with interest only

mortgages and the self-employed to

create an imperfect

proxy Source: Modelling based on DWP, Family Resources Survey

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Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

1,130,000

13%

2,330,000

27%

Re-finan

cing

Very low equity households in

2014

Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

Highly geared households in 2018

(base rate at 2.9%)

760,000

9%

2,760,000

33%

At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

Re-finan

cing

Very low equity households in

2014

Other non-standard circumstances

in 2014

770,000

9%At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

#ukdebt

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With those facing the double exposure appearing particularly vulnerable to rate rises

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Around one-in-ten of today’s

mortgagors sit within both of these groups, meaning they

are likely to have limited

ability to insulate

themselves against rising

rates

These borrowers are perhaps most

‘at risk’ Source: Modelling based on DWP, Family Resources Survey

12

Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

1,130,000

13%

2,330,000

27%

Re-finan

cing

Very low equity households in

2014

Afford

abili

tyHighly geared households in 2014

(base rate at 0.5%)

Highly geared households in 2018

(base rate at 2.9%)

760,000

9%

2,760,000

33%

At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

Re-finan

cing

Very low equity households in

2014

Other non-standard circumstances

in 2014

770,000

9%At ris

k Highly geared in 2018 and potential

mortgage prisoners in 2014

#ukdebt

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This ‘at risk’ group is particularly prevalent in Northern Ireland and in London

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Large house price falls

mean that we might expect

more ‘prisoners’ to

live in Northern

Ireland

But affordability is a bigger issue in London due to the amount

borrowers stretched

themselves pre-crisis Source: Modelling based on DWP, Family Resources Survey

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And the problem is relatively concentrated among borrowers with low to middle incomes

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Vulnerability to the double

exposure of gearing and

prisoner status falls across the

income distribution –

worrying because we

might expect those with the

lowest incomes to have most

difficulty coping with

rising bills Source: Modelling based on DWP, Family Resources Survey

14 #ukdebt

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Of course, actual outcomes will depend on the sequencing of income rises and rate increases

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Looking at wider (secured

and unsecured)

debt repayments, an optimistic scenario for

incomes and rates suggests

that the number in ‘debt peril’

might double by 2018

Source: Modelling based on ONS, Living Costs and Food Survey

15 #ukdebt

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With ‘bad’ income growth and a modest interest rate shock having very significant consequences

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Under a much more

pessimistic (but still

plausible) scenario, the proportion of households in

‘debt peril’ would jump to

around 7%, more than

triple the baseline level

Source: Modelling based on ONS, Living Costs and Food Survey

16 #ukdebt

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We haven’t experienced the debt crisis many envisaged in 2008; is it still to come?

• Ultra low interest rates, lender forbearance and government support have provided breathing space, but the underlying problem of affordability remains

• Focus has been on fixing the flow of new borrowers, but stock issue still needs resolving

• Unwinding of emergency measures is inevitable, but requires the same level of co-ordinated policy response as was seen in post crisis years

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#ukdebt

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Dealing with the debt overhang will not be costless, but there are policy options

• Tread carefully with rate rises • Rates must rise, but much debate around timing, pace and magnitude

• Sequencing of rate rises and recovery in household incomes crucial

• Make the most of the window while it remains in place • Borrowers need to insulate themselves against rate rises

• Requires signposting, market options and support for ‘prisoners’

• Prepare for a rise in repayment problems • Need to ensure capacity to deal with rising demand for debt advice

• Need to tackle social and economic upheaval associated with an increase in repossessions

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#ukdebt

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Dealing with Debt The prospect of rising interest rates

and the UK’s household debt problem

#ukdebt

Adair Turner – Senior Fellow, INET

Katie Blacklock and Matthew Whittaker –

Resolution Foundation

Gavin Kelly (Chair) – Resolution Foundation

3 June 2014