Strong sign of deflation.

Dramatic cut seen in mortgage lending

By Norma Cohen and Jane Croft

Published: August 11 2008 03:00 | Last updated: August 11 2008 03:00

Building societies have so dramatically slashed their mortgage lending that repayments outstripped new loans by almost £700m in June, according to the latest data from the Building Societies Association.

The June data follow a more modest net outflow of £110m in May on a seasonally adjusted basis and offer a bird's eye view of the credit crunch caused by a drought of available cash.

According to data from the Bank of England, the net withdrawal of mortgage lending by building societies is unprecedented; not even in the darkest days of the last property recession did net lending become negative.

Adrian Coles, director-general of the BSA, said the net withdrawal of capital reflected extreme conservatism on the part of societies. "They are keen to make sure they are only lending to those who are able to repay their mortgage," he said.

But the spectre of Northern Rock has hung over the sector and there is a sense among lenders that they would rather bolster their own cash reserves than make new home loans.

"Of the money coming in from retail savers, more of that is going into liquidity rather than into new mortgages," Mr Coles said. He said that the Financial Services Authority, which regulates the sector, is placing informal pressure on societies to increase reserves above 20 per cent of liabilities, which historically has been the long-term average ratio in the sector.

Although there were no new rules, "it is more nudges and winks from the FSA", he said.

Stephen Kingsley, head of the financial services practice at consultants LECG, said there was no question that a combination of regulatory pressure and common sense by management were forcing societies to pare back lending. "The drop is not surprising," he said. "They are conserving cash."

In the aftermath of the run on deposits at Northern Rock, regulators and lenders have been taking a hard look at liquidity, that is cash on hand to meet a sudden demand for cash withdrawals. Because building societies do not have shareholders from whom they can raise capital, they require a different regulator approach.

In May, Hector Sants, chief executive of the Financial Services Authority, gave a speech to the BSA underscoring its concerns about adequate liquidity and noted that some instruments that might once have been used to meet liquidity requirements might no longer be considered liquid themselves because the market for them had dried up.

He also warned that the FSA was considering liquidity policies that would not only allow societies to meet a sudden round of cash withdrawals but also longer-term policies that would "show inflows against worst case outflows".

But Mr Coles noted that building society lending was also constrained by the very high cost of fierce competition for retail deposits.

With wholesale lending markets in chaos, banks and others have strayed into territory where building societies have traditionally been strong. The rise in mortgage interest rates has made home loans more profitable than they were a year ago but not enough to offset the cost of competing fiercely for retail customers.

"Many societies will conclude that the increase in [mortgage] margins is nevertheless being wiped out by the cost of deposits," Mr Coles said.

Indeed, the June BSA data show that net receipts - new deposits minus withdrawals - in June were just £446m, less than half the level of May and less than a quarter of that in April. But even with that shrinkage, interest credited to depositors rose.

In its 2007-08 annual report, Nationwide, the UK's largest building society, made little secret of its intention to shrink its loan book. It said a "prudent approach" had led to a "controlled reduction" in lending to £6.7bn the year before.

Building societies were once the mainstay of the home mortgage market. And while banks and specialist lenders have taken significant market share, the societies remain active providers of housing finance.

By law, they must make at least 50 per cent of their loans to owner-occupiers and take at least 50 per cent of their funding from depositors, not the wholesale markets.

Gary Styles, chief economist at Hometrack, a residential property research company, noted that specialist lenders, many of whom rely on the wholesale markets for funding, had also had a sharp reduction in net lending.

Ironically, societies are likely to have an edge in keeping customers who have come to the end of a fixed-rate period because they are able to offer a default rate - known as the standard variable rate - which is lower than that of banks. For example, the SVR of Nationwide, is 6.75 per cent against 7-7.25 per cent at HBOS.

In the longer term, Mr Styles said, there were worrying implications for homeowners because the societies had provided rigorous competition to banks and helped to keep rates down. "It can only be that [societies] are losing market share to the banks," he said.

Copyright The Financial Times Limited 2008