Buy-to-let is UK's bubble; Northern Rock its needle

Buy-to-let property investment is Britain's version of subprime and the Northern Rock debacle will prove to be the needle that pops the bubble.

LONDON (Reuters) - Buy-to-let property investment is Britain's version of subprime and the Northern Rock debacle will prove to be the needle that pops the bubble.

Lending terms will be tightened, rates will rise, and most important of all, confidence will be hit. The army of small British property investors now taking on risk on a heroic scale will realize that an investment that costs more to own than it generates in income and stops rising in price is a bad idea.

Buy-to-let, which now accounts for about 12 percent of British mortgage lending, is the practice of buying property, typically borrowing the vast majority of the price, and renting it.

And like so many bubbles before, it has been a great business over the past decade as property values nearly tripled, making fortunes for many investors and giving lenders who were prepared to take higher risk rocket-fuelled growth.

The lesson of the Northern Rock saga, indeed of the global financial crisis, is that credit, confidence and rising asset prices form a self-reinforcing cycle on the way up, encouraging ever greater risk taking.

But that cycle can turn vicious on the way down, as the lines of depositors seeking to get their money back from Northern Rock on Monday showed.

And though the British authorities have, quite prudently, stepped in to bail Northern Rock out and pledged to make good any losses of its depositors, this is the moment when the spell is broken.

"The banks have been lending to amateur people who are investing on the basis that house prices will only ever rise," said Dominic White, an economist at ABN AMRO in London.

"The Northern Rock has been at the forefront of these aggressive lending standards and now you have reached a situation where you have cut them out of the market. That kind of tightening of lending standards will become self-fulfilling."

"Loan growth slows, housing markets slow and banks have to cut further."

ASTONISHING GROWTH, ASTONISHING RISKS

Almost unbelievably, many buy-to-let investors have bought property as an alternative to a pension plan. While surely property belongs in all pensions, the idea that a highly leveraged, totally undiversified asset should be relied upon for old age support is, well, aggressive.

The number of buy-to-let mortgages has risen ten-fold since 1999, according to the Council of Mortgage Lenders and the terms under which they are offered have been relaxed significantly.

Whereas in 1999 the maximum percentage of the purchase price an investor could borrow was 75 percent, 85 percent is now common, while banks require a weaker ratio of the rent to the cost of servicing the loan.

And banks will now advance up to 2.5 million pounds to individual investors in aggregate, five times typical levels in 2000.

Quite simply banks have had to relax standards to stay in the game, a familiar tale to anyone who has followed the U.S. subprime and buyout loan stories.

The interest rate of even the cheapest buy-to-let mortgage is now around 5.5 percent, while the amount of income the underlying property generates net of expenses is around 3 percent, according to ABN AMRO. That leaves essentially all buyers at present prices with a hefty monthly bill for the privilege of owning the house.

WILE E. COYOTE MOMENT

If the capital gains that have thus far made that privilege worth paying for go away, so will the confidence of buy-to-let investors, no matter how fast their legs spin.

Britain's Royal Institution of Chartered Surveyors on Tuesday said there was a 10 percent chance of a housing crash in Britain, and is now predicting no capital appreciation over the next 12 to 15 months.

RICS chief economist Simon Rubinsohn also said that there was a 20 percent chance of a 10 percent fall in London house prices in the coming year.

"It's important to remember that sentiment can change quite quickly," Rubinsohn said.

There are huge differences between now and the 1990s, when Britain last suffered a property crash. Unemployment and interest rates are both low, leaving few forced sellers.

But Britain is a society heavily exposed to credit, to financial services and to property investment, all of which look very fragile.

Looking at the U.S. experience, it's not hard to construct a scenario where we one day look back on buy-to-let in the same way we now view subprime: What were we thinking?

(James Saft is a Reuters columnist. The opinions expressed are his own)