Feeling Vulnerable Britain's Coming Credit Crisis

Steep housing prices and a dependence on financial services make its economy vulnerable. Some predict a blow to credit might even be worse -- much worse -- than in the US.
Von Kerry Capell

Could any country be more exposed to the current credit crunch than the U.S.? You bet, and that place is Britain. Unlike most of its European neighbors, Britain shares many of America's financial traits—and problems. Access to cheap credit has fueled a decade of unprecedented growth, with home prices tripling over the past decade, a faster rise than in the U.S. Consumer spending has skyrocketed, now making up roughly two-thirds of the country's total outlays. And the overall economy in Britain is more dependent on financial services than it is in the States.

Add it all up, and "Britain is likely to suffer more severely than the U.S." if the current market turmoil continues, says Danny Gabay, director of Fathom Financial Consulting in London. How severely? Gabay and many other economists think annual growth in Britain could drop to about half the 3% or so it has clocked in recent years.

Roughly half of Britain's growth in the last 18 months has come from financial and business services—everything from accounting and legal advice to real estate. Together these sectors bring in 30% of Britain's national income, far more than in the U.S., says Peter Spencer, an economics professor at the University of York. If a fall-off in financial services were to put the brakes on leveraged buyouts, mergers, acquisitions, and offerings of credit derivatives, thousands of jobs could be lost, primarily at banks, brokerages, and other financial outfits, the Centre for Economics & Business Research Ltd. estimates.

As in the U.S., consumers are another key driver of the economy—and today they're among the most indebted in the world. British consumers owe $2.7 trillion on credit cards, mortgages, and other consumer loans—or more than the country's entire economic output. Household debt as a percentage of gross disposable income is 166%, compared with 127% in the U.S. So it's hardly surprising that in the past year, British banks have had to write off $18 billion in bad debts, mostly consumer borrowing.

Such write-offs could be just the beginning if housing prices start to fall. Despite little growth in incomes, consumer spending has remained strong as Britons have borrowed against the rising value of their homes. That shouldn't be a problem if housing prices climb an additional 40% over the next five years due to supply constraints, as predicted by the National Housing Federation, an affordable-housing advocate.

But some economists are less sanguine. With the average home now costing $370,000—roughly 11 times the average salary—housing is less affordable than at any time in the past 15 years. The latest data show house price inflation running at about 9.5% annually for the month of August, but the rate is starting to slow. And in Yorkshire, Wales, and other areas, prices are even falling. There are already signs of strain as homeowners start to feel the pinch of five consecutive interest-rate hikes, to 5.75%, in the past year. Foreclosures and personal bankruptcies are up by 30% in the first half of 2007, compared with the same period last year. Says Jamie Dannhauser, an economist at Lombard Street Research in London: "The pain is only going to get worse."

Although most believe that the Bank of England is unlikely to raise rates further anytime soon, the cost of servicing mortgages is expected to climb. That's because the crisis in the financial markets has raised the cost of borrowing for lenders, who will in turn pass on those costs to consumers, many of whom have adjustable rates. Subprime mortgage rates have risen by as much as 2.5 percentage points this summer. Although subprime debt accounts for about 10% of the market in Britain, compared with 25% in the U.S., the growing popularity of so-called self-cert loans, where buyers don't need to present proof of income, is on the rise. Some brokers estimate that they account for one-third of new mortgages issued in the past year.

It's clear it wouldn't take much to do significant damage to the two pillars of Britain's economy. Says Maurice Fitzpatrick, an analyst at tax advisory firm Grant Thornton in London: "Because so much of economic growth relies on consumer spending and the City of London, even a small event can have disproportionate consequences."

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