According to research by Moody’s, the credit ratings agency, the UK’s banks and building societies could absorb a 20 percent fall in house prices in a year without further denting their capital reserves.

The study, set to be published on Friday, comes as shares in Britain’s largest lenders continue to slide, raising fresh concerns that the investment banks that have underwritten the rights issues for Royal Bank of Scotland and Bradford and Bingley would be left holding a substantial proportion of the new shares.

Now at their lowest level for a decade, RBS’ shares have slipped 2.6 percent to 231.75p. Meanwhile, B&B’s shares dropped almost 7 percent to close at 90.5p, which is just 8.5p above the 82p underwriting price for its £300m rights issue.

The weak share prices reflect growing concerns about the impact of the slowing UK economy and falling house prices on banks’ profits. Investors are starting to believe we could see a repeat of the housing slump in the early 1990s.

The Moody’s research suggests, however, that even if house prices were to fall by a fifth, most banks will have sufficient capitol reserves. A 50 percent fall in house prices however would leave many banks needing fresh capital.

Elisabeth Rudman, a Moody’s senior credit officer said, “We found from our stress tests that the mortgage lenders do have a considerable ability to absorb a substantial downturn in that market.”

As reported late last week, RBS, HBOS and B&B have launched rights issues to rebuild their balance sheets, although these capital raisings have mainly been designed to boost reserves after the banks suffered losses on investments linked to the US mortgage market.

Moody’s said it couldn’t rule out further writedowns at the UK banks until house prices had stabilised.

Falling share prices of RBS and B&B have confounded bankers, who priced the rights issues at a heavy discount in order to increase their chances of success.

The sell-off also hit banks that have resisted the pressure to raise capital. Barclays shares, on Thursday, fell 9.75p to close at a five-year low of 377.5p.

According to the latest Nationwide house price index, UK house prices fell 2.5 percent in May, which is the largest single monthly decline is the index’s history.

Due to the price drop, of the Bank of England’s monetary policy committee even more complex as it struggles to set an interest rate policy which is consistent both with surging inflation and a deep slowdown in economic activity.

The seventh consecutive price drop in the past 12 months makes this decline the longest single period of housing declines since 1992.

House prices, year on year, are now 4.4 percent their levels of May 2007. This is a the biggest fall since December 1992, when UK house prices were falling at a much steeper annual rate of 6.3 percent, in the midst of a severe housing downturn.

“The pace of house price falls accelerated in May as more weak economic news added to the gathering momentum of negative sentiment about the housing market,” said Fionnuala Earley, chief economist at Nationwide.

Ms Earley said that the average price for a house is £8,000 less than this time last year at around £173,583. However, house prices are still 5 percent higher than two years ago and 10 percent higher than three years ago.

Michael Saunders, an economist at Citi, noted that the drop in the price index was consistent with other data, such as that of surveyors’ and housebuilders’ groups which also show a sharp slowing in housing demand.

”Housing demand is likely to suffer a further blow in coming weeks as fixed rate mortgages rise in response to the recent surge in interest rates,” Mr Saunders said in a note.

With data showing inflation is rising faster than expected, traders have scaled back their expectations that the MPC will cut interest rates further.

Mr Saunders pointed out that a key interest rate used to set prices for two-year fixed rate mortgages had risen by nearly half a percentage point since mid-April, and large lenders are already announcing increased rates on their home mortgages.

He noted that historically, house prices and consumer spending have been highly correlated and show a closer link in the UK than in many other countries.

The drop in house prices was not entirely unexpected as Nationwide noted. The Bank of England, in March, reported an 11 percent drop in approvals for new home purchases to 64,000, which is the lowest level of demand since the records began in 1993.

The government may unpick another aspect of the budget by reversing proposed new duties on motorists and hauliers already hit by rising fuel prices after Gordon Browns ministers yesterday paved the way for a new tax retreat.

While hundreds of lorry drivers blockaded streets in London, ministers signalled that Chancellor Alistair Darling would take pity on road users when he draws up his pre-budget report in the autumn.

Members of Mr Darling’s team said he was “listening carefully” to Labour MPs and others on whether to press on with plans to increase fuel duties by 2p a litre in the autumn and for a controversial reform to vehicle excise duty.

Having already been forced to water down his plans to reform capital gains tax, the chancellor held an emergency £2.7bn mini-budget, this month, to compensate losers from the abolition of the 10p tax band.

However, as fuel prices soar and household budgets tighten, Mr Darling’s aides insist he is “very aware” of concerns raised by Labour MPs and motoring organisations. The chancellor’s team realise that any retreat on the road tax plans in particular would be seen as another humbling U-turn.

But one of Mr Darling’s allies said: “If it’s the right thing to do, he will do it.”

According to Grant Thorton, the accountants, if oil prices stay at their current highs due to North Sea oil revenues, the Treasury could fund the scrapping of the proposed 2p increase in fuel duty and its new tax on larger cars, and still beat the relevant revenue forecasts over this financial year by more than £4bn.

A commons motion calling for rethink on the road tax plan has been signed by 35 Labour MPs. The plan - under which larger family cars, including models bought since 2001, would see a sharp rise in vehicle excise duty. Labour MPs have claimed that the plan to increase taxation for older family cars would hit poorer families and undermine the government’s claim to be on the side of hard-working households in difficult times.

Insiders at Downing Street say a retreat on the VED plan was not under “active consideration” but pointedly refused to say whether it would survive in the chancellor’s autumn pre-budget report. Under the plan, cars with higher emission levels would be charged a higher level of road tax.

Justice Secretary, Jack Straw said in an interview, “The chancellor and prime minister have said quite explicitly we are listening to public concerns about this and – if there are going to be decisions announced – they could be announced in the autumn.”

John Hutton, business secretary said, “The chancellor is listening to what people are saying about VED, as he has done on a number of occasions recently about tax rises.”

Labour MPs are now expected to scrap completely, the proposed 2p fuel duty rise, which was proposed by Mr Darling by six months until the autumn.

Across Europe, the impact of rising fuel prices is a growing problem. Yesterday, French president Nicolas Sarkozy, suggested a cap on sales taxes on fuel to try to hold prices down.

In the first three months of this year more than a fifth of homebuyers in the UK, who have a chequered credit history, have fallen behind on their mortgage payments and even those with top-quality ratings have seen a statistically significant rise in delinquencies.

New research from Standard & Poor’s is based on the behaviour of homebuyers, whose loans have been packed in to mortgage-backed-securities, accounting for 80 percent of the £43bn sub-prime mortgage market.

Total delinquencies – which are defined as arrears of more than 30 days – made up 21.73 percent at the end of march while those seriously delinquent by 90 days or more, including those already in foreclosure, edged in to double digits at 10.60 percent.

Unless lenders agree to modify loan terms, the figures show that more than £7bn worth of loans are at risk of defaulting. S&P believes that the loans backing the securities it rates are a representative sample of the market as a whole. The rise in sub-prime arrears threatens further problems not only for the economy but also for those financial institutions that bought securities backed by the loans.

Potentially more worrying is the small but notable increase in delinquency rates among prime mortgage-holders.

S&P, in the report on the performance of securities in this vastly larger market, calculated mortgage delinquency rates for the first quarter of 2008 were 2.41 percent while payments 90 days or more overdue were 0.79 percent. S&P said this showed a “sharp” rise from the previous quarter when the figures were 2.11 percent and 0.62 percent respectively.

Sean Hannigan, a director and credit analyst at S&P stressed that the numbers remained very small, “We have seen numbers like this two years ago.” However, he added: “The difference today is that borrowers are not being helped by rising house prices as they have been in recent years,” he said. “In previous years, homebuyers in difficulty could find another lender to refinance the mortgage. It could mean that now more homes wind up in repossession.”

The fact that a rise is occurring while employment is strong and interest rates low suggests that it may not only be macroeconomic factors making it hard for homeowners to pay their debts.

Of all sub-prime mortgages, roughly 80 percent have been securitised, as have about 20 percent of all prime mortgages. Data from the Council of Mortgage Lenders is more comprehensive but will not be produced until the summer.

Because S&P provides credit ratings on the debt, it must closely watch the underlying loans where payments from homeowners provide the interest and principal on the bonds.

Banks in the UK recoiled from commercial property lending, leaving investors in the sector facing record margins, rocketing arrangement fees and demands for greater equity.

On Friday a survey published by De Montfort University, recorded the highest ever interest rate margins for senior debt in every sector as well as the sharpest ever annual increase.

Average loan-to-value ratios for almost all sectors were the lowest recorded, and all organisations increased arrangement fees substantially, reaching their highest ever levels by the end of 2007. Since then, most investors report that conditions have not improved for borrowers.

According to the survey, bank lending to the property sector soared to record levels last year, before the market tightened as the credit crisis ended years of easy finance. Debt rose to a record £247bn in 2007, from £215bn in 2006, with around £200bn standing on the balance sheets of the lending banks.

The figure jumped 16 percent last year, partly owing to an estimated £11bn of debt that was intended to be scrutinised but that could not be distributed following the freeze on this market last summer.

RBS and HBOS are among the largest lenders to the marker, although the sector has been filled by banks and building societies of all types in recent years. HBOS, according to its 2007 accounts, amounted for 37 percent of total corporate lending to construction and property clients - around £40.4bn.

According to the Bank of England, Commercial property lending accounts for 38 percent of major UK banks’ lending to private non-financial companies, compared with 19 percent in 1998.

The fall in capital value of more than 20 per cent recorded in parts of the market over the past 12 months has got some analysts worried. There are fears that this is putting pressure on loans, potentially leading to defaults if the market decline continues.

The Bank of England, one of the sponsors of the survey, was relatively sanguine in its most recent financial stability report, saying that although property values may have increased the risk of commercial property loans held on balance sheets, there was no increase in defaults in spite of evidence of breaches of covenants.

The UK’s largest building society, Nationwide, on Thursday said that it expected UK housing prices to fall further this year, though the percentage decline would “remain within single digits”.

Nationwide’s chief executive, Graham Beale, made the comments as he announced strong financial results for the mutually owned company.

In response to the global credit crunch, Nationwide cut back its mortgage lending and expanded its share of the consumer savings market. The company showed underlying pre-tax profits for the year to April 4 had risen by 17 percent to £781 million.

Net residential lending fell by 40 per cent to £6.7bn, and lending to the commercial property sector was down 29 per cent to £2.4bn. The company said its total net lending of £8.9bn was fully funded by net retail savings receipts of £9.1bn. This compared with 2007 lending of £14.6bn and savings receipts of £3.3bn.

“We experienced strong inflows of savings as customers sought a safe haven for their money following the uncertainty of the credit crunch,” said Mr Beale.

The building society’s cautious approach was illustrated by the fact it had a 19 percent share of the UK savings market, compared to just 7 percent of the residential lending market. In the previous year the company had 11 percent of the mortgage market.

Mr Beale said he would be comfortable if Nationwide retained a 7 percent share of UK mortgages this year.

In the first annual decline for 12 years, Nationwide announced, last month, a 1.1 percent fall in UK house prices. “We think that trend will continue throughout the year, but remaining within single digits,” Mr Beale said

Although builders have reported a further deterioration in th UK housing market, Mr Beale is optimistic, “If anything I think market conditions have improved marginally over the past month,” he said. “We may have seen the first green shoots of recovery.”

Finance Director, Mark Rennison, when asked about the commercial property market, said the commercial sector seems to have been more affected by the credit crunch that residential property.

“We have seen some significant falls in capital values,” Mr Rennison said, “and clearly there is the potential for further falls in value and further pain in the commercial sector.”

MPs were warned yesterday that Northern Rock could take even longer than planned to repay its £24.1bn debt to the government if the UK is hit by a recession or a housing slump.

The Newcastle bank, which was nationalised in February, is intending to repay its entire loan from the Bank of England by 2010 and to relinquish its government guarantees by 2011.

Northern Rock’s finance director, Ann Godbehere, signaled that the bank’s business plan could be thrown off track if the UK suffered an economic recession or a 1992-style housing crash.

Speaking to MPs at the Treasury select committee she said, “There could be a six-month delay in that scenario”.

The banks executive chairman Rob Sandler told the committee that Northern Rock’s business plan was “not without risk . . . it is a challenging plan in these respects”, before adding that the plan could come under pressure if house prices fell by 5 percent or more.

He went on to say, much would depend on the UK economic outlook, “If we suffer a downturn and this leads to higher levels of unemployment than at present . . . at that point this would place consider-able strain on the ability of the company to deliver the plan.”

Adding: “We have stress-tested the plan against a number of scenarios, including a decline in the housing market comparable to that of the 1990s, and the plan is robust [in] that scenario.”

The bank will review its current business plan in during the third quarter of this year.

MPs asked Mr Sandler whether he believed Northern Rock’s brand was broken to which he replied: “I don’t believe so . . . the results of the exercises [carried out] indicated that the brand whilst damaged is not damaged irreparably.”

He explained to MPs that Northern Rock was trying to shrink its mortgage book by almost half by encouraging customers to re-mortgage elsewhere when their loans end. The business plan was based on 60 percent of customers re-mortgaging away from the bank, but he acknowledged that fewer mortgage lenders were actively seeing new business in the current market, so the actual level of redemptions could be less.

“It becomes more challenging if there are more lenders out there who are not prepared to offer products to borrowers,” he said.

But Mr Sandler acknowledged there was a risk that Northern Rock would be left with riskier customers unable to re-mortgage elsewhere.

He told MPs he planned to keep sponsorships, such as Newcastle United and Newcastle Falcons.

Since gaining independence, the Bank of England’s investors have been more sceptical of the way the bank tackles inflation.

The widening gap between the yields on index-linked government bonds and conventional gilts indicates bon-market investors are willing to pay much higher prices for inflation protection. As Britain enters its most inflationary period for more than a decade this suggests doubts about the credibility of the monetary framework.

Ex-chief economic adviser to the chancellor, and current children’s secretary, Ed Balls described inflation expectations in bond markets as the “most important” test of credibility and confidence in monetary policy.

Paul Dales of Capital Economics said the gap could be the “first sign that the markets are starting to lose faith in the ability of the UK’s policymakers to deliver a low and stable inflation environment”.

Alongside rising surveys of household inflation expectations and corporate pricing intentions, economists said there was a greater risk of higher inflation returning to normal British life.

“In every measure you look at, inflation expectations have already moved out of the range they have occupied in the last eight or nine years.” Malcolm Barr of JPMorgan said.

Sensing that a loss of confidence in the UK from abroad is under way after sterling’s continued decline, Danny Gabay of Fathom Consulting said: “The … markets believe the ‘macro policy miracle’ [since 1997] is more style than substance”.

Over a 20-year period, the government bond market now expects retail price inflation to average 3.76 percent, according to Bank of England figures, compared with 3.47 percent on the last trading day before Gordon Brown announced Bank independence. By comparison, the 20-year expectations two years ago were just 2.85 per cent.

The warning issued by Mervyn King, the Bank’s governor, that the “nice” decade (of non-inflationary constant expansion) was over has prompted other economists to offer their own acronyms. Few yet expect a recession, but Michael Saunders of Citigroup said times will be “vile” – “volatile inflation, less expansionary”.

Urging policy makers to fight higher inflation, Jean-Claude Trichet, president of the European Central Bank said, soaring oil and food prices had created “demanding times, challenging times”, and that the challenge was to ensure the pressures did not create lasting “second-round effects” by feeding through into wage deals.

Mistakes made at the time of the first “oil shock” in the 1970s had “enshrined the high level of inflation for a long period” and led to mass unemployment. Mr Trichet sounded the alarm on inflation even as he acknowledged that financial markets were still witnessing an “ongoing, very significant market correction”.

The United Kingdom will announce its determination to launch the first Islamic bonds by a western government. This is the clearest sign that long-running doubts over costs and pricing have finally been put to rest.

The economic secretary to the treasury, Kitty Ussher will say there is a “powerful momentum” behind the plans, which should solidify London’s position as the leading western centre for Islamic finance.

In April 2007, the government unveiled hopes to issue Sharia-compliant bond, or sukuk. Since then, the initiative has been hotly debated, with some civil servants raising concern about the cost of issuing sukuk, which due to their complex structure to avoid paying interest in line with strict religious laws, are far higher than conventional bonds.

Convinced that the political and financial benefits far outweigh worries about cost, the government believes the bonds can be priced competitively to attract buyers, which is of further concern to civil servants.

Ms Ussher commented on the announcement, “This is an important market for Britain, which we are committed to growing.

“Although we don’t see this as a competition between financial centres, London is now established as the most important western centre for Islamic finance. New York has missed the boat.

“We are determined to issue Islamic bonds. It will bring money to London and send out a strong positive signal to the Muslim community.”

Bankers say that a sovereign UK Islamic bond would be a milestone for the $80bn sukuk market as it would boost liquidity and encourage other western governments to follow suit.

Although the Bulk of sukuk issues have come from the Middle East and Malaysia – around 90 percent of the market, a Texas-based oil group, a German state and the World Bank are also involved.

Bankers predict the bond will be about £500m. A bond of this size would help Islamic banks by giving them the ability to buy safe triple A rated paper, which will improve their balance sheets and provide them with collateral for other lending operations.

British Airways achieved record profits last year and reached a 10 percent operating margin for the first time in their history.

The airway has decided to pay a dividend for the first time since 2000/01 and is paying a £35m bonus to staff after narrowly achieving its profit targets despite the cost of the chaotic Terminal 5 opening in March. The dividend will be 5p a share.

BA chief executive Willie Walsh said the company had achieved an “outstanding financial result” despite significant economic slowdown in the last six months and rising fuel prices.

BA has previously warned that profits would decline sharply this year from last years peak and it said on Friday the full year would be “challenging against an uncertain economic outlook.”

The airline said that moves to reduce capital expenditure this year were being implemented and that it was reviewing its capacity, costs and network in the face of the economic pressures and high fuel prices.

BA warned the first quarter would be “particularly difficult” given the jump in the crude oil price from $58 a year ago to around $115 a barrel.

The delayed transition of its operations to Terminal 5 at Heathrow, its global hub, would also hit both revenues and costs in the quarter and in the full year.

The costly debacle of Heathrow’s Terminal 5, which cost BA around £16m over the last five days alone, has forced BA and BAA, the airport operator to revise its timetable for the transfer of the bulk of the airline’s long-haul flights from T4. This was supposed to take place on April 30.

The transfer is now due to begin on June 5 but will take place in phases and is not expected to be completed until October. Mr Walsh said T5 was “now working well.”

British Airways is also facing higher airport charges from BAA this year at both Heathrow and Gatwick.
It warned that its total fuel costs would rise by around £1bn based on the current price of around $120 a barrel. This increase is more than double the rise of £450m forecast in March based on an oil price of $85 a barrel. Last year, BA’s fuel costs rose from £1.93bn to £2.06bn.

The group has managed to hedge 72 per cent of its fuel requirements for the first half of the current financial year and just below 60 per cent for the second half.

The fuel price rise was passed on to customers earlier this month to £158 on a long-haul flight of more than nine hours. BA forecast an increase in revenues of 4 percent due to the increase in its fuel surcharges to customers.

BA was one of the most profitable airlines this year. Last year BA increased its operating profit from £602m to £875m, and raised its operating margin from 7.1 percent to 10 percent. Earnings per share rose by 59.1 percent from 37.2p to 59.2p.

Although its turnover rose by 3.1 percent from £8.49bn to £8.75bn, its pre-tax profit increased by 44.5 percent from £611m to £883m. Operating costs excluding fuel fell by 3 per cent.

In related news, BA said it was pressing ahead with its planned OpenSkies subsidiary airline despite the continued threat of strike action by its pilots over the move and the opening of a court case with Balpa, the pilots union, next Monday.

BA said it would launch the first service under the OpenSkies brand between Paris Orly and New York JFK airports on June 19.

BA plans to build a fleet of six 757s under the OpenSkies brand by the end of next year. OpenSkies will be the first time BA has operated long-haul services that do not touch the UK.
The BA share price rose in early trading on Friday by 5½p or 2.5 per cent to 229½p.