Is there any room at the inn? (or anywhere for that matter)
stephen clarke, 20 December 2011
Yesterday the FSA set out new rules for mortgage lending. The new rules were positively received as a way to prevent the excessive risk taking that occurred in the run up to the financial crisis when people were clearly sold unaffordable mortgages. This tightening of the standards comes almost a month after the Government pledged to back mortgages for first-time buyers, another move that was widely supported as a way to stimulate the housing market. Is there a contradiction though between subsidising lending and tightening up standards?
It seems paradoxical to tighten up lending standards while underwriting 95 per cent of some lending to new home owners. However the Government’s actions are understandable once one reflects upon a perpetual conundrum facing the banking industry.
It is normal practice in lending to charge a higher interest rate for more risky borrowers (and/or a larger deposit in the case of mortgage lending). The logic is that the lender (often a bank or building society in the case of mortgage lending) deserves greater compensation for taking on a riskier loan and needs the greater income from the loan to hedge the risk of default on other risky loans they may have. However with this practice there is a counter-current that works against the bank: the higher interest rate disproportionally penalises riskier (usually poorer) borrowers and so could trigger the default that the bank is trying to hedge against. Some banks refuse to charge higher interest rate to riskier borrowers, they simply refuse to do business with them or offer them a smaller loan.
Banks have looked for ways around this problem and one tactic used to reduce the negative effect that borrower default will have on a bank’s balance sheet is securitisation. Securitisation played a large part in the sub-prime defaults that triggered the financial crisis and so has had a pretty bad press since; however, as a purely theoretical concept, it is sound. Securitisation is the pooling of risk. By bundling loans together, risk can be spread around the system. One borrower may default but a bank holding a security of lots of different loans will expect the repayments of the other borrowers to cover such a loss. The problem, as was amply demonstrated in the crisis was that risk is often correlated: that is to say that as the chance of one borrower defaulting increases, the chance of others defaulting also increases. This is because lots of borrowers may default for the same reason, a recession for instance or a fall in house prices. A more effective securitisation method would look to bundle up risks that were uncorrelated, but with the housing market that can be hard to do.
The result is that we are perhaps stuck with the conundrum that faces the government and lots of the population today: we want people to own houses but do not want to encourage banks to offer loans to people who cannot pay them back. The Government and the FSA responding, to both concerns, took the two, apparently contradictory, actions mentioned above.
The real problem is that not enough people can afford houses: house prices are too high and no amount of subsidised lending will change that without seriously destabilising the financial system. With demand for houses outstripping supply, the solution is to increase supply. The Coalition has realised this and has taken steps to increase construction, there are proposals to loosen planning laws and use public funds to increase the stock of affordable housing. It is these supply-side reforms, in particular reform of the planning laws, that need to be completed and taken further. To this end the Government needs to face down the protests from those such as the National Trust and Greenpeace, who object to loosening of the planning laws. If such protests are allowed to win-out it is clear that there will be little room for anyone in future Christmases, whether at the inn or not.
Purely to follow up on the update of this issue on your website and wish to let you know simply how much I appreciated the time you took to publish this handy post. In the post, you actually spoke of how to actually handle this problem with all comfort. It would be my personal pleasure to collect some more thoughts from your blog and come as much as offer people what I have learned from you. Thank you for your usual great effort.
You appear not to have noticed that newbuild property is uncompetitively priced. The reasons for this include the loading of Section 106 costs on newbuilds, uneconomic green building standards, and builders trying to protect the value of their landbanks. The consequence is that banks will usually only offer a lower LTV mortgage for newbuild property, because on resale buyers will not pay a premium to cover these items when they have other alternatives.
Few people are conned by high prices for newbuilds: it is not the panacea you seek unless there is reform that removes Section 106 penalties, uneconomic greenergy standards, and encourages builders to divest their land banks as a starter.
The real answer is that mortgage lending must be tackled. Unfortunately, in the four years since the market peaked there has been nothing substantive done. Instead, existing mortgage holders have been heavily subsidised by low interest rates, and banks have indulged in a degree of forbearance that now concerns the BoE because it is storing up trouble. House prices are not falling because the few mortgages that are issued for house purchase average £140,000 according to BoE data – or 87% of the average house price. Banks have not used the lower rates to get borrowers to maintain their payments and increase their equity, and thus reduce the risk of negative equity as prices fall.
The subsidy to first time buyers of newbuilds is in effect a bailout for builders. On every measure it is wrong. The new FSA rules are a help – but the real problem is that average loan size needs to fall if the stock of lending and house prices are to deflate, as they must – because at present they are crowding out lending to industry. Mortgage lending is about the only sector that has seen the stock of lending increase (albeit modestly) since the credit crunch hit. It’s time that we worked on cutting it to help reduce the size of bank balance sheets.