Thursday, 7 August 2008

How not to lend money

I am told that the British fondness for owning your own home is not shared by much of Europe. More fool them, say I. In fact I go further, save for those who need to move frequently because of their work there is no sense in renting long-term because you get nothing in return. This does not mean, however, that it makes sense to expand home ownership at all costs because such an approach results in the gullible and the over-optimistic being at the mercy of spivs and blackmarketeers. I am not talking of counterfeit cigarettes being sold as genuine duty frees, nor of World War II nylon stockings, I am talking of greedy shysters pretending to be banks. To explain my point it is necessary to go back about 20 years.

The housing market last peaked in 1989. The economy had improved structurally throughout the 1980s and legislation was brought in allowing long-term tenants of local authorities to buy their homes at discounted prices. Both these factors contributed to house prices rising but they could only do so if the prospective buyers could raise the money. The government announced that it was to end a tax concession known as MIRAS (mortgage interest relief at source), this allowed people to claim part of the interest on their mortgage against tax. MIRAS had been scaled back for some years and in 1989 it was to go completely. In the time leading up to abolition people were falling over themselves to get on the housing ladder so they could benefit from the last few months of this tax break. Again, they could only do so if they could raise the money.

August 1989 came and went, the economy took a bit of a downturn, unemployment rose, the newly unemployed could not pay their mortgages, some existing borrowers could not afford their mortgages without the tax break and the housing market started to falter. It moved downwards at different rates in different parts of the country and by 1992 it was stagnant. Prices were reduced by between thirty and fifty percent depending upon where in the country the property was situated.

I have mentioned some of the reasons why this slump happened but I have left out one of the most important. Banks, building societies and finance companies were falling over each other to lend money to anyone who walked through the door. They thought prices would keep on rising and that lending to someone who cannot repay would not be a problem because the property could be repossessed and sold in a rising market thereby giving the lender absolute security. Not all lenders were so foolish but a lot of new finance companies had entered the home mortgage market and were keen to get a share of the bounty. A new form of home loan finance was devised.

Historically purchasers were required to put down a deposit (usually at least twenty percent of the purchase price) and were lent a maximum of two-and-a-half times their annual income. These figures did not arise by accident, they were the result of banks and building societies analysing risk. Insurance companies do not just pick the amount to charge as a premium out of thin air, they make calculations according to perceived risk. Banks and building societies were doing the same thing. They knew from experience that prices cannot keep going up forever, that repossession usually leads to the property being sold at less than the best possible price, that they would have to continue to pay interest on the money they had borrowed in order to be able to lend it to their customer, that repossession and sale incurs expenses and that their best chance of being paid came from the customer being able to afford the repayments. They also knew that borrowers are often over optimistic about their futures and wanted to borrow as much as they could in the expectation that their income will rise so any initial hardship would soon be overcome. Responsible lenders have to look after their own interests by maximising the chance of being repaid in full, this required them to build in a cushion of equity to guard against the risks of repossession and to impose a limit on the amount advanced in order to guard against the risk of the borrower's circumstances not improving. A beneficial side-effect is that lending in this way also prevents the customer from over-extending himself.

The new lenders were not so cautious. They were prepared to offer deals unavailable from banks and building societies in order to get a foot in the market. A greater proportion of value was lent and higher multiples were applied to customer's incomes. Many of the established lenders felt it necessary to follow this pattern for fear of being excluded from the market. Eventually loans were offered at more than the purchase price (so that the borrower without any savings could afford legal costs, Stamp Duty, new carpets and a washing machine) and no checks were done to ascertain whether the borrower could afford the repayments. In some instances the only assurance the lender required about the ability to repay was the borrower's own word that he could afford it, they did not require his income to be disclosed or, if they did, they allowed the borrower to state his income without producing supporting proof.

Not surprisingly the ready availability of money allowed full rein to the British desire for home ownership and demand for houses and flats increased. Prices were pushed up, and as the lenders relaxed their requirements a little the number of potential buyers increased and an inevitable bubble formed. House prices were not a real reflection of the value of properties in a market because the market had been skewed, demand in a market requires affordability and by making huge sums available to people who did not have means to repay there was a pretense of affordability, a pretense of demand. The bubble burst in 1989-1992 and prices fell back to something like their true level.

The reckless lenders were hit very hard by this because they had to repossess properties in vast numbers and sell them in a falling market. Many were never heard of again, some were bought-out by reputable banks and a very few survived the storm because they had made a lot of good lending and only a little reckless lending.

The absolute bottom of the market came in about 1992 and lasted for a couple of years. By then the economy was recovering and lending practices had improved. As the economy appeared to be doing well over the next ten and more years lenders with no eye on the past reintroduced the sort of foolish lending which had bankrupted many of their predecessors. Prices rocketed again and a lot of the increase was false for exactly the reasons it was false in the 1980s, it was based on false demand fuelled by reckless lending. We are now seeing a fall in the prices of houses and flats and only time will tell how large the fall will become.

The lenders sometimes seek to defend themselves by saying they have only reacted to their customers' demands, but that is nonsense. These lenders are not (or, more exactly, should not be) Mr Loanshark with his bag of cash and boys with baseball bats to "persuade" defaulters of the error of their ways, they are companies with obligations to their shareholders to run the business with a view to profit. Finance companies do not just magic money out of thin air, they have to borrow it. Their profit comes from borrowing at one rate and lending at a higher rate. There will always be cases in which the borrower cannot repay because of changed circumstances and any losses in such cases are factored into the margin between the cost of borrowing and the receipts from lending. But to have lending policies which increase the risk of default bites into the margin even more and leaves the lender exposed to collapse if the housing market takes a downturn.

Mr & Mrs Young-Borrower with no savings and a joint income of £30,000 before tax can only afford to repay a certain amount. Lending them £150,000 involves a substantial risk they will not be able to keep up with the repayments. It is bad business because it exposes the lender to unreasonable risks. It is bad policy because it builds exaggerated hopes in the Young-Borrowers, they might be able to cope but if they cannot their lives will be ruined.

It takes a very hard heart to blame Mr & Mrs Young-Borrower, they are told they can get on the property ladder and bend over backwards to do so because they see prices rising. When it comes to make the first repayment at the end of Month 1 they do so in the belief their property has increased in value by more than 1% in that month. They pay £1,000 but take comfort from news stories that they have made a capital gain in excess of £1,500. Without the market being skewed by reckless lending the true value of their property might be £100,000 and the true increase in value might be 2% a year not 1% a month. Suddenly their £1,000 a month expenditure looks distinctly unattractive.

The fault lies firmly with the lenders. I am not suggesting they owe a duty to potential borrowers, but they do owe a duty to their shareholders and that requires them only to lend against sound security - security both in the property itself and in the people who are obliged to repay the loan. Executing that duty diligently has the added benefit that it minimises the risk of a price bubble and, thereby, increases the number who can genuinely afford to buy. The real benefit of that is seen in the long-term. After 25 years Mr & Mrs Young-Borrower own their home outright, no mortgage to pay, no rent to pay and a substantial capital asset.

1 comment:

Mark Wadsworth said...

Sure, sensible banking supervision (i.e. strictly enforcing minimum capital ratios) is half the battle; the other half is rolling all wealth and property related taxes (Council tax, Business Rates, Stamp Duty Land Tax, Inheritance tax etc etc) into a single Land Value Tax that will act like a higher interest rate and dampen future bubbles.