Friday, 19 September 2008

The big bail-out

The fun and games continue. Now the US government has decided to bail out its troubled banks by, in effect, paying them the value of the bad loans which have caused such a problem. One might wonder how banks have got into this mess. Their business is to make a profit from lending money not to make a massive loss, so what has gone wrong and what can be done to ensure it does not happen again?

My regular reader knows I have a bee in my bonnet about bad lending to house buyers. It is based on experience I gained in the 1990s dealing with many dozens of cases brought by banks, building societies and tertiary lenders against solicitors and valuers. When the housing market slumped and people defaulted on their mortgage repayments the lenders took hit after hit, total losses were so large that they wanted to find someone to share the misery. So they instructed their lawyers to investigate the transactions and see if they could find a mistake by anyone other than the lender. There were two obvious targets, the surveyor or estate agent who gave the lender a valuation and the solicitor who dealt with the conveyancing. These people would have insurance and if a claim could be substantiated all or part of the loss could be recouped. I acted only for lenders in these cases and saw numerous examples of purely speculative lending, particularly from the new players in the market who attracted business by being prepared to advance substantial sums to those the established banks would not touch.

The greatest scandal was lending purely on the basis of a valuation of the house or flat being bought. The borrower did not have to provide either a deposit or proof of his income. It was known as self certification: "I Joe Smith certify that I earn £20,000pa and am able to repay a loan of £80,000." Provided the valuation of the property was at least £80,000 it was "thank you Joe, loan approved, enjoy your new home" and they might have added "for as long as you can afford it".

Established bank and building society lending practice was to require a substantial deposit (between 15% and 25% of the value of the property), to require clearly documented proof of income and to lend only a small multiple of the borrower's current annual income. Such a restrictive basis of lending necessarily excludes many people who would like to own a house but the banks and building societies are not in the business of enabling people to buy houses they are in the business of lending money for a profit. By definition, they could only make a profit from a loan where the capital was repaid with interest, therefore they only advanced money to people who appeared to be likely to be able to pay. A substantial deposit was an indication that the borrowers were prudent people who had saved money. Documented proof of income was an indication of the ability of the borrowers to repay. Restricting the loan to a small multiple of income was an indication that the repayments would be affordable. None was conclusive proof of anything, each was just an indication without which no loan would be made. Even when all those requirements were met, the bank or building society would only lend money if the manager responsible recommended the making of the advance. Many an application was refused because a bank manager had doubts about the viability of the business employing the applicant or concerns that the applicant had expensive tastes and habits which might take priority over paying the mortgage.

It is no coincidence that commercial lending operates on the same basis as the old practice for mortgage lending. When a business wants to borrow money to buy a new factory the first consideration for the bank is the state of the business not the value of the factory. "I want to buy the empty factory in the Balls Pond Road, it is worth £1million. Here is a piece of paper on which I have written that my business makes a profit of £250,000 a year from the manufacture of snow shoes for scuba divers. Will you lend me the money please?" No bank is going to entertain the possibility of lending money let alone get a valuation on the factory, use its own belief that the premises will be worth an extra £300,000 in five years time and make a loan without further enquiry. Loans to businesses are made only on seeing a business plan, detailed accounts for previous years, the current order book and evidence of the likely future market. If it is snow shoes for scuba divers the conclusion will be that there is no market because scuba divers do not buy snow shoes and that will be that, application declined.

Why is it that commercial lending and old-style mortgage lending concentrate on the ability to repay? It is obvious, that is where banks make their money. The value of the property (be it house, flat or factory) is not sufficient justification to make a loan, only the apparent ability of the borrower to make the lender a profit by paying interest is a sufficient justification for making a loan. Having a property as security is necessary to give the bank protection in the event that the borrower does not repay. Security is taken as a damage limitation exercise and for no other purpose.

The new-style mortgage lending of the 1980s in which deposits were small or non-existent and assessments of the applicants' ability to pay were virtually nonexistent was a recipe for disaster. True though it is that disaster would be averted for so long as repayments were made and repossessed properties could be sold for a large enough sum to redeem the loan and cover both accrued interest and costs of repossession and sale, there was still a problem. That problem is that levels of default and repossession were bound to be higher than for loans made following the old-style practice. To compensate for this interest rates charged on self-certified mortgages were higher in the hope that the amount received from those who did pay would balance the lack of profitability from the defaulting loans. It worked very well until the higher interest rates led to even greater levels of default.

Nothing in this analysis of lax 1980s lending practices is complicated. It is all plain and obvious. What is perhaps not so obvious is how they managed to get away with it. The loosest practices were adopted by newcomers to the mortgage lending business, not the established banks and building societies. Such companies did not take deposits from individuals the way banks and building societies do, they had to raise loans from investment banks. Those banks needed to be satisfied that they would be repaid and, sometimes, required security for the massive advances they made. One might think they would have investigated the lending practices in detail but they did not, they too were swept along on the hysteria of ever-rising house prices. And while prices were going up there was ample equity in repossessed houses to repay the capital plus outstanding interest plus the costs of repossession and sale, all the time good profit was being made from the loans that did perform. There was also a factor operating in the background that hid much of the problem, securitisation.

Securitisation is a long word for selling debts. Selling debts is shorthand for selling the right to receive money in the future. There is nothing unrealistic about people being prepared to pay a lump sum now in return for the chance of receiving more in the future. The difficulty arises when a load of debts are packaged in a bundle and sold as one. Some will be good debts with a high chance of being repaid, some will be complete rubbish that are bound to default quickly, what matters is the balance - how many good, how many rubbish? When thousands of mortgage loans are included in a single bundle scrutiny is impossible. Adding more bad debts does not make scrutiny any easier. Bundles of debts are sold over and over, split, amalgamated, split again, merged with another bundle and sold on and on. At each turn the purchaser has a smaller and smaller chance of being able to value what he is buying. So why does he buy? Because others are buying. And why are they buying? Because others are buying. And what determines the price? A general perception of the value of houses, it is nothing specific, it is not based on investigation of the loans included in the bundle. Loans backed by English houses sell well while the English property market rises and while others are buying such loans yet more will want to climb on the bandwagon.

Like most things in life, turmoil in the financial markets is usually based on something pretty simple. The current troubles are caused by one thing and one thing only, a decade of lending money to people who cannot afford to repay it. The collapse in the property market does not cause the problem it merely brings it to light. Bundling huge numbers of loans together in a securitisation process does not cause the problem it just obscures it from view.

It is bad business to lend money to someone who cannot prove his ability to repay. When hundreds of thousands of such loans are made you end up with a week like this week. Lenders did not learn their lesson from the fall-out of the 1989-1991 property crash, now they must learn. Forget pretending to be a branch of social services providing what people want and concentrate on running your business properly. Lend only to those who, on credible evidence, appear able to repay you. Prices will then reflect the true value of the houses and flats on the market and there will be no toxic waste in securitised loans.

No comments: