Thursday, 4 December 2008

Queen's Speech 2008 Part II - mortgage default

It was inevitable that the recession and banking crisis would lead to something being included in the Queen's Speech about the economy. The measures outlined in the speech itself were, as always, a potted guide to what the government has in mind and the details will emerge over the next few days. It didn't take long for poor Gordon to raise a populist idea during the debate on the Speech. He proposed a grace period of two years in which those unable to pay their mortgages would be entitled to roll-over the arrears and add them to the principal of the loan. As I understand it only mortgages of up to £400,000 are covered and you get no help if you have savings above £16,000.

Like so many of poor Gordon's ideas it is designed to win votes with little regard being paid to how it will work, how much it will cost and whether it will have adverse consequences which outweigh the benefits. Let's look at the benefits first. This proposal rightly recognises that having your home repossessed is a potentially devastating thing. Not only do you have to move out but a repossessed property will almost always sell for less than average market price and both that loss and all the costs associated with repossession and sale will fall on the dispossessed borrower. More than that, the peace of mind and sense of self-worth which so many derive from owning their own home will be lost; and that cannot be quantified in terms of mere money. Having said that, it would be foolish to ignore the monetary effects of the government's proposal because they will have consequences for everyone. So I ask myself what the consequences are likely to be. Ancient O-level physics tells me that for every action there is an equal and opposite reaction. Let me give an illustration of how I would expect the proposal to operate.

Say Mr Bloggins bought a house for £150,000 in 2003 with a 100% mortgage and it's current market value (after losing 15-20% in the last year) is £200,000. Interest on his mortgage loan is 6%pa (£750 a month) and he loses his job which results in arrears building up over three months of £2,250. The bank repossesses and takes two months to sell, at auction the house realises £160,000. The agents handling the sale charge 2% (£3,200) and there are legal and other costs of £1,500. At the date of repossession Mr Bloggins owed £152,250 and had an asset with a nominal value of £200,000, he was in profit to the tune of £47,750. At the date of sale he owed £153,750 and the asset realised a net price of £155,300. He receives a cheque for £1,550. On the face of it repossession has cost Mr Bloggins a huge amount of money, a sum far in excess of the arrears he built up by the time his home was repossessed. I have left out of account the value of any scheme he had in place to repay the capital of the loan, not least because many of them have been blown to the winds by recent stock market falls.

Then assume he is allowed to roll-up interest over two years and gets another job which allows him to resume repaying the bank. Over that two year period interest of £18,000 will accrue (assuming a steady interest rate of 6% and no compounding), making his debt to the bank £168,000 rather than £150,000, but he keeps his house. His monthly interest payments will then be £840 rather than £750. But what effect will it have on his net worth? Of course we can't tell because we don't know what will happen to the housing market in the next two years. A fall of just 10% from current values will leave Mr Bloggins with a house worth £180,000, and a debt of £168,000; a loan-to-value ratio of 93.3%. A fall of 16% from current values and he would owe £168,000 whilst owning a property worth exactly the same amount. 16% is at the low end of current estimates of the likely further fall in property values.

In one sense Mr Bloggins won't mind. He will still have a roof over his head and will hope the market will pick up in the future. But what about the bank? Let's cast our minds back a few months. The banking world was in even greater turmoil than it is at present. Inter-bank lending had dried up, Lehmann Brothers had gone to the wall, the value of security held by banks (and other lenders) had plummetted, numerous lending companies most of us had never heard of closed their doors because they couldn't borrow and, therefore, couldn't lend. All because many lending institutions had systematically advanced too much money against too little security. Instead of insisting on a substantial deposit and lending a maximum of 75%-80% of the market value of a property loans were made of up to 125% of current value. Instead of realising that their most important line of repayment was the borrower's income, they made advances against the anticipated future value of the property and allowed people to borrow five times their income or more, if they enquired about income at all.

To regain stability in their businesses banks and others who advance money for house purchases have had to go back to the old ways by limiting the loan-to-value ratio and lending a smaller multiple of the borrower's income. Giving Mr Bloggins a two-year breathing space by rolling-up arrears of interest and adding them to the principal of the loan rocks the boat in two respects. First it increases the loan-to-value ratio above what it was when he first went into arrears. It might still be below what it was when he first borrowed to buy his house, but that loan was way above currently acceptable limits. Secondly, by increasing his monthly interest bill once the period of grace has ended the lender is more reliant on the security of his employment and income than it would consider prudent for a new borrower. There is a third possible problem in that Mr Bloggins might well not be able to secure a job commanding as high a salary as he enjoyed before. In that case the proportion of his income required to pay the mortgage would increase, thereby increasing the risk of future default.

Where does this leave the lenders? At a time when they need to increase the security they hold to make up for past bad lending practices they will be faced with having to carry defaulting borrowers and the diminution of the value of security that their defaults cause. The very problem they have to remove from their books will be inked-in with a thick red pen. It is no answer to say that the lenders cannot lose because the government is guaranteeing the two-years' arrears with taxpayers' money (estimated at a maximum of £1billion - yet another billion being added because, as I said the other day, the figures are now so huge that an extra billion doesn't seem to matter to this government). The government might well guarantee the £18,000 extra that Mr Bloggins adds to his mortgage loan account with the Nearly Bankrupt Bank but it will not guarantee anything else. It will not step in when the additional repayments required of Mr Bloggins cannot be met out of his reduced new salary and new arrears accrue under a loan of £168,000 rather than £150,000. It will not step in when the housing market falls further and repossession leads to an even lower auction price than it would today.

I must not overstate my reservations about this proposal. There are a great many borrowers who are a good risk in the long term and for whom the availability of a two-year cushion will be beneficial both to them and to the company that has lent them money. But there are also many who default now because they should never have been lent so much money in the first place and for whom a two-year deferment of interest will result in an unaffordable position becoming even more unaffordable. No doubt the government is hoping that the housing market will stabilise over the next two years. I am sure it will, but not at current market values. The bubble element of house prices has not yet deflated, not by a long way. A further substantial fall is inevitable and to lock lenders into unrepayable loans secured against sinking assets will deepen the difficulties those lenders face.

Some good will result from this measure, it a matter of guesswork whether that will be outweighed by the detriment.


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