Tuesday, 24 February 2009

Mr Darling hits Rock bottom

Yesterday the government decided to abandon all sense and enter the home mortgage market through its puppet bank, Northern Rock. As you will probably know, Northern Rock got itself into difficulties through a pincer movement of spectacular irresponsibility. It made huge numbers of advances without making proper enquiries into the borrowers' ability to service the loans and advanced a very high proportion of the perceived value of the properties given as security; in many instances it advanced far more than the perceived value of the property. That was the first line - bad loans. In order to fund these loans it had to get its hands on money, much of which it borrowed from other financial institutions over short periods of time. When wholesale credit became harder to find, it still had to repay existing borrowing despite not being able to lay its hands on replacement funds at an affordable price. That was the second line - over-reliance on temperamental sources of funds. The difficulty in securing new funds was made worse by the fact that its mortgage book was stuffed full of dodgy loans, thereby giving rise to doubt whether it would be able to repay any new funding. We covered all of that a few months ago.

Northern Rock borrowed £27billion from the Treasury in 2007. That's an awful lot of money. After being nationalised the bank effectively stopped making new loans and concentrated on turning existing loans into cash to repay the £27billion. To its credit, so far it has repaid around £18billion. This money has come from two main sources. Existing borrowers have continued to make repayments (albeit with high levels of default), giving a cash flow that has not been re-lent; and many have been encouraged to remorgage with other banks so that their borrowings from Northern Rock were repaid. In effect, it was losing the chance of future profits but securing repayment of the capital sums advanced. It has also taken quite an aggressive position with accounts that have gone into arrears and have repossessed and sold properties quickly to prevent losses on those accounts getting even worse. All fairly standard stuff when you are winding-down a business.

I'm no genius, but I reckon repayment of £18billion out of £27billion leaves £9billion plus interest still to be paid back to the Treasury. Some might think the government's first priority would be to get this money so as to make a small dent in its own unaffordable debt. But no, now Mr Darling thinks Northern Rock should start lending money again and is suspending further repayments to allow the bank to make new loans. We wait to see the lending criteria applied, but the indication is that they will be more generous to borrowers than most other banks.

The other banks have reverted to the historically stable formula of limiting loans to 75% or 80% of the perceived value of the property offered as security and advancing only limited multiples of the borrower's income. They have done so for three reasons. The first is that they need to know they are writing sound business because these new loans will be a substantial part of their income stream from which to cover losses which are still waiting in the system but have not yet attached their mandibles to the pin-striped posterior. The second is because they don't have as much cash to lend as they used to, so they can be more selective and advance it on only the soundest deals. The third is that there is no longer a race to the bottom in which they all think they must lend hither-and-yon because their competitors will do so and make profits if they don't. There simply aren't the borrowers out there willing to buy in a falling market.

What is happening now is an interesting example of the extent to which house prices were previously inflated not by genuine demand but by the availability of unsustainable loans. Classic supply-and-demand theory states that where supply is greater than demand prices fall because the buyer is in the driving seat, he knows he can buy elsewhere if one seller doesn't give him the right price; and where demand is greater than supply prices rise because the supplier dictates the price, either the buyer pays it or he misses out because another buyer will pay it. Of course it is far more complex than that because there are numerous factors at play other than a simple numerical comparison between the number of things available and the number of people wanting to buy them. For example, people might be willing to pay more in a local shop than they would at the supermarket three miles away because it is more convenient, and some wouldn't be seen dead in Tesco so they shop at Waitrose instead even though it is more expensive.

One of the major factors affecting house prices is the amount of money potential purchasers have available. Even where numerical demand far exceeds supply, buyers can only pay what they can pay. That five people might each offer £200,000 for a particular property does not necessarily mean the seller can get another £5,000 out of any of them, if they only have £200,000 then £200,000 is the ceiling. It goes without saying that the ceiling will rise if potential buyers can borrow more. Say you have Mr Ordinary on a salary of £30,000. When lending is limited to three times his salary the most he can borrow is £90,000. Applying a laxer standard and allowing him to borrow five times salary means he can lay his hands on £150,000. Not surprisingly, the more he can borrow the more he can afford to offer but that does not mean he can afford a larger property because every potential purchaser is in the same position. Those looking for a one-bedroomed flat can afford more, as can those seeking a two-up-two-down, as can the three-bed semi crowd and those desirous of a five-bed detached with low-level suite in duck-egg blue. Prices all along the chain get pushed-up a few notches simply because banks are prepared to lend more.

Over the last year or so relatively few new house purchase loans were made while the banks reassessed their lending criteria. No doubt part of the slow rate of business was caused by many purchasers deciding to wait and see what will happen to prices over the next year or more, but a part was, nonetheless, due to the banks being extremely cautious. That caution has now translated into the new standard of lending criteria, requiring substantial deposits and applying not just limits to the multiple applied to income but also more stringent assessments of the security of the borrower's income. Now that a new standard has been applied the banks are lending more than they did in 2008. In exactly the same way that their lending was suicidally lax over the preceding few years, leading to far too many unserviceable loans being made, so it was tighter than long-term interests required in 2008 while they reassessed their options.

I can see some sense of Northern Rock re-entering the mortgage market and applying the same strict but sustainable lending criteria applied by the other banks. This would produce valuable assets which could be used to service the outstanding government loans, but only if enough sound new business is done to provide sufficient income to service those loans. What I find difficult is that Mr Darling has already announced that mortgages up to 90% of valuation will be made available. The other banks aren't doing this because they perceive it to be unduly risky in these turbulent times. If Northern Rock is to trade its way out of trouble, one would think the last thing it should do is take risks other banks are not prepared to take. Nor does it seem to make much sense to try to trade your way out of trouble when you have already disposed of much of your existing sound business in order to repay two-thirds of an enormous government loan unless what remains is viable as a business in its own right. It seems highly unlikely that it is viable because it has not been able to shift the bad loans which are defaulting at a very high rate.

In order to re-enter the mortgage market Northern Rock needs money. Having repaid £18billion to the government by cashing-in its existing good business, it is now going to borrow up to another £14billion in order to make loans on less sound terms than most of those they have disposed of. On the face of it the whole thing is bananas. It's bananas for Northern Rock which will then be in hock to the government for up to £23billion with no obvious means of repaying this sum other than selling-off every sound loan it still holds and all the loans it is about to make. And it's bananas for the Treasury which needs to find ways to reduce its own borrowings rather than terminating repayments from a debtor and lending that very debtor yet more.

There is only one possible reason for this move. It is to maintain the existing part of the house-price bubble (if not to re-inflate it to former levels) by challenging the other banks to match Northern Rock's new lax lending criteria. If those other banks are foolish enough to do so the result will be substantial additional funds being made available to potential purchasers with the inevitable result of prices being kept higher than they would otherwise be. It overlooks the need for house-purchase to be affordable and, therefore, sustainable and, therefore, a stable force in the economy. Lend too much and prices are pushed up. Lend too much and the level of default will be high. This risks lenders suffering capital losses which will have to be passed onto their customers which will make the cost of credit high, which will risk yet further defaults.

The idea of lending more to "stimulate" the housing market so as to aid recovery from recession is fundamentally flawed. It will not aid the way out of recession because it will not create new wealth, it will just create new pretend wealth (as to which see my offering of yesterday). There will also be marginal benefits in an increase in trade in carpets, corkscrews and Swedish flat-pack furniture, but that will be dwarfed by the longer term stifling effect of the house price bubble being extended. And, at the same time, it will increase government debt yet further thereby prolonging the post-recession period in which real growth is reduced or nullified by the additional taxes needed to repay that debt.

Mr Darling does not seem to realise that this country's systemic economic problem cannot be cured by the creation of more pretend money.


The Great Simpleton said...

"I can see some sense of Northern Rock re-entering the mortgage market and applying the same strict but sustainable lending criteria applied by the other banks."

If memory serves me correctly NR is paying quite high interest rates on the Government loans. In which case relending the money it gets from mortgage repayments rather than paying off Government debt only makes sense if the interest rate on those repayments is higher than that paid on the Governement debt.

TheFatBigot said...

Indeed so, Mr Simpleton.

We seem to have entered real la-la-land. NR currently owes us £9billion plus accrued interest. It will then borrow up to £5billion this year and a further £9billion next year in order to make home-purchase loans. What can they expect to get from borrowers, 5% or 6%? Once you factor-in likely defaults even these returns are overstated.

How does the outstanding £9billion get repaid, let alone the interest already accrued on the initial £27billion? And then there's the further interest on the outstanding £9billion while repayments are suspended to allow the new mortgage loans to be granted. It's a phenomenally expensive way for the government to provide capital to a lender.