Thursday, 18 October 2007

Loan-to-value margin calls will destroy the UK housing market

Loan to value ratios aren't something I have given much thought. However, this moneyweek article, written by Merryn Somerset Webb, was a real eye-opener. In fact, this article has transformed the way I see the housing crash unfolding.

Previously, I thought that house prices would slowly decline as the the consumption fell due to rising personal indebtedness, unemployment increased and repossessions increased. I had in mind a re-run of the 1989-91 crash. However, the buy-to-let phenomenon means that the consumption-interest rate story will probably play a minor role in the upcoming crash. It will be the imploding buy-to-let business that will bring the whole market down.

It is fairly clear that the vast majority of buy-to-let investors are rank amateurs who have little financial sense. The buy-to-let brigade are gamblers, who instead of blowing money on the horses in their Ladbrokes bookies, have gone down to Northern Rock, and taken out a loan. With this loan, they place their high risk bet. In fact, buy-to-let investors have bought their houses on "margin".

However, as this excellent article suggests, the lenders can make a "margin" call. Once the market slows, lenders can call in these buy-to-let speculators and ask them to put some additional cash into their so-call investments.

Since most of the investments generate insufficient cash flow to cover the mortgage payments, these investments will have to be liquidated to cover these margin calls. Rather than paying up, most buy-to-let investors will cut their losses and sell. The housing market will be like the proverbial house on fire. It will be a race to the exit, and the slowest will be burnt alive.

Could this be the ruin of the buy-to-letters?

Money week, Merryn Somerset Webb

I appeared on BBC Breakfast last week with a buy to let investor who was convinced he was very rich. He had, he said, made £8m out of the buy to let boom. Further chat revealed that he had properties valued at £8m but £5.5m worth of debt. So he is on paper ‘worth’ £2.5m. You might think that sounds like a reasonable margin of error but I’m not sure its enough: property can turn nasty fast.

Many of the reasons not to invest now (the main one being the fact that yields are lower than interest rates) have been widely discussed but here’s one more reason to steer clear. Buy to let mortgages deals tend to contain little read covenants regarding the loan-to-value ratio of the mortgage. In a rising market this isn’t the kind of thing borrowers take notice of but in a falling market they may find that it is the ruin of them.

It works like this. The loans allow lenders to periodically revalue properties (at the borrowers expense naturally). If the value has fallen and the loan to value ratio has, as a result, risen above the level required by the mortgage (say from 80% to 85%) the lender can then ask the borrower to come up with more cash to get it back down. The result, says my lawyer friend, will be that as capital values drop, buy-to-let investors will start to receive letters from the lenders along the lines of "Dear Mr Bloggs, I should be grateful if you would restore your loan to value ratio by sending us a cheque for £25,000".

This, most mortgaged-up-to-hilt investors will be utterly unable to do. The result? Panic selling and not just from the market’s new entrants. People who have been in the market for more than a few years are keen to suggest that they will be immune from any drop in prices thanks to the equity they have built up. But most of them – the man I met on the BBC sofa included - have also bought new properties in the last year. If margin calls – for this is what they are - start coming in on these how are they going to come up with the cash? No one’s immune.

1 comment:

Budvar said...

Oh yes, and wait until all those mortgage co's start chasing up the "Buy to Let'ers" who are buying with "residential" mortgages.
They all do around here, one was recently collared after being a bit of a dick over a neighbour dispute of one of his tenants, as he said it wasn't his problem.

The neighbour reported him to the taxman, they in turn reported him to the local council over back council tax as he'd declared the property was empty.
His mortgage company was told he was renting out the property and wanted a few years extra interest payments as he had a residential mortgage.
He knocked on the door of the neighbour, clutching bills in excess of £25k asking how he was going to pay this, to which the neighbour replied, "Not my problem".
By all accounts he's no longer driving his brand new Jag.

He wont be the only one collared, of this I'm absolutely sure.