Take no comfort from LTVs

Are we talking down the housing market? The answer appears to be yes for James Harding, Business Editor of the Times. Harding takes comfort from the fact that things are different this time. "A repeat of the negative equity blight is unlikely because, despite the concerns about reckless lenders, banks and building societies have been more conservative in managing loan-to-value ratios (LTV) than they were in the late-1980s."

Unfortunately, Harding hasn't thought this one through. He is taking far too much comfort from seemingly prudent LTVs. Unfortunately, LTVs are ratios, they can move. Rather than ensuring that banks make prudent lending decisions, LTVs often lure them into making bad ones.

The following simple example will illustrate the point. Take an individual that earns ₤10,000 a year; takes out a mortgage out for ₤30,000 and buys a house for ₤40,000. To keep things simple, we will assume an interest only mortgage of 5 percent. The house price to income ratio is 3; the LTV is 75 percent, while the interest costs are 15 percent of income.

Sometime later, this same individual wants to trade up. The value of her house has increased to ₤60,000 and as such, she has ₤30,000 in home equity. At the same time, her income has risen by 50 percent to ₤15,000. She puts down her ₤30,000 as a deposit and like the previous purchase, she buys a new house with a 75 percent LTV. With the higher deposit, this allows her to buy a house for ₤120,000. Interest rates are unchanged at 5 percent.

The LTV might be the same, but everything else is different. Interest costs have doubled and are now 30 percent of income, while the houseprice to income ratio is now 8. Athough the home owner's income has increased, debt servicing costs have risen faster. The capital gain from the previous house sale has allowed our home-buyer to take on a higher level of debt relative to their income. Naturally, the LTV ratio doesn't capture this fundamental change in the level of indebtedness.

One day, the banks wake up and stop looking at LTVs and start looking at repayment capacity. The banks take a look at the ratio of personal debt to disposable income in the UK and see a number 1.6 staring back at them. Some of the smarter banks realise that this is an unprecedented level of indebtedness and tighten up lending standards. The more stupid ones, like Northern Rock, just keep on lending.

The gradual tightening of credit reduces the number of mortgages, and demand falls away. Remember, the UK has already reached this stage, mortgage approvals in October were down 37 percent compared to last year.

When house prices fall, what happens to the LTV. Yes, it suddenly starts to rise. To illustrate the point, our homeowners house falls by 25 percent, taking back half the gains from house price appreciation. The LTV goes up to 100 percent. There is nothing conservative or prudent about a 100 percent LTV.

Now here is the kicker - banks were not giving out loans with LTVs of 75 percent. The average is much closer to 95 percent. Some banks - like Northern rock - offered loans of 125 percent. It won't take a big fall in prices before many LTVs go above 100 percent.

Here is what Harding has really forgotten. LTVs only determine what a bank will recover when it has to repossess a defaulted mortgage. If prices fall, LTVs rise, equity falls and the bank takes more of a hit. Low LTVs can not sustain high house prices.

As for "negative equity blight", it is coming back. Just give it a year or so of solid falling prices, and negative equity will replace property prices as the great national obsession.