Saturday, 8 March 2008

A banking crisis template

I saw this disturbing article in the Guardian today describing how many buy-to-let investments obtain financing. Somebody please tell me that this kind of thing is not widespread, because if it is, then the UK banking system could be in serious trouble.

Here are the key paragraphs:

"Want to climb on to the buy-to-let bandwagon and become a property millionaire? The secret, according to property investment clubs, is to obtain discounts on new-build apartments so you can start building a portfolio with virtually no upfront payments.

The trick is to find a property where the developer is willing to offer "off-plan" buyers a discount of at least 15% off the brochure price. This means a buyer can apply to a lender for a buy-to-let loan equal to 85% of the "value" of the apartment - even though this amounts to 100% of the cash needed to buy the property.

In a rising property market, the trick works. But once property prices fall, tenants fail to pay expected rent levels, or lenders are unwilling to accept that discounts are real, and the model fails.

Surveyors are now taking a more conservative approach to valuations, which means that buy-to-let borrowers are finding it tougher to raise the cash. And lenders have also clamped down on "day one" remortgaging to extract equity, preventing buyers from rapidly building themselves a portfolio"

I will freely admit to being quite naive about buy-to-let. For a long time I quietly ignored it. The flyers advertizing Inside Track seminars came through the post box and went straight into the bin. Even with a quick glance, it seemed obvious that one could not become a "property millionaire" without massive leveraging. This, of course, carried the risk of being completely wiped out financially if property prices fell.

If, as I now suspect, many buy-to-let investments were done with this kind of arrangement, then UK banks have a serious collateral problem on their hands. Property developers and borrowers have inflated valuations, and as a consequence, they are holding little or no equity in their investments. If prices fall, investors have no capacity to absorb the financial loss. Bankruptcy will follow and the losses are immediately transferred to the balance sheets of original lender.

The "off-plan discount financing scam" is a template for a banking crisis. Banks depend on limiting loan-to-value ratios to ensure that borrowers and not banks take the hit if asset values fall. Banks are also highly leveraged institutions, with only a limited capital buffer. As such, banks can not absorb huge losses easily.

However, there are some deeply, more troubling questions. Here are just a few:

  • What were the FSA doing when this scam was taking off? Wasn't the FSA supposed to regulate the financial sector in order to prevent excessive risk taking?

  • How could banks possibly confuse the difference between an asking price and a discount. It beggars belief that banks would accept a client who would claim that they had put down 15 percent of the value of a property purchase but in reality had received a discount.
  • Finally, this scheme sounds like fraud. Is it not downright dishonest to claim to put down a 15 percent deposit, but in reality receive a so-called discount in order to obtain 100 percent financing.

  • So, when the BTL scam finally collapses, there will be plenty of blame to go around.


    Budvar said...

    They've all jumped on the BTL bandwaggon around here. A friend of mine sold his house to a BTLer for £120k, he rents out the house for £100 per week. The BTLer has quite a few houses he rents out besides this one, and even I can see that the numbers don't add up with a cursory glance. I had a look on "Nationwides" mortgage calculator, and monthly payments over 30 years range from about £718 - £780 per month. The idiot bankers who OKed these mortgages must have been sniffing glue, smoking crack and shooting acid all at the same time, as no one in their right mind could fail to see how this will all pan out!!

    Andy said...

    One of the big problems is also that people have been encouraged to 'build a portfolio'; if you have 2 BTLs for a pension, then you might be able to subsidise then in lieu of retirement savings, especially if they are repayment mortgages. If you have 5 or 10, rental shortfalls will average so much more.. there is already evidence that BTLers were having to 'extract equity' to stay afloat.

    It's going to be a horror story.

    Josh said...

    BLT is just so mad, I can't get my head around it.

    Josh said...

    eerrrr that should have been BTL, whereas BLT is a very pleasant sandwich normally eaten at around 11am as a replacement for breakfast.