Sunday, 20 April 2008

The magic circle

Up to last summer, mortgage lenders enjoyed a decade of spectacular growth. The good times were based on a strategy of abandoning traditional borrowers, in particular first time buyers, in favour of buy-to-let investors and recidivistic remortgagers.

While the drift to new markets was undoubtedly profitable, lenders are now beginning to understand that these new customers were only viable as long as house prices kept rising. Now that the market is weakening, buy-to-let investors and their bloated remortgaged cousins threaten the very stability of the UK banking system.

Back in the mid-1990s, traditional home loans accounted for about 80 percent of gross mortgage lending. Last year, that figure fell to just 43 percent. Over the same period, remortgage activity increased in importance. It now accounts of just over a third of gross mortgage volumes. However, the real action was with buy-to-let lending. Ten years ago, BTL mortgages accounted for a fraction of mortgage business. Last year, it accounted for under a quarter of lending volumes, along with other exotic products, such lifetime mortgages.

Although the customer base changed spectacularly, increasing lending volumes were even more staggering. Between 1995 and 2007, gross mortgage lending volumes increased by almost 600 percent.

How did the mortgage industry pull off this extraordinary growth? Whether by accident or design, mortgage lenders benefited from the emergence of a magic circle of borrowing, buying and asset appreciation.

The cycle kicked off when interest rates began to fall and ushered in the era of teaser rates. Cheap credit and periodic remortgaging allowed homeowners to begin their long journey up the property ladder. Homeowners were always looking for bigger and better, and as trading-up took off, so did prices.

Homeowners could never trade up without the support of lenders, who provided the financing, and often generously gave a little extra for home equity withdrawal. Conveniently, a fair amount of this equity withdrawal found its way back into the housing market as deposits for buy-to-let investments. It completed the circle. Lower quality housing, left behind by trading up, were transformed into rental properties.

The magic circle pushed mortgage lenders increasingly towards remortgaging and investment and away from first time buyers. Moreover, the circle ensured that house prices kept on rising; creating an almost riskless market. Lenders could sit back and relax, happy in the knowledge that their customer base was getting richer. Even on those rare occasions when one defaulted, the value of their houses were always much larger than their loans. A lender could repossess a house, recover the loan and even munificently charge the legal costs to the unfortunate borrower.

On paper at least, the magic circle created huge disparities of wealth. As home equity accumulated, homeowners seemed to become richer, leaving everyone else behind. In reality, this wealth was little more than a twinkle in the estate agent’s window. Homeowners were actually metamorphosing into an army of highly leveraged and deeply indebted individuals.

Early last year, the magic circle broke apart. The first cracks appeared after lenders received a message from across the Atlantic that said that housing might be a little more risky than previously thought. This started out as only a marginally disconcerting message. Lenders and homeowners alike reassured themselves. The UK had no sub prime, and the comparison between the two markets had only limited usefulness.

However, the unassuming message from America fed on itself and grew. As the sub prime catastrophe exploded, UK banks felt it prudent to take a modest step back from the housing market. Nevertheless, even this limited pullback threatened continued house price appreciation, which needed a relentless flow of credit growth in much the same way as a car needs petrol.

As doubts about the future increased, banks became more fearful and tried to pull back further. What started out as a modest retreat became a riotous panic for the fire exit. Banks began to look at each other fearfully, each knowing that the other carried huge portfolios of dodgy mortgages. What followed was the now famous credit crunch; the interbank market collapsed, mortgage approvals evaporated, and house prices have begun to slide.

The mortgage market is now undergoing another dramatic structural break. Instead of explosive growth, the market is contracting sharply. Previously, lenders saw their customers as profitable opportunities with huge untapped housing equity. They now see high-risk, heavily indebted borrowers ready to default should the economy go south. Now that the magic circle has evaporated, a new, more chilling cycle is about to take its place; the great wheel of default and repossession.

In desperation, the banks are looking for help. Their balance sheets are carrying mountains of dubious debt. Even a modest economic slowdown and a rise in unemployment should be sufficient to expose the banking system to an unprecedented crisis of solvency.


Anonymous said...

I fell into a burning ring of fire.....

burn, burn, burn....

QG said...

One of the difficulties we face is that if several big UK banks are insolvent, then can we let them fail? It sticks in the throat to say it but it might be better to bail the banks out than let our finance system collapse.

Vodka drinker said...

qg, no we shouldn't let them collapse, but neither should the taxpayer reward failure. If a bank is insolvent, Darling should take it over, sack the board, and wipe out the shareholders. Then, refloat the bank.

Anonymous said...

Why the worry if they fail? The settlement system won't collapse and that's the only important thing. Everything else is just hyperbole because the only losers are holders of securities and people who want to borrow.

Really. All the BoE needs to do is transfer custody of insured deposit accounts to a safe bank and let everything else burn. Ok so there won't be much lending but that's no big deal. It's not a collapse.


traderboy said...

Would be interesting if they let them fail I must say...if only the government had been bolder on Northern Rock, and just declared them insolvent and transfer depositors money (at the deposit protection limit) to another safe institution, the whole mess could have been cleaned up in a few weeks.

At least some Central Bankers have the balls to tell it how it is...the Reserve Bank of Australia governor, Glenn Stevens, said recently

"Any such support should … come at considerable cost to the private owners and managers of the troubled entity. Public-sector support should not be used to 'bail out' private shareholders or those who were responsible for running the troubled institution," he said.

This was important to guard against "moral hazard" - where companies which knew they would eventually be bailed out without penalty would run higher risks, increasing the chance of getting into trouble.

Such penalties could include higher interest charged on loans, along with non-monetary penalties like sacking the chief executive, executives or board members of the company and ensuring private shareholders bear losses from the financial difficulty.

(taken from one of Mish's recent posts)

Also note that the RBA has been hiking rates into a slowdown to contain inflation. Top marks.

Anonymous said...

1- Isn't all this exercise a political one. Gordon Brown just want to be reelected at some point so if there a bank meltdown, the labor party will lose the next election. Their credibility has already been damaged with the first bank run in 100 years...

2- Unfortunately, you have to remember that the majority of the people are homeowners, so bailing out the banking system, would be to save the value of homes of the majority. I have to say, that I was a strong believer of Capitalism and its invisible hand: now it turns ugly and intervention, bail out is on full steam. Maybe we are witnessing the end of capitalism as such.

Simple Simon said...

Dear anon,

"I have to say, that I was a strong believer of Capitalism and its invisible hand:"

Industrial capitalism is 'fine' as long as those nasty unions are allowed some strength.

Since the 80's UK capitalism has been based on parasitic finance and oil.

Now that the oil is declining we have little left.

No matter how grandiose the job title... (Speculator Extroadinaire)

...Everyone that does not work in farming,mining or manufacturing is essentially parasitic to them. (We can sell each other coffee/houses/life styles, all day long, but no wealth is created.

It is not worth sneering with joy; all the evil/clever money ditched housing 2/3 years ago. (Commodities).

Only the idiots are still holding title deeds with massive debt.(Excepting the bankers of course).