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.