Sunday, 17 August 2008

Looking at the wrong numbers

As the housing market crashes at an unprecedented rate, the UK banking system is staggering towards the abyss of insolvency. How did this happen? Didn't New Labour set up a special agency. the FSA, that would regulate the financial system? Wasn't there a promise of "no more boom and bust?"

How did the FSA fail to pick up on the potential for a banking crisis? Unfortunately, we will be much older before the FSA ponies up an answer to that question. However, recent data from the Building Societies Association offers an intriguing insight into how UK banks operated during the huge run-up in housing prices.

This data also suggests how an inexperienced agency like the FSA could have placed too much weight on loan to value ratios (LTV), and allowed itself to be taken in by unscrupulous bankers determined to expand their lending books without much regard for the long term risks.

Low LTV good, high LTV bad

During the housing bubble, banks pointed to loan-to-value ratios as evidence that their lending books were in good shape. Sure enough, over the last 7 or so years, the proportion of loans with LTVs lower than 90 percent increased, while the less than 2 percent of loans had LTVs greater than 95 percent.

When the FSA came to do their regular check-ups, Banks no doubt pointed to these ratios and said "we can easily handle a fall in house prices, most of our borrowers have at least 10 percent equity." In other words, all the risks were with heavily indebted home owners. With huge amounts of accumulated housing equity, the banks had nothing to worry about.

21st century banking; income multiples don't matter

There was, however, another number that should have scared the living daylights out of the FSA. It was the income multiples that banks were using when originating their loans. The proportion of borrowers taking out loans with ratios greater than 3 increased from about 30 percent in 2000 to 68 percent in 2007.

If the FSA questioned this alarming development, banks could point to the low interest rate environment; "our borrowers can carry higher debt, because debt servicing costs are so much lower".

Wakey, Wakey, the credit crunch has arrived

When the credit crunch began, everyone in the world of banking suddenly woke up to the fact many of those borrowers enjoying the "low interest rate environment" had taken out mortgages that would shortly reset at much higher interest rates. Suddenly, those income multiples began to look very dangerous.

Now events are conspiring to undermine the viability of UK bank balance sheets. Since the peak of the housing bubble, prices are down about 9 percent. The LTV comfort zone is about to be invaded. As negative equity begins to accumulate, it will interact with those huge income multiples and interest rate resets. Added to this, we have the highest inflation rate in 20 years which is eating into real incomes. The economy is slowing, and unemployment is beginning to rise. It all points in one direction; struggling borrowers, higher default rates and huge losses for banks.

Could this have been foreseen? Of course it could. Rapid credit growth coupled with heavily indebted borrowers should have warned the FSA that something nasty was cooking on bank balance sheets. However, the FSA were probably paying too much attention to LTV ratios. They had a comforting "we don't need to act" feel about them.

As the debt piled higher, the FSA did not act. The banks carried on lending, the risks accumulated; and now, the whole house of cards is about to fall.


Brad said...

LTV is the inverse of negative equity; banks see it as their shock absorber. With prices slipping, the absorber is being squeezed.

Mark Wadsworth said...

the FSA could have ... allowed itself to be taken in by unscrupulous bankers

Nope. The FSA were wilfully negligent, as the gummint was complicit in the whole house price/credit bubble.

I covered this topic a while back.

Anonymous said...

A very good article about the housing crash in the USA:

Bank seizures of US homes reach record high
By Andre Damon
16 August 2008


VADO said...

funny, I thought LTVs were higher i.e. NRK and their 125 percent loan.

Vado said...

I assume this data does not cover banks.

aSteve said...

There's something worse too.

An LTV of 3.5 x earnings is fine when you're in your 20s, expecting pay rises and 30-40 more years of work to pay off debts.

An LTV of 3.5 x earnings is far less Ok for someone in their 50s or 60s - they are likely well past their peek earning potential. I'd like to see a graph of mortgagor age alongside the wage multiple graph.

Anonymous said...


Off-topic but did you see Naked Capitalism is talking about a report on UK housing and banking written by Jeremy Grantham. I've been trying to find the report itself but can't. I suspect it'll be an extremely good read if someone can lay a hand on it.


Anonymous said...

You can find the Grantham report on

He predicts 40% decline in UK housing prices. And he's well known as a most percipient commentator (as well as being a very successful fund manager)

Anonymous said...

Interesting (and annoying) that the UK yoy housing decline for August (-5.8%, I think) was disclosed very early this am and has not appeared in telegraph, ft, etc. It appeared in Reuters v early and then got shunted and I can only see in Bloomberg now. Someone is trying the old US trick.
Alice, get the word out!

Anonymous said...

Ok found it. (must register but it's free and you don't need to wait for a confirming mail). July 2008 Quarterly Letter. Highlights include:

- "The Fed has lost more credibility and lost it faster than expected"
- "Marked to market six months ago, Bear Stearns and Lehman were bankrupt as are Fannie and Freddie today"
- "the growing surpluses of oil countries must be recycled, and this can be destabilising"
- "Congress behaved at the lower end of its range of effectivenss"
- "No sooner do we finish wallowing in the idea of Soviet incompetence than we start to believe that Chinese central planners can wonderfully manage a complicated economy"
- "we run a serious risk of a meltdown in confidence in leadership totally unlike anything we have seen since WWII"
- S&P down by 10-15% by 2010
- 40% decline in UK house prices
- "in a global recession no one decouples"
- "Our advice until now was very simple: take as little risk as possible except for emerging markets. Now it is even simpler: take as little risk as possible."

There's an excellent chart on page five concluding UK house prices "need to fall 38% tomorrow or stay flat for 7 years to reach fair value.

Good report.