It's not often I cover similar subjects in successive posts – but this week I was asked for my opinion by Kathleen Kelly at the Joseph Rowntree Foundation on Twitter about the new proposals for hybrid mortgages by David Miles at the Bank of England.
The report by Miles is pretty epic (pdf version available here) but with some extensive paraphrasing, the basics of it are as follows:
The problem is that most houses are bought using debt (a mortgage from the bank) meaning that if the loan to value rate is on the high side – only one institution is left holding the debt if the buyer defaults.
Miles' suggestion to reduce the risk levels for the banks is to restructure this so the purchase is split into a combination of debt and equity funding. Equity funding works along the following lines:
Let's say I want to buy a house that costs 100k, but I only have 10k cash.
At the moment I would find it difficult to get a mortgage for 90k (90%ltv) due to the banks tightening on lending levels – they might offer me 70%, which leaves me short by 20k.
Miles' proposal under the hybrid system would be to acquire equity finance for the remaining 20k.
- Basically ask someone to lend me the cash, with a contractual promise of a return on a fixed date or upon the sale of the property itself.
- The investor's reward would be in the form of a percentage of the capital gain when selling – basically the provider of the equity finance is reliant upon house prices going up. (It should be noted there are caveats and clauses to limit loss should the value of the property be lower at point of sale.)
There are several equations and examples within the report and, when read in the context of the document itself, they make a reasonable amount of sense and there is a high level of thought gone into the creation of the plan.
Equity funding, mezzanine lending and venture capital funding can all be very successful and profitable in commercial business. The reason for this is it is a business that is being invested into, as well as people and products in most cases – all of which can be changed, modified, hired/fired etc. Ultimately there is an element of control over the success or failure of an investment.
Equity funding to the individual to buy a house is a different matter – all there is to invest into is a single inanimate object that is at the mercy of the housing market. You can't move it, rebrand it, demand the owner decorates it or doesn't harass the neighbours – all factors that remove control over the investment itself.
Perhaps there is something I have missed here – but the concept of providing funding at an individual level, into a volatile market that has been created by irresponsible lending in the first place does not sound like a solution to me. A huge private fund? Perhaps. A residential real estate investment trust? – Certainly (the government has made provision for the creation for these in recent years).
However, there are once again a few areas of concern with this model and the fact that it's been produced by one of the top bods responsible for cash flow in the UK.
The report relies heavily on the UK population increasing – whilst I won't dispute the likely fact it will, the report doesn't fully include factors that are also important like inflation, unemployment and so on.
It also contains a lot of assumptions – 36 in total in the 23 page document. Projection documents always do contain a lot of language of this nature of course – but this document is being used as a proposal to change the way the mortgage industry works. I am inclined to think a little more fact-based arguments would be more appropriate.
Another point that is overlooked in the report is both sides of supply and demand. I agree the demand for housing is going to rise – no question there at all. The problem however has stemmed from the oversupply of high LTV lending. The only cure for this is to curb lending right back and force the market down.
Finding ways to lend even more money to make something that is overpriced more affordable is simply not the answer. Moving some of the risk from the buyers and the banks to the private investor is not the answer either – it might result in reducing losses by eliminating excessive lending by the banks without actually introducing any regulation (which no-one seems to want to take responsibility for).
On top of this, the government still has to consider how it is going to claw back the mass of bail-out cash issued to rescue the banks that caused the problem in the first place.
In my opinion the concept is just another pig in a wig with make-up at the farmers' ball – at a quick glance it looks great from a distance – on closer inspection however, the horror is waiting to catch you off guard.
The bottom line is the property market needs to be reigned in – not given yet more ways to hang itself. I am the first person to admit it won't be an easy or pleasant task at all; it will likely be the best part of a whole generation before a "normal" housing market can exist again.
Tough decisions need to be made and time needs to pass – there is no "quick fix". LTV's need to be pegged to a sensible level, banks need to thoroughly check borrowers' affordability and take into account a margin for the unforeseeable. Sure, it does mean the first-time buyer market will suffer for a few years – but simply lending more and more cash out that can't be paid back is not the answer, no matter how you dress it up.