Accountant Ross Baptie (RB) answers some of Corporate Watch’s (CW) questions
CW: ARETHESE ‘SUB-PRIME’ MORTGAGES A NEW THING?
RB: Relatively new. A decade or so there was very little mortgage lending to people who couldn’t afford them. There were rigid, self-imposed, rules governing how banks & finance companies chose whether someone was creditworthy enough to qualify to get a mortgage. As with all things in capitalism however, once a particular market (i.e. creditworthy borrowers) has been exploited and pushed to the limit, it begins to look elsewhere. This means it will seek to either deepen penetration of the existing mortgage market or to expand into areas that were previously untouched.
One new area was the increase in buy-to-let mortgages and the encouragement of that whole sector (which has yet to collapse), and the other area was that of ‘sub-prime’ lending. A whole raft of people were watching from the sidelines during the boom in the housing market. Partly due to their own desires, but also partly from the manufactured desire whipped up by the housing boom, these people were desperate to own their own homes. Under traditional (risk averse) approaches to mortgage lending they never had a hope of getting loans big enough and affordable enough to buy a home.
Normally it wouldn’t make sense for banks and building societies to lend to someone who was clearly a bad risk and had a bad credit history. However, a mixture of things caused lenders to move beyond this traditional approach:
i) The massive rise in home values in the last few decades meant that even though someone who borrows money to buy a place may eventually struggle to pay back the repayments on it, the fact that in general house prices were rising, meant that if the borrower did default on the loan, the lender could simply repossess the house. The chances are it would have increased in value so they could then sell it and recover their outlays
ii) As existing mortgage markets were nearly saturated there was a risk that there would be a halt of ‘new’ money coming into the housing market. First time buyers were finding it harder and harder to find somewhere affordable to buy; especially as money coming into the housing market from first time buyers is what props up the whole market and allows people to buy and sell at the higher end.
iii) After 9/11 US interest rates were slashed from around 6% to 1% to ‘stimulate’ the economy. As result of this, servicing the loans on mortgages became more than 80% cheaper than before. This drew new people in to home ownership – which was now within their grasp due to the supply of cheap money being made available in the wholesale credit markets.
iv) Normally the worse a borrower’s credit rating is, the higher the rate of interest charged on a loan. This is to compensate the lender for the increased risk that they take on in lending in the first place. Usually this would mean that the borrower would be unable to afford the repayment/interest payments – as they might be paying 10% interest on a loan that someone with a good credit would only pay 5% on. To get round this problem, the notion of ‘credit repair’ was dreamt up. This involved lending money to the borrower to buy their home, but for the first two years of the mortgage term, on a massively reduced interest rate (say 4%). The idea was that the borrower would pay this reduced rate for the first two years then when it came to the end of that period, they would re-mortgage, with their two years of good credit history allowing them to get a mortgage at a more normal rate of interest.
The theory didn’t work at all well in practice. Borrowers came to the end of the two year term, found that their credit had not been ‘repaired’ and were then faced with a near-doubling of their monthly payments when the rate on the loan reverted back to its normal market rate. In addition, this rate rose again, as interest rates went back up to the pre 9/11 level. Therefore the bulk of people had to default on their loans. Although a nightmare for the individual, this would not have been catastrophic for the market, but for the sheer scale of it. In 2006 sub-prime mortgages accounted for about 20% of the entire mortgage market.
The massive levels of defaulting led to houses being repossessed and sold off to recover the debts, causing a huge downwards pressure on house prices. The repossessed houses coming onto the market forced prices down to a level lower than the one lenders had borrowed at, which left banks and building societies facing big losses on their loan portfolios. The collapse was compounded by sub-prime mortgages being parcelled up into ‘investment vehicles’ and sold off to hedge funds and the like – companies which had a higher appetite for risk. This made it difficult to see where risk was concentrated, as ownership of the initial mortgage asset had been sold on countless times since the original loan.
CW: IS THENORTHERNROCKFIASCO A RELATED ISSUE?
RB: It’s related, but indirectly.
The initial lenders of sub-prime mortgages – i.e. those who deal directly with the person who wants the mortgage – were mostly finance corporations set up to specialise in this type of risk. These companies got their money by borrowing on the wholesale credit markets. These markets consist pretty much of big institutional investors lending money between themselves: mainly pension funds, insurance companies and traditional banks. When the extent of the sub-prime problems became known and it looked likely that huge numbers of people would default, these institutions, that had previously happily lent to the sub-prime mortgage companies, began to sit up and take notice and became extremely cautious as to who they would now lend to/invest in, and also increased the rates of interest that they charged on the money they were lending. This led to a ‘credit crunch’ in the wholesale lending market, and the relatively cheap money feeding into the US sub-prime mortgage companies dried up. This put a lot of the sub-prime mortgage companies out of business.
Another impact of the credit crunch was that the other banks and mortgage providers, who also borrow in the wholesale international credit market, found that they were either unable to access this market or to afford the increased interest on borrowed money. This hit all banks and mortgage lenders in the UK.
Northern Rock stood out from the rest in that their massive share of the UK mortgage market (something like 20%) was mostly financed through borrowing on the wholesale credit markets. This is unlike other mortgage providers in the UK, who fund a large proportion of their mortgage lending through banking deposits from customers. As Northern Rock had such a big share of the mortgage lending market and a relatively small level of depositors, they had to rely more on the wholesale credit market to plug the gap. When this closed up, they were the first to start wobbling. Panic leads to panic and the subsequent run on the bank with depositors withdrawing their savings meant that they faced an even bigger funding gap. In the end they had to take an emergency loan from the Bank of England to keep them going.
CW: WHATIMPACT DO HOUSEPRICESHAVE ON THESTOCK MARKETS?
RB: Rising house prices increase the value of home owners’ assets. This in itself has no direct effect, but recently many more people have taken advantage of this increased asset in various ways
i) Re-mortgaging (borrowing more money on the basis of a higher house value, and then using that money for home improvements, investing in more property, buying cars, holidays, etc.)
ii) Running up higher credit card bills, safe in the knowledge that even though they have £10-20,000 debt here on various cards, their overall net asset position is still good as the rise in house prices dwarfs this debt.
iii) Spending their existing savings, safe in the knowledge that they have the buffer of their main asset, their house, continually rising in value
So all these factors meant that much more consumer spending could be systematically maintained by home owners during a period of extraordinary house price growth. The more consumer spending there was, the more companies benefited; their share prices also increased, due to the actual and potential future profits they could make on the back of ever increasing house prices. This resulted in stock markets surging ahead in tandem with the housing market. The opposite applies when house prices collapse.
Accountant Ross Baptie (RB) answers some of Corporate Watch’s (CW) questions
CW: ARE THESE ‘SUB-PRIME’ MORTGAGES A NEW THING?
RB: Relatively new. A decade or so there was very little mortgage lending to people who couldn’t afford them. There were rigid, self-imposed, rules governing how banks & finance companies chose whether someone was creditworthy enough to qualify to get a mortgage. As with all things in capitalism however, once a particular market (i.e. creditworthy borrowers) has been exploited and pushed to the limit, it begins to look elsewhere. This means it will seek to either deepen penetration of the existing mortgage market or to expand into areas that were previously untouched.
One new area was the increase in buy-to-let mortgages and the encouragement of that whole sector (which has yet to collapse), and the other area was that of ‘sub-prime’ lending. A whole raft of people were watching from the sidelines during the boom in the housing market. Partly due to their own desires, but also partly from the manufactured desire whipped up by the housing boom, these people were desperate to own their own homes. Under traditional (risk averse) approaches to mortgage lending they never had a hope of getting loans big enough and affordable enough to buy a home.
Normally it wouldn’t make sense for banks and building societies to lend to someone who was clearly a bad risk and had a bad credit history. However, a mixture of things caused lenders to move beyond this traditional approach:
i) The massive rise in home values in the last few decades meant that even though someone who borrows money to buy a place may eventually struggle to pay back the repayments on it, the fact that in general house prices were rising, meant that if the borrower did default on the loan, the lender could simply repossess the house. The chances are it would have increased in value so they could then sell it and recover their outlays
ii) As existing mortgage markets were nearly saturated there was a risk that there would be a halt of ‘new’ money coming into the housing market. First time buyers were finding it harder and harder to find somewhere affordable to buy; especially as money coming into the housing market from first time buyers is what props up the whole market and allows people to buy and sell at the higher end.
iii) After 9/11 US interest rates were slashed from around 6% to 1% to ‘stimulate’ the economy. As result of this, servicing the loans on mortgages became more than 80% cheaper than before. This drew new people in to home ownership – which was now within their grasp due to the supply of cheap money being made available in the wholesale credit markets.
iv) Normally the worse a borrower’s credit rating is, the higher the rate of interest charged on a loan. This is to compensate the lender for the increased risk that they take on in lending in the first place. Usually this would mean that the borrower would be unable to afford the repayment/interest payments – as they might be paying 10% interest on a loan that someone with a good credit would only pay 5% on. To get round this problem, the notion of ‘credit repair’ was dreamt up. This involved lending money to the borrower to buy their home, but for the first two years of the mortgage term, on a massively reduced interest rate (say 4%). The idea was that the borrower would pay this reduced rate for the first two years then when it came to the end of that period, they would re-mortgage, with their two years of good credit history allowing them to get a mortgage at a more normal rate of interest.
The theory didn’t work at all well in practice. Borrowers came to the end of the two year term, found that their credit had not been ‘repaired’ and were then faced with a near-doubling of their monthly payments when the rate on the loan reverted back to its normal market rate. In addition, this rate rose again, as interest rates went back up to the pre 9/11 level. Therefore the bulk of people had to default on their loans. Although a nightmare for the individual, this would not have been catastrophic for the market, but for the sheer scale of it. In 2006 sub-prime mortgages accounted for about 20% of the entire mortgage market.
The massive levels of defaulting led to houses being repossessed and sold off to recover the debts, causing a huge downwards pressure on house prices. The repossessed houses coming onto the market forced prices down to a level lower than the one lenders had borrowed at, which left banks and building societies facing big losses on their loan portfolios. The collapse was compounded by sub-prime mortgages being parcelled up into ‘investment vehicles’ and sold off to hedge funds and the like – companies which had a higher appetite for risk. This made it difficult to see where risk was concentrated, as ownership of the initial mortgage asset had been sold on countless times since the original loan.
CW: IS THE NORTHERN ROCK FIASCO A RELATED ISSUE?
RB: It’s related, but indirectly.
The initial lenders of sub-prime mortgages – i.e. those who deal directly with the person who wants the mortgage – were mostly finance corporations set up to specialise in this type of risk. These companies got their money by borrowing on the wholesale credit markets. These markets consist pretty much of big institutional investors lending money between themselves: mainly pension funds, insurance companies and traditional banks. When the extent of the sub-prime problems became known and it looked likely that huge numbers of people would default, these institutions, that had previously happily lent to the sub-prime mortgage companies, began to sit up and take notice and became extremely cautious as to who they would now lend to/invest in, and also increased the rates of interest that they charged on the money they were lending. This led to a ‘credit crunch’ in the wholesale lending market, and the relatively cheap money feeding into the US sub-prime mortgage companies dried up. This put a lot of the sub-prime mortgage companies out of business.
Another impact of the credit crunch was that the other banks and mortgage providers, who also borrow in the wholesale international credit market, found that they were either unable to access this market or to afford the increased interest on borrowed money. This hit all banks and mortgage lenders in the UK.
Northern Rock stood out from the rest in that their massive share of the UK mortgage market (something like 20%) was mostly financed through borrowing on the wholesale credit markets. This is unlike other mortgage providers in the UK, who fund a large proportion of their mortgage lending through banking deposits from customers. As Northern Rock had such a big share of the mortgage lending market and a relatively small level of depositors, they had to rely more on the wholesale credit market to plug the gap. When this closed up, they were the first to start wobbling. Panic leads to panic and the subsequent run on the bank with depositors withdrawing their savings meant that they faced an even bigger funding gap. In the end they had to take an emergency loan from the Bank of England to keep them going.
CW: WHAT IMPACT DO HOUSE PRICES HAVE ON THE STOCK MARKETS?
RB: Rising house prices increase the value of home owners’ assets. This in itself has no direct effect, but recently many more people have taken advantage of this increased asset in various ways
i) Re-mortgaging (borrowing more money on the basis of a higher house value, and then using that money for home improvements, investing in more property, buying cars, holidays, etc.)
ii) Running up higher credit card bills, safe in the knowledge that even though they have £10-20,000 debt here on various cards, their overall net asset position is still good as the rise in house prices dwarfs this debt.
iii) Spending their existing savings, safe in the knowledge that they have the buffer of their main asset, their house, continually rising in value
So all these factors meant that much more consumer spending could be systematically maintained by home owners during a period of extraordinary house price growth. The more consumer spending there was, the more companies benefited; their share prices also increased, due to the actual and potential future profits they could make on the back of ever increasing house prices. This resulted in stock markets surging ahead in tandem with the housing market. The opposite applies when house prices collapse.