UK houses, Occam’s razor and fraud

By J Saft
July 15, 2010

We may just possibly have an explanation for how British property prices have held up so well though the crisis: fraud.

One of the puzzles of the past year is the way in which British house prices have managed to recover in value despite still being extremely expensive relative to both British earnings and historical precedent. While house prices are down a bit more than 15 percent since their peak, on the Halifax measure, they have actually risen 6.3 percent in the past year, not the best vintage in British economic history.

Even more astounding, a British house now costs 4.76 times average earnings, down from the silly 5.85 times in early 2007 but still 20 percent above a historical average which itself is inflated by two bubble periods. How, you must wonder, do these people afford those houses?

Medieval British logician William of Occam taught that when considering competing explanations for a phenomenon a good rule of thumb is to choose the simplest, a rule called Occam’s razor. In this instance the simplest explanation is mortgage income fraud.

It all begins to make sense once you look at one statistic recently released by British regulator the Financial Services Authority: even as late as the first quarter of this year 43 percent of all mortgage loans were made without proper verification of the borrower’s income.
What’s more, a survey by the FSA found that 46 percent of mortgage-holding households in Britain either had no money left or a shortfall after they had forked over mortgage payments and living costs every month.

Let me translate that for you: many Britons are lying to banks about their income in order to borrow money to buy houses they really cannot afford, something we used to call fraud back in the old days. The banks, for a variety of reasons none of them laudable, are making these loans to people, many of whom then find they haven’t got enough money to both repay the mortgage and live.

The FSA is proposing to ban non-income-verified mortgages, sometimes called self-certified, and if they do, let me tell you, British property prices will sink like the proverbial stone.

Like so many things that turn out to be terribly risky, self-certified mortgages started out to make relatively low-risk loans; people with multiple incomes, often self-employed, wanted to take out small loans relative to the price of the property they were buying. Some of this was probably more about defrauding the Inland Revenue than the banks, as many doubtless were not reporting their true incomes on tax returns but wished to borrow against it anyway.

WHO’S HOLDING THE BABY?

As the property bubble accelerated past the point of legitimate financing, self-certification grew. By 2008, 52 percent of all mortgages were being made without income verification. Self-certification mortgages were mostly pulled from the market last year, but so-called “fast track” mortgages, which also often do not have proper checks, have taken up the slack. I fail to understand what legitimate purpose there possibly can be in British banks, in the aftermath of a blood bath and in the midst of an ongoing global economic crisis, in making loans without checking the income of the borrower.

To be sure, there are competing explanations for why British property has managed to stay so expensive. Record low base rates at 0.5 percent have filtered through to repayments, keeping them less expensive and allowing many borrowers to hang on. As well, unemployment in Britain has been mild, standing at 4.5 percent as against 10 percent in the euro zone and 9.5 percent in the United States. Both of those factors have definitely supported house prices, though you have to wonder what happens if rates rise.

Supply has also been thin, possibly because many homeowners are trapped by owing more on their houses than they are worth.

All of this may contribute, but none explain things as powerfully and as simply as mortgage income fraud.

If the FSA is successful in imposing income verification rules the biggest loser won’t be borrowers it will be banks, who will see the value of their mortgages books hit very hard as the supply of buyers dries up. This will make the recapitalization of the industry that much more difficult and would also serve as a drag on the economy.

Economics is, at best, a social science and anyone wanting to understand that need look no further than the cult of property in Britain, where years of inflation and repeated bubbles have conditioned people to make huge sacrifices and take great risks to get on the property ladder. It all must, from the inside, seem normal, the way things work. House prices only ever go up, right?

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To think that British people would lie about their income is almost as horrifying as the concept that banks might go along with it, while lying about the value of their assets. But not quite. Because banks are supposed to know better, so they can’t say they didn’t.

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