Beware generous UK banks
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. — British banks are being surprisingly generous with troubled homeowners, raising red flags over the health of the housing market and their own earnings.
An investigation by Britain’s Financial Services Authority found that 63 percent of all troubled home loans have been switched onto some form of forbearance, typically ones that make the loan interest-only or extend the repayment period.
Some 3 percent of borrowers, or 300,000, with mortgages totaling 60 billion pounds ($97 billion) have switched to interest-only mortgages, under which no principal is retired, since the onset of the financial crisis in 2007, according to the FSA.
Most of these loans have no provision for saving to pay back principal, and in the case of one lender the FSA found that more than 95 percent of borrowers seeking to switch to an interest-only deal were in financial distress, raising grave doubts about whether the loans will ultimately be repaid.
Yet loans under forbearance are not listed as being in arrears, giving a deceptively flattering account of banks’ health.
“We require firms to report accurately and transparently the impairment of their mortgage book. We did not generally observe this,” the FSA said in its report.
It would be very easy to conclude that banks are performing an extensive “extend and pretend” exercise with the entire UK housing market, extending terms to borrowers who cannot ultimately afford to pay the money back in order that the bank can avoid recognizing the losses.
Write-off rates on loans to UK households — at less than 1 percent — are currently about where they were in 2001, according to Fathom Consulting, even after a deep recession and a 20 percent fall in house prices.
The British market has been spared the deluge of forced sales of houses that has made the U.S. housing crash more severe — little wonder given how accommodating the banks have been.
While it is possible that mass loan forbearance “works” as a policy, allowing homeowners to stay in their houses until the economy and their own fortunes revive, it is a gambit where banks take risks with other people’s money. Many borrowers with limited income and high debts would be better off letting the house go, especially if the current weakness in the housing market gathers pace. Bank shareholders and lenders to banks have reason to complain that banks are taking their funds without giving them a fair view of the risks. And lastly, of course, the British government is the ultimate bag-holder if it all goes wrong and they are forced, again, to guarantee bank debts and make them good.
LIAR LOANS REDUX
Interest-only loans are in some way the heir to the “self-certified” loans which British banks used to hand out so freely. These loans, which were originally intended for the self-employed or those with multiple incomes, became very popular and were widely used fraudulently, allowing borrowers to buy houses they had no business risking money on.
While self-certified loans disappeared in the aftermath of the crisis, they were replaced by so called “fast-track” loans which were also easy for mortgage brokers to game, putting borrowers in loans where few questions would be asked.
As recently as the first quarter of 2010 non-income-verified loans accounted for 43 percent of all mortgage lending in the UK, a stunning figure. The FSA is reviewing non-income-verified lending and will announce new guidelines this year.
So, the UK housing market is populated by people who are likely to have lied about their income and are increasingly likely to have been given pie-in-the-sky, interest-only loans as a way of papering over that very lack of income. What could possibly go wrong?
Well, the UK economy could easily slip into another recession, one that finally shakes the weak borrowers from the trees, bringing their houses crashing down onto the market with them.
Or, conversely, the Bank of England might be forced to raise rates to control inflation, hikes that would be very painful to the interest-only set.
Morgan Stanley is betting on a 10 percent fall in house prices before the end of 2012, a forecast predicated on 150 basis points of rate hikes in the same period.
While I am not so sure about the rate hikes, it is easy to see a 10 percent fall, a seemingly modest move but one that would put 90 billion sterling worth of negative equity mortgages on the books of Lloyds Bank. Other banks would have smaller but still meaningful exposures. Barclays Plc would be looking at negative equity mortgages of about six billion pounds, or 14 percent of its total net asset value, according to Morgan Stanley.
The whole idea of a market supported by interest-only and liar loans is unbelievable. Unbelievable, that is, until you consider how painful and disruptive the alternative will be.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)