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Roger Elwell - Yes Please

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Innovation in Financial Services

A discussion of trends in innovation management within financial institutions, and the key processes, technology and cultural shifts driving innovation.

Sowing The Seeds Of The Next Housing Bubble

13 September 2011  |  4064 views  |  0

Here in the UK, mortgage providers are already sowing the seeds of the next housing bubble.  I read in this weekend’s Telegraph about a product innovation that is ‘designed to help first-time buyers get on the housing ladder’.  Expecting to read about how house prices would continue to fall to affordable levels, and thus enable people to actually buy properties at a cost that was consistent with their ability to service the loans, I should have known better.  No, instead, what some institutions are now doing is promoting a ‘product’ that enables parents to put up the equity in their own property in support of a guarantee.  This guarantee allows the lender to loan up to 100% of the value of the property, because the parent guarantees the 10-30% that the borrower would normally have to find as a deposit.

I find it incredible that responsible financial operators should even contemplate such a move.  Quite apart from what will become serious consequences for the guarantor in such a situation (see below), this will only serve to enable house prices to stay at their ridiculously high levels – and possibly climb further, rather than use price correction as the mechanism to restore affordability.  If this ‘product innovation’ (and no doubt others to come) gains traction, I can see the next housing bubble emerging over the next few years.

If I understand what I read properly, the parent would guarantee the deposit element, thus allowing the lender to advance the whole amount, rather than 70-80% of the property’s value, as has now become the norm.  This would be backed up by a charge over their own property; naturally the parental home will need to have sufficient equity in it to do this.  I see lots of issues with this, quite apart from irresponsibly throwing petrol on the embers of the housing market.

First, there’s the impact on the parents’ relationship with their own lender.  Now, maybe I’ve been out of mainstream banking for too long, but this would have been frowned on in my day.  Banks preferred only one charge over a property – theirs – and second charges were discouraged, because the prime lender then had less control over the security – the second charge holder could just as easily ‘call in’ the security, for instance, and the presence of a second charge tended to limit the prime lender’s room for manoeuvre in managing the loan.

Further, if I had lent to the parents at a good low rate, taking into account that the LTV on their house was, say, 60%, I’d now be returning to the borrowers with a significant rate increase if I’d found out that they had just pledged a significant proportion of that equity to a second charge holder.  My justification for this would be twofold; one, that the terms of the deal had changed significantly (i.e. the price assumed a level of free equity that no longer existed) and two, the risks associated with the deal had grown – don‘t forget that the parents have no control over the financial fortunes of those they have guaranteed (unlike, say, if they had borrowed some further amounts for their own use).  Do parents understand that this (rate increase) could indeed happen and are they prepared to pay this price?

Second, if the parents had secured a short-term mortgage deal, when this comes up for renewal, as their current lender I would certainly significantly raise the rate for the next deal, even if I had not been able to raise it earlier.  Do parents understand this?

Third, I imagine that the process of re-mortgaging generally (especially moving to a different provider) will be a lot more difficult if there is a second charge on the property.  What lender would take on such a deal?  How would the new provider gain a ‘first mortgage’ and protect their interests?

And lastly, there is the question of what happens if the guarantee is called in (e.g., because the mortgage-holders become unable to pay their way).  The parents either have to find the cash to pay their obligations, or they will lose their house, and most certainly lose control over the process of selling that house to security holders.

Oh, and will these mortgages find their way into CDOs?  If so, how will they be clearly identified and what kind of risk profile will they have?  Are these to be considered lower or higher risk?

It's only a personal view, of course, but I think this has the potential to be a bad product, and it’s the sort of thing that the FSA should have the power to outlaw.  It starts with the best intentions (helping young people get a house) but does it in the wrong way.  It undoubtedly places pressure on parents to ‘do the right thing’.  It creates all kinds of potential problems for the parents in question, and encourages the borrower to enter into commitments that they may well struggle to keep.  This initiative displays all the hallmarks of a return to loose lending and really should be stopped.

TagsRisk & regulationRetail banking

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Roger Elwell

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Yes Please

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