Banks have decided that they’re going to be more careful about writing interest-only loans (where you only pay the interest on your loan, then pay the capital in one go at the end of the period).
In the good old days before the bust, you could get an interest-only loan with only the vaguest notion of how you’d repay the capital. You’d mutter something along the lines of, “house prices never fall – the government won’t let them”, and the computer would cheerfully say ‘yes’.
Now the answer is a resounding ‘no’. Santander for example, won’t lend interest-only on anything above a 50% loan-to-value. In other words, you need to own half the house already before the bank will even think about interest-only. Others have followed suit with similar restrictions.
Of course, unless you’re a mortgage broker, the only shocking thing about these rules is that they weren’t in place before the financial crash.
But the big question is: why the crackdown now?
The horses bolted ages ago – why shut the stable doors now?
New, tighter rules on interest-only home loans are being blamed on the Mortgage Market Review (MMR). In short, this is the usual story of regulators tackling yesterday’s problem.
The rules on interest-only lending were clearly too lax before the crisis. Rather than change them when they needed to, and take the flak from the property lobbyists, regulators have left it until now, when all the damage has been done.
The review basically puts the onus on lenders to make sure their customers can repay their loans (you’d think that would be a basic function of sensible lending). Trade bodies argue that banks are now reining in interest-only lending for fear of being sued if people suffer a shortfall.
But I don’t think that’s the whole story. Banks are past masters at evading regulations they don’t like. I think the MMR is an excuse for the banks to tighten up. Here’s why.
Banks haven’t been snatching back brollies
Throughout the aftermath of this financial crisis, everyone has been amazed at the leniency of the banks.
Usually a banker is defined as someone who tries to force an umbrella on you when it’s sunny, then wants it back when it starts to rain. In the current crisis, that’s not been the case.
Banks have been slower to repossess houses, and to shut down struggling businesses. That’s helped the economy to wobble along, albeit with a depressing, lurching, zombie-like gait.
Have they learned some lessons from previous crises?
Not at all. It’s just that in previous crises, banks haven’t been as fragile as they were this time around.
In the lead up to 2008, western banks overstretched themselves to the point where it would only have taken some very small losses to tip them into technical bankruptcy. In the event, we got huge losses that threatened to wipe out almost every major bank standing.
The central banks stepped in to keep the banks afloat and functioning. They dealt with the ’liquidity’ problem. And in the case of the very worst banks, they tackled the solvency problem by nationalising them.
But banks in general were still left with a lot of those dodgy loans on their books. They couldn’t dump them all at once – their balance sheets couldn’t take the stress.
Instead, what tends to happen with a banking crisis is that banks ‘deleverage’ in fits and starts.
When the crisis first happens, banks are bankrupt. So they pretend not to be, by avoiding writing down any of their bad loans. Instead, they start calling in any good loans they can, in order to ‘de-risk’ their portfolios.
What happens to the bad loans? It’s called ’extend and pretend’. Companies are given a longer time to repay loans – the debt is ’rolled over’. People struggling with their home loans negotiate lower payments – or are moved from repayment loans to interest-only ones. That’s called ’lender forbearance’.
As time wears on, the banks start to stabilise their balance sheets, aided and abetted by central banks making life easy for them. Meanwhile, regulators are pressing them to start behaving more responsibly (always after the event, of course).
So eventually, the banks get to the point where they feel they need to start addressing some of those dud loans. That’s when they decide they want their umbrellas back.
The end of forbearance
Last week, Paul Diggle at Capital Economics tried to put a figure on how important a role forbearance has played in propping up the UK housing market. “The most common forms of forbearance are a switch to interest-only or a reduction in the interest rate charged.”
Lenders have also taken arrears and added them to the outstanding balance of the home loan. Interestingly, when this happens, “a borrower is no longer counted as being behind, removing them from the arrears statistics”.
The Bank of England estimates that 11.8% of borrowers have benefited from some form of forbearance. Of these, roughly a third thought they’d be in arrears if they hadn’t been given a break by their banks (and the other two-thirds were clearly chronic over-optimists).
In short, says Diggle, if banks had been less forgiving, then the proportion of home loans currently in arrears of three months or more would probably be around 5-6%. That’s “in line with the peak reached in the 1990s”.
In other words, if the banks decide it’s “no more Mr Nice Guy”, then the UK property market could run into some serious turbulence in the months ahead. And this crackdown on interest-only might be the signal that forbearance is at an end.
After all, who are likely to be your riskiest home loan customers? The ones on interest-only deals. If you can offload these people on to another lender while the going is good – or even repossess their home while the market is still defying gravity – then maybe that’s starting to look attractive to the banks.
Of course, if the banks kick off another downward turn in the housing market, pushing prices lower, it’ll hurt them too. But that’s how a banking crisis plays out – in fits and starts. The next dip in the rollercoaster could be right ahead of us.
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