Another subprime mortgage crisis waiting to happen?

At 6:30pm on Tuesday 26th November 2013, an extraordinary meeting of Norwich City Council’s cabinet was held, in order for cabinet to review and subsequently approve a proposal entitled “Local Authority Mortgage Scheme”.  It needed to be approved by cabinet at that particular time because it was then to appear on the agenda of the full city council meeting at 7:30pm on the same day.

This in itself arouses suspicion – it only gave opposition councillors and members of the public a week (the period the agenda has to be published) to scrutinise the scheme, which to me seems quite undemocratic.

Whilst the Labour councillors simply followed their whip and voted it through, some of the Green Party councillors investigated the consequences this scheme might have for the local and national economy, the council, and for local residents.

At first sight, the scheme can seem very attractive – helping young first-time buyers onto the property “ladder” and an improved interest rate for the council, but once you dive in, there are some monsters lurking beneath the surface.

Risk Transferred

In the report, this scheme is compared with a typical 5-year investment (paragraph 18). It is therefore claimed that this scheme would earn an extra £10,000 over its 5-year lifetime; that’s £2000 a year. So £10,000 is what we stand to gain, financially, all being well.

Now, what do we stand to lose?

Under the scheme, the city council guarantees 20% of the property value.  The maximum loan size has been set at £152.000 in Norwich, representing a maximum purchase price of £160,000 (paragraph 15). If the applicant buys a property at the maximum price (which is a fairly typical house price for Norwich, at present), this would mean that the council’s guarantee would be worth £32,000. Although unlikely, a default on a single property bought under the scheme could lose the council this deposit and therefore wipe out the potential benefit of the scheme three times over.

Much more likely, however, would be a wholesale reduction in house prices if the economy fell apart again like it did in 2008.  House prices would only have to fall 5% to potentially trigger a default, as the homeowners’ equity is (initially) just 5% (their deposit).  Ok, in reality, the homeowner may put up with a small amount of negative equity on the basis that they hope house prices will increase by the time they need to sell or finished paying off the loan.  But still it would be a lot less than the 25% drop in house prices that would be required to trigger a normal 75% LTV (loan to value) mortgage to default.

If such a drop in house prices occurred, several defaults may be triggered on properties under the scheme – indeed it would be much more likely that homeowners would default on these loans before their counterparts who have taken out a 75% LTV mortgage, even if they have exactly the same income and mortgage repayments, simply because their equity stake in the house will be wiped out more quickly.

When the bank repossess properties which have been defaulted on, they will most likely put them up for auction with a reserve price of their stake and because of the depressed market, few will be willing to purchase these properties at much more than the reserve price, which means that the council’s deposit is going to be heavily hit.  This could mean that the council would not only lose out on the interest they were promised by the bank, but also end up forking out some of the £1m capital that they invested!

Impartiality

Banks, other financial institutions and individuals make risks like this from time to time, and as far as I’m concerned are welcome to do so. However, local authorities should be more cautious about investing in schemes with this kind of risk, not just because the risk has been transferred to them rather than the banks, but because it also reduces the council’s impartiality to changes in house prices.

Currently, the council owns a lot of property in the city, but because it owns it outright, it is not really concerned if house prices fall, as long as rental rates remain fairly consistent.

By taking on this scheme, however, the council now has a direct interest in the value of local property staying constant or going up, because if any property were to lose value and default, it would be the local authority taking the hit if it sells for less than its purchase price.

This matters because local authorities ought to be able to make impartial decisions on things which may affect the values of local property for the benefit of their residents, not in the council’s own financial interest.  Under this scheme, it is the council’s fiduciary duty to pursue policies that maintain house prices, in the interest of protecting their investment.

What’s more, because the capital deposit in this scheme is entrusted to Lloyd’s bank, the council has no further power to decide who they lend to. This could mean that they end up lending to a reliable, low-risk borrower, who has a good salary and can easily pay-down this loan (in which case, it is likely that they would just be able to get a normal mortgage). Or they could end up lending to someone who really needs the help because they can barely afford the rates, in which case, they would be at much higher risk of default, potentially losing the council its deposit.  Whichever way, the intended objectives of this scheme are being missed, with potentially disastrous consequences for all involved except… surprise, surprise… the bank. Sound familiar?

House price inflation

At the same time as this putting the council itself in a difficult (and potentially risky) position, its also worth asking whether this scheme is even doing what it sets out to do, which is to make housing more affordable.

Because housing is a basic necessity of life, and there is a considerable housing shortage, house prices are generally determined not by supply of houses, but by the availability of loans to purchase them. This is demonstrated in this graph from Positive Money:

Graph: UK House Prices: 1997 - 2010

Because it increases the credit available to first-time buyers in Norwich, the result of this current scheme could be to increase house values for those houses that are eligible to be bought under the scheme.  Although this difference is likely to be small, it is compounded with national government schemes such as help to buy, and other speculative schemes driven by banks to plough money into property – the very mechanism pushing house prices out of the reach of ordinary citizens in the first place.

No increase in supply

In speaking out against this scheme, I run the risk of being criticised as opposed to the ownership of houses, and of making housing available to those on a low income.  This couldn’t be further from the truth – it is because I think we should be tackling the actual problem that I oppose this scheme which is tackling the wrong side of the equation – the problem is not with housing demand, it is with housing supply, and this scheme does nothing to increase supply.

None of this money will actually be going into building new houses, so there will still be the same number of houses available, sold and filled. The only difference will be that the market will be distorted to make different people eligible for the same properties.

Is buying even desirable for the resident?

There is a prevalent assumption at the moment that buying your own house is a good thing.  There obviously are advantages to buying your own home, no matter what economic climate you’re in, such as being able to change it and having complete freedom to do with it what you want – not having to conform to tenancy agreements.  However, it is also a huge risk, especially since within the current financial climate there is no guarantee that the value of your property will go up. This is in stark contrast to the type of time when the term “property ladder” was coined, when house prices were constantly rising, sometimes at a very alarming rate!

Putting pressure on those who can barely afford it to take on this risk, however, is asking for trouble.  Many other countries have much lower rates of owner-occupied dwellings, not because they can’t afford it, but because tenants would rather that professional companies were taking on the risks associated without housing ownership, rather than themselves. The ideal of owning your own home is a cultural one, and we shouldn’t put pressure on people to follow these ideals unless we can be absolutely sure that it is the right thing to do for themselves, and for the wider community.  In this case, I’m not convinced!

So in summary…

The Local Authority Mortgage Scheme will not have the desired outcome for resident or local authority, and poses significant risk to both these parties, whilst removing risk from banks. This makes a sub-prime crisis more likely, as only small decreases in house prices could trigger defaults and leave the council out of pocket.

If you’re concerned about Norwich City Council’s economic decisions, please vote Green Party in May, to make sure that schemes like this are challenged and better economic decisions pursued.

If you’re concerned about the national economic structures that have led to banks being able to pass risk on to governments, and want to know more about how we can challenge that paradigm, go to the Positive Money website and join their campaign.

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2 Comments

  1. Tom Harper
    Posted 16 March, 2014 at 12:52 am | Permalink

    Good post. I agree, ownership is heavily touted as the best option, a cultural shift that took place in the seventies when the gap between economic productivity and wages started to expand with economic productivity continuing to climb and wages flatlining effectively. This is also when the credit card was heavily advertised by banks (remember the access one from the early 80’s?) as a means to cover the credit gap between wages and living costs. But that was when houses were often only twice as much in value as an annual salary (my mum bought her house in London 1970 for 14,000. – she was earning about 9,000 per annum).
    Looking at trends like collaborative consumption and the sharing economy, access is becoming preferable again over ownership for most products and services (Streetbank). But when it comes to housing, the banks have still got us by the goolies. The cost of renting is often equal to our higher than an average mortgage monthly payment. I can see the housing authorities plan as being very attractive to a lot of people, but they are not addressing the systemic problem here, only hoping to exist successfully within it.

  2. Mark Crutchley
    Posted 16 March, 2014 at 10:45 am | Permalink

    To me the crucial point is the one about boosting demand rather than supply. Just as with the government’s help to buy scheme this creates additional demand without increasing supply, so prices must rise making housing less rather than more affordable. Obviously this is what has happened in the broader economy in the last year. Any government which really wanted to help people to afford their own home would take steps to push house prices down – but of course that would be electoral suicide since there are far more owners than potential first time buyers.

    While I wouldn’t think the default risk is too great – people do tend to hang on to houses even when in negative equity because they expect prices to rise eventually – I do think it is also worrying that new buyers are making these commitments at a time of unprecendetedly low interest rates. Rates will rise putting pressure on household budgets with risky consequences for people if they have overstretched themselves to buy a property they can only just afford at current interest rates.

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