Regent Estates - Are mortages a risky business

A bank or mortgage company is nothing more than a box in which to keep money. The owner of the box has to do a few calculations. Firstly, how much is he going to offer those people who deposit cash in his box, in return for such a deposit ? Secondly, how much of that money should he keep as cash in case the owners of that cash want it back ? Maybe 5%, maybe 10%, what are the regulations in his jurisdiction ? Thirdly, how much is he going to charge those people who wish to borrow the money of others, previously deposited in his box ?

The person who owns the box then sets out to find lots of other people to put their spare cash in the box, in return for which he promises to give them their money back plus interest. In the eyes of some economists, these people are lenders and not investors. This terminology is based on the fact that the capital investment of lenders does not change, whereas the capital value of investors, in stocks or property for example, can go up or down. The owner of the box then has to find other people who do not have spare cash, but in fact wish to borrow it.

Fixed or variable ?

Both the lenders and the borrowers can sometimes be bewildered by the variety of terms offered by such institutions. The easiest terms to understand are those that are based on a current rate that will vary according to the market for interest rates, which alters daily, although the companies will try to even out such daily fluctuations with only periodic changes in the rate. Fixed rates, for a given period, are more difficult for the average lender or borrower to understand, a fact that has given rise in the past to greedy companies being able to reap huge benefits from such lack of knowledge. The reason for an institution wanting to attract deposits at a fixed rate could be based on the fact that their advisors calculate that interest rates are going to rise. Should they find it possible to attract deposits at e.g. 3% over 3 years, and then find that current rates are 5%, they will be somewhat pleased. In the case of a borrower finding that they are in this situation they should be congratulated for being better at guessing than the company's advisors. On the other hand, a borrower tied in to a contract at say 10% for several years who then finds that rates have dropped to 5%, will not exactly be celebrating. In my short experience since I started many years ago, I have seen deposit rates vary from 14.5% down to 1.5%.

Over 30 years ago I suggested that a notice be posted in every bank manager's office in the world, for all future managers. As notices can be easily removed, I then thought of carving it in the desk top.

1. "If interest rates go up to 10% will this borrower still be able to repay?"

2. If buying property to let; "If the property does not have a tenant, will the borrower still be able to repay?"

Is a bank safe ?

There is also a common belief among lenders that their capital is safe. In the absence of a government or similar state authority providing such a guarantee, this can be far from the case.

Dodgy borrowers

The money deposited in the box by lenders has to be lent to someone else at a higher rate of interest than that paid to the depositor. If the box gets full, there is a tendency for bank managers to forget the history of lending, and lend to those who cannot afford to borrow. This is often done at a higher rate of interest, as though that justified the unacceptable risk. Sometimes this tranche of lending, or book, is sold on to another institution, that, if it is careless in due diligence, could be storing up a whole heap of trouble.

Interest rate fluctuations

If a loan is granted at a time when interest rates are low, what position will the bank be in when the rate has risen and the borrower finds that the repayments are far too high to be affordable ? Why is it that management does not learn from the experience of their predecessors ?

Source of short-term funds

When the business is going well, there is a tendency among such institutions to imagine that the gravy train will last forever. Why not, they suggest, borrow money on the short-term market, even though the lending is long term ? A great idea one might think, but what happens if that source dries up, and the money already borrowed has to be repaid, even though they don’t have it, because it has been lent out to borrowers.

How much cash should it keep in the box ?

At university one of the cases we studied, was that of a particular savings bank. A rumour went around the city that the bank was in trouble. A great number of people went to the bank to withdraw their savings. Those that represented the first few % of the total deposit had no problem. When the percentage rose to 6%, which in this case was the amount decided by "the owner of the box", the rumour became fact, in that there was no cash to pay out to depositors. As this was in a country in which the owners of all the boxes were members of a club, the aim of which was to protect the undeserved, but perceived, reputation of said members, the members sent round security vans with sufficient cash to pay out all those who people who had taken notice of an unfounded rumour. Things quietened down after a while, and the government decided to introduce legislation to create a minimum liquidity level.

The stock market ? Are you kidding ?

Another case we studied was that of one of the world's largest banks, the board of which was mainly composed of greedy souls. They had decided that the stock market was a good place to keep the liquidity margin, so that in the event of a bear market, they could create more profit for the shareholders. A sudden bear market wiped out the liquidity margin, and the bank came within a hair’s breadth of going belly up.

Lending institutions provide a necessary service, and, apart from penal conditions sometimes imposed on borrowers, is a vital service to our society. From the investor's point of view, it depends firstly on the mentality of the treasury function within the bank, and secondly the legislation that governs their actions and accountancy practices. From the investor's point of view, who might be considering investing in the stock of such an organisation, it depends entirely on an analysis of the bank’s net worth and profitability.

Since writing the above in 2003, the world has changed and my comments on what might happen has happened. The mortgage market in the US became a shambles when the lenders changed from proven income to stated income. A prospective borrower earning 2,000 a month could simple say that they were earning 5,000 a month in order to secure a mortgage with repayments of 2,500 a month.

The value assessors became delirious with the excitement of the housing boom and overvalued properties in order that existing home owners could remortgage for a substantial amount, again on stated income.

When the borrowers could not make the repayments the lender's liquidity came into question to the point that many famous names in the banking world simply ran out of money and went belly up.

Not only that, but these crazy lenders packed these non repayable mortgages into bundles and sold the package to other banks, with an impossible monthly return in mortgage repayments as the incentive.

For some inexplicable reason these packages were given a AAA rating, so duping the purchasing bank into believing that it was a sound investment for their shareholders.

This reverbrated aroud the world almost bringing the entire financial system to its knees. Hopefully ledislation will be put into place to ensure the future liquidity of all banks and lending institutions.

To this day, the public don't understand how huge bonuses are paid to bank employees while the bank is losing money, and only exists because public money was pumped in to rescue it from insolvency.

The way that I try to explain to those who ask is to say that they assume that they own a company that has two different businesses. One of those is a building firm that is losing 100,00 a year. The other is a computer operation that is making 50,000 a year. The owner is therefore losing 50,000 a year, and that figure is known by the public.

The computer business is run by a brilliant guy who was offered a bonus of 10% of profit, when he was recruited, if he could turn it around from a loss because of the contacts he had in that type of business. This he did and was therefore due 5,000 as a bonus.

So, the information taht the public have is that a company that lost 50,000 in the year paid a bonus of 5,000 to an executive.

At an Institute of Directors lunch several years ago I suggested that banks should be split into two, one being what the public know as a bank, in the High Street, and the other a betting shop, renamed without the word bank being used. The idea was met with derision by the bankers present.

Is mortgage lending a secure business ?