Sean Oldfield is chief executive officer at Castle Trust
The cause of the global financial crisis was actually quite simple: too many people borrowed too much money, which was unrealistically cheap for too long.
The problems we are now facing are all knock-on effects of high personal leverage and, to a lesser extent, corporate leverage. The problem wasn’t obvious at the time but as asset values fell, particularly house prices, the real situation emerged.
All leverage is risky and a mortgage, often very high leverage and very personal, is no different.
Giving a speech before Christmas, Monetary Policy Committee member Professor David Miles suggested shared equity arrangements could provide a long-term solution to the risk associated with mortgages: “As a result of the major changes in financial markets in the wake of the crises of 2007 and 2008 the ways in which home-ownership is financed are changing. Many of these changes will be permanent. More equity will be used by new buyers to finance house purchase than was typical in the years before the crisis. Some of that equity will come from outside financing – which creates benefits in terms of risk sharing.”
I’ve outlined below the three macro issues facing today’s economy and three key related benefits of shared equity arrangements.
Issue 1: Housing is probably the largest source of systemic risk in the banking system.
It is the largest asset class in the UK, worth more than £4,000bn but has more gearing than other asset classes – with similar volatility to a UK equity index. The average loan to value for new mortgages in the UK is around 69% for home movers and 80% for first-time buyers, whereas UK equities, to continue the comparison, are typically held with little or no gearing.
Issue 2: Bank regulation reforms are likely to reduce lending.
In the aftermath of the credit crunch, there has been much discussion of the need for banks to hold more loss-absorbing capital on their balance sheets. While this will protect the banking industry from a systemic crisis, it will also reduce lending and hold back the economy.
Issue 3: These reforms are also likely to induce “cyclicality”.
A side effect of the current regulations and the proposed reforms are that they will induce cyclicality, the tendency for booms and busts. However much we try to dampen our estimate of capital requirements, it is human nature to think that we have too much capital during a period of boom and too little during a period of bust. As a crisis hits, the banking system capital will be eroded. Banks could attempt to mitigate this by raising capital but raising capital when it is needed most (in a bust) is much more difficult and costly than raising it during a boom. This will inevitably lead to banks reducing their lending capacity in a bust and remaining pro-cyclical.
Shared equity offers clear benefits relating to all three issues in the following ways.
Benefits of shared equity… to the banking system
Because banks lend less in shared equity arrangements, those deals take a significant proportion of the house price risk out of the banking system and therefore reduce credit risk and credit losses.
… to the economy
Shared equity frees up bank capital, allowing increased lending to other sectors of the economy. It reduces leverage, which can contribute to bubbles in house prices, in the housing market.
… to the government
Shared equity reduces the likelihood of a government bail-out by distributing the risk of house price declines to investors who have the capacity and appetite for it, rather than leaving it opaquely embedded in banks and with individuals who do not.
But for shared equity to work on a large scale, those who take on the partial shares in UK housing, and who will be exposed to house price volatility, must be hedged against these risks. Traditional lenders’ liabilities (depositors to whom they pay interest) are not linked to house prices so they would be unacceptably exposed to house price risk and this would not overcome the problems they are already facing.