Blah, blah, black sheep, have you any rules?

Unwittingly, bank regulators use some ancient rules of thumb to cleave people into two groups: those with the means to buy and those denied that privilege. Renters and buyers live cheek by jowl, pay the same council tax, stroll in the same parks, and send their kids to the same schools. However, a pernicious membrane separating these neighbours profoundly impacts their prospects in life. On average, people who can afford to buy earn more than those who can’t. People forced to rent long term will pay tens, if not hundreds, of thousands more to survive in retirement and will bequeath far less wealth when they die. I doubt the rule makers intend these stark outcomes, but the regulatory quilt is patchy, and the stitches have long been fraying.

A new regime – one that makes buying as easy as renting – would help everyone find homes that are both more affordable and better suited to their needs. Such a new framework requires rules that make intuitive sense to banks and other institutional investors, landlords, and people with no special financial education. It’s time to level some tall trees the better to see the forrest.

First, some guiding principles:

Security of tenure: The rules should tilt towards ownership rather than renting because most people want to end up owning outright. Don’t look at me. Ask them.

Progressive sure beats regressive: As equality of outcomes is never possible, the rules should militate in favour of those that need the most help.

No begging bowl: The new rules should not require yet another call on the public purse. We live in a capitalist country. Let those who profit from deploying capital do the risk versus reward dance on a level playing field, not on the head of a pin.

Keep it simple, Stuart:? The rules should be clear enough to gain broad public acceptance without the paralysis that comes with endless analysis.

Pareto optimality: Any new framework should leave consumers (renters and buyers) at least as well-off as they were before.

As ever, it’s important to throw facts at the wall to see which stick. Most people leave their parents searching for a place to live independently. Extrapolating from the Department of Levelling Up and Housing’s English Household Survey 2023, three quarters end up renting. As the chart suggests, very few find a berth with their local council or a housing association. So, let’s focus on the ways new households find places to rent privately versus places to buy.

Any holistic framework must govern the activities of all firms that offer competing services. The right to occupy a property is a service with various bells and whistles attached. Landlords combine occupancy rights with a bell called maintenance. Banks facilitate occupancy combined with a whistle called progressive ownership. As owners, their customers take responsibility for maintenance and most make that trade willingly. Apart from that, the membrane separating a lease from a loan is as thin as parchment, though, curiously, as revered as the Dead Sea Scrolls. I believe these services should sit within the same regulatory perimeter.

Affordability and suitability are conjoined twins. There’s no point saying that this property is more affordable than that one if the first is located, somewhat inconveniently, in southern Reykjavik. Location is the most important component when assessing suitability, followed by location, location, and a few other factors. There are no special rules dictating where landlords site their properties. Nor are there detailed regulations or a quango assigned to help prospective renters find them. There are a couple of dozen search platforms and almost twenty thousand estate agents with properties displayed in their windows to take care of that. Left to their own devices, renters select a platform, like Rightmove or Zoopla, and answer two questions at a minimum. Where would you like to live (denoted as "L" in the image below) and how much do you feel comfortable paying (denoted as "R").

In real time, the platforms produce a list of alternatives, some more suitable than others, but with no specific rules telling renters which is which. There are not nearly enough decent properties on the market but few renters complain about the ways today’s platforms help them select those most suitable.

Next stop, affordability. Most people call their rent “affordable” when:

“…the amount they must pay is no higher than the amount they feel comfortable paying…”

It's a strange formulation that takes some getting used to but it has the advantage of brevity; weighing in at just eighty-six characters, including spaces. There is no specific definition of the word comfortable which is not a legislative oversight as there is no such legislation. Most folks take it to mean their rent leaves them with a decent amount in the bank at the end of the month. Again, no government agency sets out a “reasonableness” standard for landlords to follow or stipulates the qualifications advisors need when renters ask whether rent is reasonable.? Ordinary kids leaving the comfort of their parents' homes somehow figure it out by looking at their income minus their necessary expenses. Let's call this a kitchen table analysis.

And no specific rules make private landlords responsible for the tenant’s sense of comfort. Local competition between landlords takes care of pricing. If one sets the rent too high compared to comparable places in the neighbourhood, that landlord will suffer long void periods between tenancies. Indeed, the chronic shortage of quality homes available for rent makes it incumbent on the applicant to persuade the landlord or their agent that they will be a reliable tenant.?

You can see where this is heading

Progressive versus regressive: On average, renters are younger than buyers. It costs considerably more to rent a home than it does to buy one because rents rise relentlessly in line with local incomes. Renters devote a larger portion of their earnings to occupy homes they will never own than people with greater means spend to buy a home.? If anyone needs protection, it’s the renters. And as the number of people who rent from lightly regulated private landlords grows, the need to rebalance the rules becomes more pressing.

Keep it simple, Stuart: The regulatory-light regime governing private landlords can be improved but, in my view, no obvious social good would be served by subjecting landlords to the needless gumph and complexity that banks need to deal with. The Financial Conduct Authority’s Mortgage Conduct of Business rules (MCOB) set standards for all firms that provide home loans but are curiously silent about firms or individuals that provide places to rent.

MCOB section 11.6 – the chapter that deals with responsible lending – runs to almost five thousand words; a tad longer than eighty-six characters including spaces. But wait. There’s more. The Bank of England’s Financial Policy Committee sets out yet more rules to guard against mortgage underwriting standards that create the spectre of excessive household debt. The rules are so complex, banks must maintain expensive compliance departments. Landlords do not.

How it works in practice: House hunters encounter these complex rules at the very beginning of the home buying journey. Aspiring buyers visit the same search platforms that serve renters. They too enter a location but there the similarities end. They must next enter the value of the home they want to buy, as opposed to the amount they are willing to pay for it.? The value they enter is generally the sum of two numbers ?“M” being the maximum amount the banks will lend and “S” being their life savings. Increasingly, people add a decent chunk of their parents’ savings for good measure.? Let’s denote the sum of M&S with the letter “P” being the purchase price. The screen below (cadged from our friends at Rightmove) is beguilingly similar to the one above but differs greatly in the approach to the critical question of affordability.

The regulatory rules dictate that the house hunter is presented with a list of homes worth “P” or less. In other words, if you want to rent, you tell the platforms what you think you can afford. If you want to buy, the banks tell you what they think you can afford.? As renters occupy homes worth vastly more than banks are allow to lend, the rules tell you where you must live, even if you can afford to occupy a better place that you will never own. Are you with me so far?

Are the current rules explicable and do they have broad public support? Lending is constrained by rules established by both the Financial Conduct Authority and the Bank of England’s Financial Policy Committee. These rules work together, mathematically. For any one rule to be effective it has to slot into a formula that starts with the words: “Banks can lend no more than the lower of…blah, blah, blah…” where each blah is a race to the bottom. Let’s step through them slowly. Strap in. It gets bumpy from here on in:

The deposit barrier: A standard 90% deposit means that banks can lend no more than nine times income. In 2021, Rishi Sunak introduced a 5% mortgage guarantee scheme to encourage banks to lower the deposit barrier. Thus, banks can – with the government's blessing – lend up to nineteen times your savings. Oh, happy days. So, why was the take up so pitiful? Forty thousand loans or so is a drop in a bucket. But the Prudential Regulation Authority imposes capital stress tests that penalise banks when they lend with a very low deposit.

Not to be outdone, Sir Kier has promised to extend the program predicting that this will help some eighty thousand first time buyers in the next five years. So, between 2021 and 2029, this much vaunted policy will help about 120,000 of the two or three million people who have or are likely to buy a home in that time frame. Alternately, compare that 120,000 over nine years to the ten or eleven million families that have or are likely to move from one rented home to another in that time frame. Is anyone surprised that merely dropping one of the blahs will make a difference? There is a paucity of ambition here, a sort of learned helplessness along with a lack of high school level maths. Say it with me

Banks can lend no more than the LOWER of…blah, blah, blah… and we haven't finished with the blahs

The loan to income barrier. Banks cannot lend more than 4.5x income. There are rare exceptions, but the average is 3.4x. Renters occupy homes worth considerably more than 4.5x income. There are rare exceptions but the average is 9x. As the value of their rented home is not visible, renters are only vaguely aware of the trade offs involved when attempting to move from renting to owning. And these trade offs are not uniformly distributed. ?While the loan to income barrier applies across the whole country, house price to income ratios vary substantially by region, vary materially from town to town within regions, and vary meaningfully from postcode to postcode within any given town. But wait. There's more.

Income stress tests. In addition to the PRA capital stress tests that constrain the bank's lending at the portfolio level, the Bank of England requires banks to perform case-by-case stress tests at the borrower level. Prior to 2022, lenders had to evaluate whether an applicant had sufficient income (minus their essential expenses) to repay the loan – a kitchen table analysis – plus enough income to survive a hypothetical hike in their loan repayments in the event that the mortgage rate spiked from the initial rate they had agreed to pay to a rather arbitrary (if standard) variable rate plus another rather arbitrary three percentage points.?

I say arbitrary because nothing compels banks to offer mortgages that revert to standard variable rates. The spectre of the future rate hike is invented out of whole cloth in Britain and is quite unlike the terms of standard mortgages in other countries. Usually, borrowers refinance their loan to escape the rate hike but, sometimes, no bank will touch them so they remain trapped and compelled to pay the higher rate – a penalty applied to customers who might not have missed a payment in quite some time. Yes. These folks are called mortgage prisoners and yes there is a class action suit in progress to contest this absurdity in court.

But wait. There’s more. The MCOB requires banks to perform a similar stress test (yes, a third stress test) but, in this case, the arbitrary amount that must be added to the standard variable rate is a mere one percentage point. This loosening of the belt and braces comes as a relief to first time borrowers but, sadly, a very small relief.

We all know how to perform a kitchen table stress test, but who knows how to interpret a test that includes a sophisticated convexity analysis? By that I mean: the change in the annuity payment required to provide the banks with the internal rate of return they demand in the event the loan reverts to the standard variable rate that the bank chooses to impose is a function of (a) the remaining term of loan and (b) the arbitrary percentage points the regulator adds to the standard variable rate and, in addition, the change in the rate of change of the annuity payment depends on the prevailing level of interest rates for the appropriate benchmark (corresponding to the remaining term of the loan) that the banks choose to use to hedge their rate risk exposure.

That sentence runs to six hundred characters, including spaces so please, please pause for breath

I know that’s a simplistic description of a more complicated process, but this is intended to be a short article. In English, these stress tests are really rather complicated and, prior to 2022 there were two of them. It will come as no surprise that when the Bank’s Financial Policy Committee dropped the more stringent stress test (after much consultation with the industry) nothing much happened. Indeed, the number of first time mortgages has gone down. In a recent survey of mortgage advisers conducted by Mortgage Solutions the removal of the affordability stress test had a negative impact on the market according to 8% of the respondents. Approximately 34% said that this simplification has had a positive impact but the majority opined that the rule change made not a jot of difference. Why does this surprise anyone? Banks can lend no more than the lower of…blah, blah, blah. When one blah is removed, another blah kicks in.

With apologies to Frankie Goes to Hollywood. There has to be a better way.

And, as luck would have it. We have a ready made set of rules and plenty of empirical evidence that they work in the rental market. Private landlords have every incentive to avoid renting to people who cannot pay. Banks have a similar incentive. And, as there is no great difference between the rate at which renters end up in the County Court system for non-payment, compared to mortgage borrowers, it would appear, empirically, that the skein of rules designed to ensure that borrowers do not become enmeshed in too much debt is redundant.

So here is my suggestion for a new set of rules. Banks should be compelled to offer mortgage alternatives with no deposit. Banks should remain free to charge more to cover the additional risk. The loan to income cap is well past its use by date. Toss it. This will allow banks to finance homes that are comparable to those applicants are demonstrably capable of renting. ?And, finally, banks should be barred from offering loans that revert to standard variable rates.

What will remain is a kitchen table analysis conducted by the borrower who must determine how much they feel comfortable paying, followed by verification by the banks that this amount is reasonably affordable. Three million private landlords perform this type of analysis without the benefit of the tech and compliance teams banks employ. When the rubber met the road during the financial crisis, the private landlords emerged unscathed. The banks? Not so much.

There is only one community of people when you combine renters and borrowers. Thus it is almost certain that this relaxation of underwriting standards will precipitate a modest rise in the number of borrowers that run into payment difficulties, offset by a corresponding reduction in the number of renters that fall into payment difficulties, leading to the Pareto optimal outcome that almost everybody will be at least as well off as they were before.

People affected by these issues should feel free to get in touch.

#socialinclusion begins at home

Ike Udechuku | Cofounder | CEO | The Pathway Club?

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