Equity is rarely negative

In one of our prior articles [Number Ten: Skinny Evidence in the Game] we addressed the simple question about the mortgage market: does having “skin in the game” materially reduce the likelihood that borrowers will walk and let the bailiffs repossess their homes? Such counter-intuitive behaviour is rare but oft-discussed. Why?

This piece tackles the flip side of the risk equation: are banks leaving money on the table? What would be the likely commercial reward for helping people for whom homeownership is not a game?

Number Seventeen: Equity is rarely negative

Foreclosure is bad. Stipulated. But who really loses, the bank or the borrower? Unless the borrower is in negative equity, the bank loses nothing; except time and effort as banks – to their credit – do everything they can to avoid foreclosure.

This series of articles has a common theme: how best can house hunters craft their own financing package? It would be simpler, grammatically at least, to ask how best first-time borrowers can craft the terms of a mortgage, but one answer to that question might be that banks should stop lending money altogether.

Our daysrent? purchase plans, for example, are leases with a negotiated Full Ownership Day, not loans. Our plans provide many advantages for customers who don't have or prefer not to contribute skin to the game.

Meanwhile, banks defray default risk by insisting that those with the least means bear the most risk. It is traditional to ask borrowers to contribute deposits –generally their life's savings, sometimes more. The families must risk a complete wipeout if foreclosure coincides with negative equity. Technically, they still owe the banks the shortfall unless they declare personal insolvency.

Fortunately, this worst-case scenario rarely happens. So rarely, in fact, there would be little harm in changing the rules so that it never happens. If given a chance, first-time buyers would design purchase plans with no minimum deposit. Don’t look at me. Ask them.

The risk equation is flawed

Some people believe that minimum deposit requirements protect society from systemic banking risk. Others believe deposits protect society from the moral hazard inherent in lending to the wrong sort of people. I've even heard bankers whisper that some people don't deserve to borrow, which is tantamount to saying that some children don't deserve to inherit property. It's important to be clear-eyed about these things.

Bankers should spend less time moralising and focus on creating value for their shareholders. British banks have offered shareholders very little growth for the past fifteen years. Clearly, they don't have a monopoly on good ideas.

Here's one we baked earlier: A mortgage product aimed solely at people with no deposits makes good commercial sense. A few brave souls (Skipton and Yorkshire) are making baby steps in the right direction ???? ???? ???? but the quasi-mystical adherence to the mortgage deposit is a phenomenon that deserves further study.

Let's do the maths. Pencils at the ready.

1?? At 5% equity to assets, ￡80 billion of shareholder capital underpins the ￡1.6 trillion mortgage market. Mortgage loans are "fifty percent risk-weighted" because even the regulators acknowledge that banks are less likely to lose money when the borrower's home is at risk.

2?? There were 540 foreclosures in Britain in the third quarter of 2023. That number spiked alarmingly to about 730 in the final quarter.

3?? This rate of growth is a distraction. Pay attention to the absolute numbers.

There are nine million mortgage borrowers in Britain, give or take. There are ten million renters of which most would rather own. Given a chance to buy in their mid twenties, renters would be tens, if not hundreds of thousands, of pounds better off in retirement. This value would not come at the expense of the lender

On the contrary, this lending would be profitable (see below) and doing so would reduce the burden taxpayers face supporting people in retirement. This tax burden falls largely on the wealthy, many of whom are bankers, and the wealthy deserve a break too. Fixing the housing market profitably need not be seen as an act of charity.

But it is a worthy social goal too

There are over a million unemployed and over a million families languish on social housing waiting lists: families, not people, there are kids to think about too. Seen in this light, the attempt to drive foreclosure down from a few hundred families a month to zero is... I was going to say immoral but stopped short to avoid being controversial.

Seriously. The risk to the banks of losing money in a dual trigger event (foreclosure and negative equity) is vanishingly small. The concomitant risk to society is vast.

Making whoopee

There is abundant evidence that years wasted saving adversely impacts family formation. Britain needs more babies. What could be more conservative than that?

Remember that nineteen eighties TV show, Thirtysomething? The average age of recent first-time buyers is rising. The average age at which British women have their first child tracks the age when couples buy their first home. I have used data pertaining to London alone but the rest of the country is not far behind.

But wait. There's more. The typical first-time repayment mortgage was 25 years before the crash of 2008 when people bought their first homes in their late twenties. So, you'd be in your early fifties by the time you owned free and clear, giving you a more than a decade to save money for a pension. Today, first-time buyers start in their early thirties and borrow for thirty-five years. That puts them deep into their sixties before they own outright.

Written out longhand: people put less money aside before they retire. People are living many more years in retirement. There's pressure on the state pension system... you can see where I'm going with this.

These aging first-time buyers are the lucky ones ?

Data from the latest English Housing Survey suggests that 170,000 families renting from local councils and housing associations, expect to buy a home at some point. There are five million such families in Britain, give or take. Annually, banks lend to fewer than 20,000 a year. When will banks become brave enough to close this chasm between hope and reality?

Meanwhile, more than one million families can't get council housing, rent their homes, and pay their housing benefits to private landlords. No, worst still, typically the government gives this money to the local district authority which then transfers the money direct to the landlord. Who is the benefits recipient in this scenario?

I've highlighted two relevant numbers below. The words in grey are the social and political messages. The highlighted numbers are there to help people see the scale of the profit going begging here.

Benefits recipients pay a few hundred pounds a month, multiplied by a million people adds up to a few hundred million a month trousered by private landlords. As the saying goes, a billion here, a billion there, annually for decades; pretty soon we're talking about real money.

Let's be clear-eyed about what's going

There are three million private landlords in a nation of thirty million households. Put simply, most private landlords are in the top 10% of wealthy families. Now, there are more than five million privately rented homes. Most landlords don't take "DSS" tenants, so this government largesse is funneled to a small number of canny operators who earn far more than the banks who extend low-interest buy-to-let loans.

Rental yields are inversely correlated to absolute house prices. Benefits recipients rent low-valued homes, which means that landlords who accept DSS tenants receive yields very substantially higher than mortgage rates.

This rent equates to a 7% gross rental yield. Forward inflation in the gilts market is around 3%. The economy ambles along at about 2% real dragging house prices and rents along with it. The math ain't hard and all the numbers are in the public domain.

Do try this at home, folks. Answers on a self-addressed postcard, please:

1?? John and Jane expect to rent for 60 years between the ages of 25 and 85

2?? They expect to pay a 7% yield, rising in line with the economy, to rent a home worth ￡150,00 that they will never own

3?? How many years does it take before they have paid off the landlord's 60% LTV mortgage?

4?? How many years will it take before they "buy" the house they occupy five times over, in nominal terms?

5?? How much would a bank lose if it lent 100% LTV to a portfolio of Johns and Janes assuming it donated the homes to the Battersea Dogs' Home once the bank has been repaid five times over?

Just for fun, please assume the bank suffers three times the typical rate of foreclosure on this portfolio of reckless loans and that loss given foreclosure is 200% of the declining balance to take account of the cost of administering the county court process.

The deposit barrier revisited

Based on data from UK Finance, the average mortgage deposit for a first-time buyer in the East Midlands is just over ￡50,000. This deposit amounts to 20% of the value of the loan. These borrowers devote 21% of their income to service these loans, compared to about 33% for a typical renter.

The maths imply that the typical first-time buyer brings home twice the income a typical renter can muster in the East Midlands. If you have two years' worth of salary lying around, you too can cut the recurrent cost required to occupy a home for decades.

As a bonus, you can keep the home at the end of the deal. Meanwhile, your poorer neighbours continue to rent. Go forth and multiply the frequency and severity of this profound social exclusion.

Note that I picked the East Midlands as it's smack dab in the middle of middle England. These affordability differences are not uniformly distributed across the country. Don't get me started about London and the South East.

The word equity has many definitions

There is simply no empirical evidence that society, writ large, benefits from this fear of negative equity. There is abundant evidence to suggest that bank stocks have languished below book value for many years. How much longer before bankers need to ask if they're missing a trick? If you have data to contradict my assertion, please reach out.

For some, equity means the value they get to keep if they sell their home. Most people own (65%) but a substantial minority does not. For these families, equity might be defined as a state where everyone is treated fairly according to their needs. This type of equity is rarely negative.

#fintech innovation begins at home.

Ike Udechuku | Cofounder | CEO | The Pathway Club