Intelligent ways of repairing the UK home loan market

The UK government has come up with a package of measures to boost the UK housing market and to help those who find themselves with mortgage servicing bills they can no longer afford.

A very damp and small squib

The first measure is one year stamp duty holiday for property transactions between £125,000 and £175,000. This would cost £615mn, according to the Treasury. Doing away with stamp duty would be a good idea regardless of the state of the housing market. Stamp duty is a stupid tax, which penalises transactions in housing. It taxes labour mobility. If the government wants to tax wealth, let it tax wealth, but not transactions in specific assets. A one year partial stamp duty holiday is better than nothing, but nowhere near as good as a permanent abolition of this fiscal monstrosity. Higher taxes on non-doms could make up the revenue shortfall…

The second measure, costed at £100 mn, helps people who lose their jobs to keep paying their mortgages. The waiting period for this Income Support for Mortgage Interest, will be reduced from 39 weeks to 13 weeks and the capital limit for claims will be raised from £100,000 to £175,000. This is a terrible idea, both from an efficiency and a fairness perspective. People who take out mortgages and worry about losing their jobs should take out mortgage protection insurance against loss of labour earnings, or, more generally against interruptions in the cash flows – whatever they are – out of which they plan to service their mortgage. If they cannot afford the insurance, they cannot afford the mortgage. Those who don’t take out mortgage insurance and lose their jobs should suffer the consequences, including the repossession of their homes.  If the state cannot credibly commit itself not to bail out the uninsured ex-post, the insurance should be mandatory.

The third measure allows housing associations to buy homes from those facing repossession – at market rates – and rent them back. Why not, if housing associations are more efficient and more trustworthy than private companies offering “sale-and-rent-back” deals? Housing associations can also offer shared ownership or shared (home) equity deals in which the occupier only acquires, say, a 30 percent ownership stake in his home, with the housing association owning the rest.

There appears to be no new money associated with these measures. However, even just removing artificial barriers to the scope of housing association activities can be a good thing if housing associations are managed effectively and transparently and don’t distort the housing market level playing field.

The fourth measure is a new £300m shared equity scheme called “HomeBuy Direct”. Here buyers can borrow up to 30 per cent of the value of a new-build home, with the government and the developer picking up the tab for the remaining 70 percent. The loan will be interest-free for five years. This is another terrible idea. Why favour new homes over existing homes? Is there some huge externality associated borrowing for the acquisition of a new home (as opposed to borrowing for the acquisition of an existing property or borrowing to take a holiday in the South of France) that I have been missing for all these years? The interest-free nature of the loan for the first five years replicates the teaser rates that were one of the most pernicious of the financial perversions that created the subprime mortgage crisis in the US. Lure them in with low rates now, then whack them over the head with a massive reset when the next government (preferably formed by the opposition) is in power.

The fiscal stimulus involved is tiny – around £ 1 billion. The measures are either useful but minor or counterproductive. The current Chancellor has clearly taken a leaf out of the book of his predecessor, and has become a compulsive micro-tinkerer with little understanding of how the interaction of all these micro measures will affect incentives and behaviour.

The only way to restore normalcy to the UK housing market is to address directly the collapse of mortgage financing. There is a potential role for the government here, because market failure is involved. ‘Normalcy’ does not mean a restoration of the insanity of the 3 or 4 years before August 2007.  That was a housing price bubble compounded by a housing finance orgy, in which every principle of sound lending was forgotten or declared irrelevant.  A restoration of home lending activity to perhaps 50 percent of its level in the first half of 2007 is all that I hope for.  This means a sharp contraction in the scale of the financial and related service sectors involved in residential mortgage financing.  Balance sheets, profits and jobs will shrink radically.  There will be insolvencies, mergers and other defensive consolidations.  Both the residential mortgage finance sector and the other residential real estate service sectors (estate agents, surveyors etc.) will be decimated.  This is unavoidable and overdue.  Government intervention should not try to slow down or limit the necessary contraction of these sectors.

The Bank of England is not necessary to operate the SLS or an SLS+

But the virtual cessation of all securitisation of residential mortgages is a clear anomaly and an example of market failure.  The Bank of England has managed the Special Liquidity Scheme, swapping liquid Treasury Bills for residential mortgage backed securities (RMBS), other asset-backed securities (ABS) and covered bonds (collateralised bonds) since the end of April 2008.  It only accepts securities backed by mortgages originated before 2oo8 as collateral in these swaps.  That’s better than nothing but does not address the problem that since the summer of 2007, there have been only two private issues of RMBS in the UK – way below any reasonable estimate of the fundamental demand for such sources of finance.

The Bank of England does not want to become the lender of first resort to the residential mortgage lending industry.  It is rightly afraid of crowding out normal, market-based securitisation of residential mortgages if if were to accept new mortgages (originated after December 31, 2007) as collateral at the SLS.  This makes no sense, if the Bank considers, with an open mind, the straightforward ways to mitigate or even eliminate these risks.

The Bank of England could insist that any new mortgages acceptable at the SLS (or acceptable as collateral in its other repo operations) satisfy stringent creditworthiness criteria.  Examples are a low maximum loan-to-value ratio; thorough income- and financial strength verification of the borrowers; no history of debt default or impairment etc..  In addition, the Bank of England could value even these ‘gold standard’ mortgages aggressively or even punitively, say by organising reverse auctions for them if they are illiquid.  Tough haircuts (discounts) imposed on the valuations of these mortgages (RMBS) if offered as collateral would further discourage the use of the SLS as a ‘soft’ source of funds.

Not only does the Bank of England not wish to extend the SLS to securities backed by residential mortgages originated since December 2008, it has (in public statements of the Govenor) suggested that it will effectively close the existing SLS (restricted to RMBS backed by residential mortgages originated before December 31, 2007) to new business by October 2008.  Unless the market for RMBS backed by new mortgages has perked up significantly by October 2008, this would be a dereliction of duty by the state.

The government could, I believe, overrule the Bank of England on this matter, and instruct it to keep the existing SLS open for new customers – and even to extend the SLS to RMBS backed by new mortgages.  This would not interfere with the Bank of England’s independence as regards the setting of Bank Rate.  The Bank of England Act does not make the Bank of England independent as regards the design and implementation of liquidity management.

It would, however, be preferable for the government to take the SLS off the Bank of England’s hands and operate the scheme itself.  After all, the SLS offers Treasury Bills in exchange for a range of (possibly illiquid) collateral.  What better agency for providing the liquid Treasury Bills than the Treasury itself?  The Bank of England is just a middleman in the provision of liquidity through the SLS.  It is a, fundamentally redundant, agent of the Treasury.  The task of managing the SLS could be performed equally well (with some intelligent recruitment and secondments) by the UK Debt Management Office (DMO), which is part of the Treasury and would effectively be transformed into a UK (Sovereign) Portfolio Management Office.

Once the SLS has been transferred to the DMO (with its assets and liabilities on the balance sheet of the Treasury), the new UK Sovereign Portfolio Management Office could extend the scope of the SLS to include RMBS backed by ‘gold standard’ residential mortgages originated after December 31, 2007.

Mortgage Guarantees

Guaranteeing mortgages would not remedy an obvious market failure, except possibly for long-maturity (25-ear or over) fixed rate residential mortgages. If it were to be done at all, it should be done on-budget and on-balance sheet by the Treasury, not through pseudo-private but implicitly publicly guaranteed hybrid monstrosities like Fannie Mae and Freddie Mac in the US.

Fannie May and Freddie Mac purchase and guarantee trillions of US dollars worth of residential mortgages.  They are public sector sheep masquerading in private sector wolves’ clothing, as Federally Chartered but privately owned companies.  The implicit federal government guarantee of their borrowing allows these Government-Sponsored Enterprises (GSEs) to borrow on much more favourable terms than honest private companies.  The resulting rents are distributed between the shareholders, the management and the mortgage borrowers they subsidise.  The actual and contingent liabilities of the two GSEs are kept off the federal government’s balance sheet, because these entities don’t benefit from a de jure federal government guarantee. The result is a couple of massive economic and financial whorehouses: opaque, unaccountable, inefficient and distortionary, with astounding lobbying power.

If the UK government were to guarantee any residential mortgages at all (and the case for such guarantees is by no means clear), it should be done openly and transparently by the UK Treasry, on-budget and on-balance sheet.   Only is this way can there be a proper accounting for the use of public money – tax payers’ money.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website