The trouble with interest-only mortgages

You could walk up to a guy with a spider’s web tattooed on his neck and offer an unsolicited critique on his selection of face studs, or you could invest in property; in either case, the result will be painful. 

Right now, the world economy is like Wile E. Coyote when he’s just chased Road Runner off a cliff; only his disbelief keeps him hovering, defying gravity itself.

After the 9/11 terrorist attacks, US Federal Reserve chairman, Alan Greenspan, flooded the world with money and the UK followed suit. This may have been a decent strategy at a time when the world economy was under threat and they reckoned stuffing loot into our pockets would take our minds off the bogey man; but they forgot to turn off the tap.

Almost six years later, our central banks are still pumping vats of cash into our economies. These massive levels of liquidity are laundered via that gargantuan money-creation scheme known as the property/mortgage market.

Of course, many people would say I’m completely wrong about all of this. In fact, it’s really only me showing my ignorance. Take, for example, the good folks at the recent “Great Housing Debate“, run by PR consultancy Wrigglesworth. “House prices look set to continue to rise at an unstoppable rate for the foreseeable future, experts have said.”

That headline on aboutproperty.co.uk put paid to my ropey theories all right.
 
But, not content with foreseeing the foreseeable future, aboutproperty went on. “At the Great Housing Debate… lenders, economists and housing industry experts agreed without major economic decline house prices would keep rising.”

They continue: “‘A serious correction in the housing market traditionally occurs as a result of a sharp economic downturn, which looks extremely unlikely. It would take a reversal in recent increases of income multiples or a considerable tightening in lending criteria by banks, for there to be a serious downturn in prices,’ commented Nigel Terrington, Paragon Mortgages chief executive.”

Don’t you just love the property market? It never goes down, it always goes up forever.

The chaps at “The Great Housing Debate” even had a proper expert to explain it all. “Our expert, David Miles, Chief economist at Morgan Stanley said: ‘Public expectations regarding house price growth is key to the market’s stability. Growth would need to fall successively for a number of months before peoples’ expectations, and therefore prices, were seriously impacted.’”

And finally, just in case we didn’t get it, they finished with a bit of financial voodoo: “…experts also agreed keeping homes affordable would be down to offering mortgages with more income multiples. ‘Focusing on income multiples alone is not helpful – they must be considered instead in the context of affordability,’ said Michael Coogan, director general of the Council of Mortgage Lenders. He added ‘income multiples of six or seven could be a possibility in future.’”

So, what they’re saying, in other words, is that the price of a home itself has become irrelevant in the property market as long as the means exists to match it. That doesn’t seem a sustainable basis for rising prices – but then what do I know?

Our friend from Morgan Stanley is spot on about one thing: buyer sentiment – let’s call it the Coyote effect – is all that’s levitating the property market. There’s no chance at all that legislation will be put in place to curb the enthusiasm of bankers; multiples will continue to rise and lax lending standards will persist until bad debts overtake profits and the whole house of cards is revealed.

When I stare into the sheep’s entrails in front of me I see over a thousand City wags awarding themselves over a million pounds apiece in bonuses for being so clever. I see central banks pumping massive liquidity into a war-torn world where the price of oil can go into the sky and beyond without apparently affecting inflation. I see a media that believes it’s reporting on the property market when it provides a daily platform for vested interests to talk it up.

It’s as if all the problems in the world are hidden under a great pile of money. Homeowners are rich! The meek have indeed inherited the earth. Where do I sign?

Because our political and financial betters refuse to let the air out slowly (it’s hard to pull your snout out of the trough when things are good) they will make the market crash, as they always do; for a market in economic equilibrium is hard to make windfall profits out of. Only by whipping markets into a crazed frenzy can exceptional profits be made with relatively little effort.

All of the arguments about houses having more intrinsic value than say for example, tulip bulbs or domain names are true. People need a place to live, bricks and mortar and all that. But when the money supply starts to falter, and it surely will, all hell will break loose and the little people will find that they aren’t rich after all. The money they thought they had will evaporate into last year’s City bonuses and someone else’s villa in Estonia. Some could save themselves by selling-to-rent now; but they won’t.

Every time there’s a crash of any kind in any market the professionals spend a lot of time whining that the amateurs are the ones who are spooked into selling. This is not and has never been true. The little people, unversed in the vagaries of high finance, always try to stick it out. This time it will be the same.

Mervyn King, the Bank of England governor said earlier this year (with the consumer price index (CPI) bursting from its corset at 3.1% and the retail price index (RPI) at 4.8%, both in an uptrend) that he expected inflation to ease back later this year. But he also said, in the Bank of England inflation report published a mere six months ago, that he expected inflation to ‘drop back’ to ‘target rates’ (2%) by mid-2007 (so he’s already out by around 50% on his previous ‘expectation’). And now he’s one of the ones pushing hardest for rate hikes.

There are only two blunt monetary instruments economies can use to ‘control’ inflation. They can raise interest rates to try to make the currency more attractive to hold, or they can plug up or throttle back on the money supply, thereby increasing the perceived value of the money already in circulation. But while the Bank of England has raised interest rates incrementally, the cash is still gushing forth along the river M4. (M4 is the sum of all money in circulation in the UK plus bank and building society accounts: our collective wad, if you will.)

And as long as the money supply keeps raging forth a significant subset of the working population, choking on cheap money, will hold onto their “Naked Options” (because this is what interest-only mortgages are, as I‘ll explain in a moment) to the death in the belief that they’re trying to save their homes. But many never had homes to save in the first place. It was all smoke and mirrors. They borrowed to buy one of the riskiest financial instruments yet conceived in the belief they were actually buying property. They were not. But they don’t know that… yet.

What am I on about? Surely, as anyone will tell you, an interest-only mortgage is a simple loan. It’s not the kind of esoteric financial instrument that, mishandled, could rip through the world economy like a cluster bomb. You just go down to the local estate agent or bank or broker or ice cream shop or one of 8,000 or more ‘sources of capital’ who will smile at you like a potential life partner, do a deal and you pay amount X every month for Y years. Nothing complicated about that, is there?

Well, actually there is. An interest-only mortgage carries with it the possibility of at least two sources of serious trouble. Both interest rates and the underlying house price can potentially bite you in the backside. And the proliferation of such mortgages represents a real threat to the financial system.

Even if you can get an impossibly low interest rate (Rl) and unbelievable multiples (Mh) so that you can afford the half million or so for that trendy, ex-council two-bed in Clapham (whoops; Tooting), the chances are that this low interest rate requires a low-inflation environment (in which to exist). So in other words, when the time comes to actually pay for the house at the end of the mortgage, the ‘principle’ (P) will be high in real (adjusted for inflation) terms. In other words, if your payments have stayed low, the end result will be an unaffordable bill to pay for the actual house itself.

If, on the other hand, interest rates head on upwards (Ru), the real value of the principal (at the ‘end’ of the mortgage) will be easier to meet (inflationary erosion and all that). But the mortgagee may feel as regretful as a dog when their actual monthly mortgage payments stay in the sky long enough to strip them of possibly everything they own. So, in this twisted economic world of mine high is bad and low is bad. But how can that be?

Well, here’s the answer: go down to the City of London or Wall Street and ask someone in a suit whether borrowing serious multiples of your projected pre-tax income to bet on a single investment idea is a viable strategy and they might ask how you escaped from the head-trauma ward.

Pumping vats of liquidity into the world financial system is more like religion than economics. It is the end result of a theory that believes economic expansion is something we can control by constantly expanding. And we can, if by control we mean keep it going until we can’t keep it going anymore (which seems to be what our pals at the Great Housing Debate think).

There is a yawning gulf between the knowledge required to understand interest-only mortgages and the knowledge of actual home buyers. Most people, even if they studied for years, couldn’t care less anyway; which is why they’re easy to sell in the first place. Putting these things in our hands is the equivalent of putting Homer Simpson in charge of a nuclear power station: Mostly, it’ll be okay. We might never see a meltdown at all if our luck holds out; but that would be extremely unlikely. Credit simply cannot expand indefinitely. There’s no need to foresee anything at all to understand that it’s all just a matter of time.

This is not about foreseeing the future; which is not possible, no matter the language within which such claims are couched nor the status sphere within which such claims are made.

It is about inevitabilities.

 

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