One of our most treasured documents is an article written by P. Henry Mueller when he was Chairman of the Credit Policy Committee at Citibank in 1978. His article which was based on a talk that he gave to the eighth Annual Meeting of the Financial Management Association in Minneapolis, was about the basic principles that should apply to bank lending, its title was "What Every Lending Officer Should Know About Economics".
The lack of applied knowledge about the lending/business cycle link can, he then said, be traced to both the manner in which current lending practice has evolved and to the widespread failure of borrowers and lenders to appreciate fully that business decisions, which they make or do not make, are in themselves economic forecasts.
The key to sound lending is perceiving and understanding risk and protecting against it. Having a grasp of the business cycle is fundamental and yet, it seems that in 2006 the market although much cleverer is not much wiser than it was thirty-years ago. Let's consider what is happening in the UK mortgage market as demonstrated by the Kensington Group (click here for a free company report). We can then go back to Mr Mueller's article and maybe glean a key insight.
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Mortgage lender case study: Kensington Group
The Kensington Group's business is mortgage lending to customers with patchy credit records. Sound lending principles, according to Mr Mueller, should be thorough evaluation of the borrower's honesty, integrity, viability, competence and ability to complete a loan transaction in the manner proposed plus a determination as to whether or not the transaction is feasible, economically and technically, and free from inordinate risk. Kensington obviously don't agree because they knowingly lend to borrowers with a bad credit history.
In our view, the reason Kensington has prospered so far is not because of their risk management, it's just that the assets used for security have enjoyed above average appreciation in value. In addition, the credit markets have been easy so that borrowers who previously failed, did not fail in the new environment, they could if need be borrow using credit cards and overdrafts to keep mortgage payments up-to-date. So as long as the property market goes up, the net worth of the previously troubled borrower gets better, even though he might continue to live beyond his means and part finance his mortgage payments with additional borrowings. Kensington's historic profitability could not have been better. Above average interest rates were charged because of the higher risk, that higher risk evaporates as the margin of security improves. The good outcome, however, is more a consequence of random market conditions than good business practice.
Why exposure to risk is on the increase
Over time some interesting developments occur. Firstly, for loans made several years ago; many of those borrowers have now got exemplary records and can refinance away from Kensington at lower rates. At the same time, new business coming on the books is arriving at a time when the property market may not be set for further years of stellar growth. Subtly, Kensington's exposure to risk has increased!
In March this year Kensington's share price was 1210p, the latest price is 726p, a very considerable fall. On the surface, one might think that the business is troubled with defaulting borrowers but that is not yet the case, although we are sure it will eventually happen. No, what has happened is that other banks see Kensington's market as an attractive profitable business and are coming in charging much lower rates than Kensington. Now we have a recipe for disaster. Five, even three, years ago the property market had plenty of potential to the upside. We find it hard to believe that one can look at the UK property market today and expect the same considerable upside. Furthermore, we know that the credit squeeze is on, it was recently reported that Barclaycard are refusing more than half of all applications, so the ability to finance future debt with additional debt will become more difficult.
Mr Mueller, in his article, included a table depicting how borrowers and lenders behave over the cycle. The penultimate stage of the business cycle is the boom when the borrower's optimism mounts. The lender's behaviour at this point is described as "Susceptibility to euphoria and loss of perspective as to what constitutes a good credit. Mania for growth - going down-market to get it." This is exactly what Kensington's new competitors are doing.
Mueller said business decisions that are made or not made are in themselves economic forecasts; in which case, Kensington's competitors, by going down market for growth, are unwittingly forecasting an economic crunch, the final stage in the business cycle.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/
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