Thursday, 30 October 2014

Economic Myths: Repayments of principal and interest

Banks are primarily balance sheet exercises. When they grant somebody a mortgage to buy land, they just 'split the zero' into an asset (the loan out) and a liability (the money which the vendor gets credited to his deposit account). This is about eighty per cent of all banks' assets and liabilities.

The banks then have to show that the value of their assets (mortgage principal) exceeds the value of their liabilities (all the deposits). As we will see, this is actually irrelevant.

(The banks then make real profits by charging mortgage borrowers more than they pay depositors. So really they are just being paid to act as debt collection/risk pooling agents for people who have sold land.)

Most mortgages are based on the borrower paying a fixed total amount in interest and repayments of principal for the next twenty-plus years. Once a loan has been granted, this is all that really matters to the borrower and this is all the bank really cares about as well.

So for example, you borrow £100,000 for 4% fixed over 25 years, your monthly repayments are £533. You get statements at the end of each year showing that the amount of principal is going down, which is nice, but pretty irrelevant. What really matters is how many more years to go.

But you can work backwards from the £533. It doesn't actually make any difference whether that is a £100,000 loan at 4%, a £75,000 loan at 6.9% or a £50,000 loan at 12.1%.

Which is why I can't take the whole concept of negative equity and the corresponding 'threat tio the health of the UK banking sector' seriously. Psychologically, it can't be a nice position to be in, and it only really matters if you want to move home (apparently a lot of banks allow you to 'port' negative equity anyway).

So if you have a £100,000 mortgage @ 4% on a home 'worth' only £75,000, all the bank would have to do is write the mortgage down to £75,000 and increase the interest rate to 6.9%. That's you out of nequity.

Although the bank's balance sheet would look a bit weird (liabilities now exceed assets), it doesn't actually make any difference to anything in the real world.


Dinero said...

Actually the balance sheet would be OK in some respects, because the value of the assets includes the value of the capitilised interest, which is now incresed, although there would still be some mark to market reduction from the diminished physical collateral. Its a good observation, some people might actually prefer that arrangement, but it would need to be binding and include an appropriate repayment calulation for repayment during the term.

Bayard said...

AFAICS, the main 'threat to the health of the UK banking sector' is that the borrower in nequity can just post the keys to the bank and walk away, as did the previous owner of one of the houses I have lived in.

Mark Wadsworth said...

Din, yes, the bank would have to impose stiff early repayment penalties to break even, but this is all do-able, isn't it?

B, we've done that, it's no bloody threat whatsoever.

Even if house prices fell by half and every borrower in nequity walked away and refused to pay another penny (two very highly unlikely assumptions), then banks would only lose about 15% of their real net assets or about 5% of what they claim are their total assets.

That's nothing which debt-for-equity swaps can't sort out over the weekend.

Graeme said...

In the US it is a whole lot easier to walk out on a property under does not seem to matter that much

Steven_L said...

Aren't there rules on early repayment penalties / hasn't it it been subject to litigation.

Even if there weren't rules, the Financial Ombudsman Service can change the goalposts whenever it wants and decide something is 'unfair'.

Lola said...

SL. The FOS is appallingly activist. It uses hindsight judgement, and, well I cannot put is any other way, lies.

You have to remember that the FSMA2000 was deliberately configured to ensure that all these functionaries can do what they like without any fear of accountability.

However, that doesn't mean that MW's idea could be stopped by the FOS, if the TSC got behind it.

Apropos this, just been to a round table meeting with the FCA about whistleblowing. They are putting this obligation on banks as part of the 'work' they are doing following the publication of the Report of the Parliamentary Commission Banking Standards. (They are looking at whether they need to extend the same whistleblowing rules to micro sized FS businesses like mine). The thing is that the Report does not correctly, or perhaps fully, analyse the reasons behind the bank failures and only recommends more bureaucratic intervention. It says nothing about ideas like MW's as possible solutions. Nor does it analyse the fundamental instability of the current, officially sanctioned model, of FRB.

Most of the stability and neg equity / balance sheet issues can be sorted with ideas like MW's without any new reg-yew-lay-shuns.

Bayard said...

"B, we've done that, it's no bloody threat whatsoever."

In the grand scheme of things, of course it isn't, but it is if you are a banker and you've got your bonus to think about who do you thing is actually doing the wailing about "threat to the health of the UK banking sector"?

Every time a report, publication, article, television programme etc is produced, somebody somewhere has paid for it to be produced and the cynic in me says that 99 times out of 100, that somebody stands to gain from what is being recommended by it. See also APD above.