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America Sneezes, Britain dies of Pnuemonia?

Read any Newspaper and there are articles canting on about greedy banks, which just because they have lost money on sub-prime mortgages in America, are trying to get it back off similar cases over here by pushing up interest rates. Well let’s not let the truth get in the way of a good story.

I hope to clear some of the fog.

If we think of the scale of lending over here, it is fair to realise that to lend money, banks also need money. The clearing banks and building societies, as well as other institutions, take deposits from savers and have access to this money for lending. These organisations have to be licensed to do this. Lending organisations also raise money in the money markets by a process known as securitisation. Securitisation is a method of raising finance secured on the back of identifiable and predictable cash flows derived from a particular set of assets – that’s clear isn’t it? Essentially this means the pooling together of similar loans (e.g., mortgages) into standardised bonds, or mortgage-backed bonds. These bonds use the interest paid on the underlying loans to pay interest to the bondholders. Put simply investors buy bonds, issued by lenders, backed by mortgages that have already completed. The interest payments paid by the borrowers then fund the interest payments to the bondholders and hey presto you have the money to lend again. The bank makes a profit by charging a margin over what it pays to bondholders.

Given this arrangement, it follows that those lenders dependant upon this method of raising cash must continually securitise to continue trading. Investors in bonds are predominantly investment banks. These banks (like any investor) want a reasonable return for their investment according to the type of risk they are undertaking. It is axiomatic that the greater the risk the greater must be the return.

I reckon it might be useful if I explain a little about what these terms actually mean. A sub-prime or a non-status borrower is one that ordinarily a prime lender (e.g. Barclays Bank) will not lend to, due to an adverse financial status or history. An adverse financial status might be due to mortgage or other loan arrears, the existence of court judgments and defaults against the borrower, bankruptcy or those in voluntary arrangements, the need to self-certify income, or a combination of these things.

Way back when, the market for this type of borrower over here was very limited and accordingly rates were very high and loan terms unattractive and the lenders tended to be those of last resort.

It was American money coming in, that made the market what it is today and we have found that interest rates have dropped dramatically so that the rates and terms available from many sub-prime lenders are not materially different from prime lenders. These lower rates were only offered because the rates paid to bondholders were relatively cheap. So, before we criticize the bank’s and the US too much, we should bear in mind that were it not for many of the American investment banks, (that the press are now so quick to flog with a bull whip) there would not be the market there is today; and many a borrower would be faced with rates of interest and terms considerably harsher than they are. That’s if they could get a loan at all.

In recent years, as a company, we have found that we can often beat the clearing banks on the rates on loans we arrange in the rural sector, so I rest my case.

What has happened in the market over here is typical of a market that is in its mature stage. We can see that there were fewer lenders in the old days but when the American money came in, lenders became more numerous with many getting on to the band wagon so that the only way these lenders could get business was to lower rates and/or become more flexible with the sort of situation they were lending in. As a result, rates lowered, the size of loans went up and the loan to values (i.e. the size of the loan as a percentage of the security value) went up. Now unless I am missing something here, this was all good news for borrowers but not so according to the press who say this is all down to the irresponsibility of lenders, lending to folk who have no means of paying back these loans. Clearly, the press must have trawled through a number of lenders’ loan books to establish just how many of these good people have defaulted under these loans. Then they have doubtless compared this to the level of performance to be found within prime lenders – somehow I don’t think so. Remember, sensationalism sells newspapers.

Any road up, because lenders have been more generous, particularly with loan to values, this has resulted in an increased risk to bondholders. In some cases, lenders have been lending at very high loan to values and have continued to peddle their bonds to the Investment Banks to securitise. The investment banks therefore, were being paid the same rates for their purchased bonds but with increased risk. In America, the housing market has seen difficulty and prices have fallen meaning a further reduction in security backing up the bonds bought by investors. There is no doubt that the lending policies over in the US have made this worse with the result that security values have fallen below bond values and lenders and investment banks have lost money and when we talk about money I do mean serious money. This is not to say that this will happen over here since the credit market is already over-regulated, the property market remains strong, and the good news is that, in the rural sector, land values keep going up. Moreover, the market in America is at a more advanced stage than over here, with an over supply of credit and the basic laws of economics are coming to the fore to force a market adjustment. In my opinion, we may feel grateful that the adjustment over here will happen before it has a negative impact on the British economy. Accordingly, lenders are increasing their rates though the other good news is that some aren’t and others are only marginally and we know whom these guys are – so call us if you want the best deal.

The immediate inclination then, is to suggest that lenders have put up rates over here to help recover losses in the US, which is simply not true. The facts are that investment banks are more cautious about risk and to encourage them to buy bonds over here, a higher rate of return has to be offered to them. In some cases, lenders like Northern Rock, which is heavily dependant upon the money markets, has been unable to find funds in the markets at all which is why the Bank of England has stepped in to offer a line of credit so that it can keep trading. If we think about the logic of all this, it cannot be right to offer an investor the same return for a higher risk – would you buy these bonds in such circumstances? Answers on a postcard please, but the answer has to be no. You might consider the increased risks but expect a higher return and that is what the bond investors are now doing. We have to bear in mind that most of the proper sub-prime lenders only make their money out of lending money perhaps unlike the household name banks, which can also flog an insurance policy, sell a pension or charge you for the privilege of a bank overdraft. Therefore, it goes without saying that the increased cost of raising money to lend has to be passed on. I don’t expect even the press to expect lenders to trade at a loss.

Let us reprise the sight of all those impecunious folk standing in a queue to get their money out of Northern Rock – nothing has been seen since the Weimar republic in Germany, after the Great War, when inflation was so rife that a shopper went to buy butter with cash in a wheel barrow only to find the price had already gone up. If the same happened here, we’d be taking cash in a trailer for a gallon (or is it c4.5 litres these days) of petrol. This is what the press would have us compare this ‘crisis’ with.

The cynics may say that the banks have been irresponsible for being so flexible. They have only been so flexible because there has been a demand for such flexibility. Let us all bear in mind that we live in a country where things are so damned expensive that it could be argued that access to credit is the only way things in the economy can work. Lest we forget, that people borrow for all sorts of reasons and if they didn’t, a house may not be sold (with stamp duty land tax to HM Government), small traders may not get business for, say, home improvements (with VAT and income and corporation tax for HM Government), and things would not be purchased (with VAT and income and corporation tax for HM Government). House prices may not be so high (with stamp duty land tax and increased inheritance taxes for HM Government). And if people were not, for example, buying ipods and Sony, then Apple and Sony or their stockists would not advertise; in amongst other places Newspapers.

So let us not be too hasty to criticize. We are I believe, despite heinous interference and red tape from HM Government, a capitalist country. Were it not for capitalism we would not have had the massive developments we have had in terms of flight, transport, medicine and a whole load of other things. Drug companies come up with cures for illnesses only because there is a market for their products and it is this market concept that will see us through – the market will come up with a solution to climate change because it has to find an alternative to fossil fuels because these are running out and necessity is the mother of invention.

The market will also find the solution to the current so called credit ‘crisis’ because it has to – in everything there is equilibrium. There is a saying that if you think you can or think you can’t you’re right. If the brain is a bio-computer, then it will respond to whatever negatives or positives fed into it. So the press scream ‘crisis’ or ‘recession’ and many think there is one when really there isn’t but because they think there is one it becomes a self-fulfilling prophecy. Remember the epitaph on the hypochondriac’s gravestone – “I told you I was ill”.

In the end, it’s still a good time to borrow so call us.

Mark Bracegirdle FCCA FMAAT

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