Forever growing bubbles
The UK may be on the way to making periodic property busts history. A senior executive at the Bank of England said on Oct. 19 the regulator would take forward a property sector proposal to encourage responsible lending. It’s a welcome outbreak of common sense.
The normal practice is for gung-ho banks to set a maximum ratio of the loan to the value of the property (LTV). The value is always the current market value. That can bring risks when prices are rising. Higher prices bring down LTVs, so banks consider ever larger loans to be safe.
When prices fall, apparently safe LTVs can prove toxic. A 25 percent fall in market value is not extraordinary after a boom, and is enough to wipe out the entire reserve on a cautious 75 percent LTV.
That was the LTV on a group of U.S. commercial mortgages studied by Moody’s. They were written from 2002 to 2007, as property prices boomed. Losses ranged from 2 percent to nearly 20 percent. The assumptions on rental cashflows did not change much. But over-bullish investors increasingly overvalued those cashflows.
The BoE wants to make the collateral valuation more stable. One way to do this, according to a commercial property think tank chaired by Grosvenor Group Finance Director Nick Scarles, would be to value the collateral over a longer period of time, based on rental cashflows and consistent discount rates. The collateral value would rise with rents, not with open market prices.
The method should work fairly easily for commercial property, which is mostly rented out. Residential property is more of a challenge in the UK, where the rental and purchase markets are quite separate. Besides, many politicians like high-LTV lending, because it allows poorer people to own their residences.
Still, the BoE has a responsibility to protect financial stability, and property markets are probably the largest threat. It is right to work on the Scarles group ideas, even if at this stage it’s pushing them via disclosure rather than edict. Anything that further eases the UK obsession with galloping property values is worth a try.