Have banks been hiding their losses?
- 27 June 2011
- From the section Business
You may think that there is not much for which we should thank banks at the moment.
But it is striking that in the Great Recession of 2008-9, they put fewer businesses into insolvency under administration procedures and turfed fewer individuals out of their homes for failing to keep up payments on mortgages than might have been expected from their behaviour in previous recessions.
They engaged in what bankers call forbearance - which is to vary the terms of a loan, when a borrower can't keep up the payments or breaches the conditions, rather than pulling the rug.
So, for example, in the case of mortgages where a borrower is at risk of falling behind on the payments, banks have frequently moved borrowers on to an interest-only basis, to reduce the size of payments.
And where the security of property underpinning a large commercial loan has fallen below a covenanted minimum, banks have resisted the temptation to seize control of the property - if they felt there was a chance the borrower could trade his or her way through the downturn.
To be clear, banks' help for struggling borrowers wasn't motivated exclusively by altruism. You'll remember they were under enormous political pressure not to evict families or contribute more than strictly necessary to rising unemployment.
And at a time when they were incurring enormous losses on loans and investments that were conspicuously beyond redemption, their reluctance to call in loans on borderline cases protected their own balance sheets and profit-and-loss accounts from even more savage damage than they were suffering in any case.
Putting off the pain?
There have in fact been widespread allegations that banks used forbearance techniques to disguise the full hideous scale of their reckless lending in the boom years.
So the question has been for some time whether this rise in forbearance was pain eliminated or merely pain postponed.
I've mentioned here before that the private-equity pioneer, Jon Moulton, has been arguing for well over a year that the incredibly low relative rate of corporate collapses in the past recession was a temporary phenomenon.
His view has been that insolvencies were bound to rise sharply, as evidence accumulated that the revenues of overstretched businesses were not bouncing back with a vengeance.
What's more, the prospect that interest rates and mortgage rates will increase at some indeterminate point - and when unemployment remains resolutely high - means that there is a significant risk that a growing number of households will fall behind on payments.
That would increase losses for banks, because the collateral underpinning the mortgages, the value of houses, has been softening.
Here is one way of seeing the risks: because of the explosion in lending to households in the years running up to the crash of 2007-8, the Bank of England's official rate would only have to rise to a historically modest 5% for households' interest payments to capture 14% of their disposal income - which is more than double what they are current shelling out in interest.
Think about how strapped for cash many households feel right now to appreciate how large would be the blow to consumer spending - and the strength of the economic recovery - from a precipitate rise in interest rates.
So how big are the dangers for banks that their past forbearance will come back and bite them, in the form of higher losses on loans going bad during the coming two or three years than would otherwise have been the case?
Well the Financial Services Authority, the soon-to-be culled City watchdog, has done some initial probing of this issue but doesn't have a precise answer.
Which is why the new Financial Policy Committee (FPC) of the Bank of England, set up by the Treasury to monitor and contain risks of this sort, has asked the FSA to gather more information that would allow an informed judgement of whether our banks have sufficient capital to absorb potential losses from loans to borrowers who have been helped by forbearance but have never got back on their feet.
The scale of the problem could be pretty big, according to an analysis by the Bank of England contained in its latest Financial Stability Review.
Here are a few choice statistics:
1) The Bank of England estimates that up to 12% of UK residential mortgages could be receiving some kind of forbearance or special help from banks at present.
2) A report by the Property Industry Alliance suggests that around 80% of loans to commercial property businesses made since 2004 may be in breach of their Loan-to-Value covenant, though - for all the woes of commercial property companies - only fraction of these have been declared in default, with the banks preferring instead to extend maturities by between one and three years (according to research by De Montford University). So the Bank of England says that around a third of all UK commercial property lending could be receiving some kind of forbearance.
3) And the Bank of England seems to corroborate Mr Moulton's view when it says that "contacts suggest that forbearance is one reason why corporate default rates in the United Kingdom have remained low relative to past recessions".
The great fear of the FPC is that banks, when engaging in forbearance practices - when extending maturities or moving repayments on to an interest-only basis - haven't been making adequate provisions to cover the risk of future losses.
Which would mean that if these loans were to go bad on a significant scale, the capital resources of banks would be severely reduced - which in a best case would curb their ability to provide credit at this time of fragile economic recovery and in a worst case would undermine the confidence of their creditors and threaten their viability.
Right now there doesn't appear to be evidence that any of our banks is at serious risk of collapse from past forbearance.
But the pace of their rehabilitation could well be set back if - for example - it becomes clear that those over-stretched borrowers put on to interest-only plans will never be able to afford the principal payments, or if a spate of consumer-facing businesses with extended maturities on loans suddenly tell the banks that there's no chance of paying down the debt at a time of pronounced high-street weakness.
As the FT pointed out this morning, there is a chart in the Bank of England's latest Financial Stability Review (chart 2.22 on page 28) which shows that Lloyds may face the biggest potential hit of all the big banks if the housing market were to continue in the doldrums for months and years.
According to the Bank of England, about 28% of Lloyds' domestic secured debt - most of which is presumably its UK residential mortgages - has a loan-value-ratio of more than 90%.
Or to put it another way, borrowers accounting for well over a quarter of Lloyds' mortgages have only a sliver of equity left in their houses to cushion them and to cushion Lloyds, if the worst comes to the worst and the banks takes possession of the property.
By contrast, for RBS and Santander, the proportion of their mortgage books with 90% or more loan-to-value ratios is nearer 10%, and for Nationwide, Barclays and HSBC it is a bit less than that.
One conclusion is that Lloyds' battle to return to full health will be longer and more arduous than its new chief executive, Antonio Horta-Orsorio, may have thought when he took the job a few months ago.
And another, more important conclusion is that, unless there is a sudden rebound in economic growth - and right now there is no sign of that - banks' past tolerance of borrowers running into difficulties may come back to haunt them and all of us.
If banks face a sudden increase in losses on loans where they've shown forbearance, their ability and appetite to provide new credit could be significantly impaired.