Are banks taking dangerous mortgage risks?

 
Lloyds bank sign

After we learned in 2007 and 2008 that banks in general had far too little capital as a protection against losses on their loans and investments, you would probably think that by now it would be difficult to find examples of banks continuing to lend several hundred times the sums they hold in reserves to protect depositors and taxpayers against the risk of picking up the bill when borrowers default.

You might think that, but according to the banking team at Morgan Stanley you would be wrong.

In gripping and slightly alarming research published this morning, Morgan Stanley cites £143bn of high quality mortgages on the books of Lloyds - and it calculates that Lloyds holds just £314m of capital against the specific risk of these mortgages going bad.

In other words, Lloyds seems to have lent 455 times the value of the capital earmarked in its balance sheet to absorb losses, just in case these mortgages go bad. To put this in another way, just 0.2% of these mortgages would have to go bad for this capital to be wiped out.

Now Lloyds may be right that these really are the most succulent and prime of loans, where the probability of them going bad really is more or less zero.

But history, especially recent history, would probably remind us that by the time a bank has lent £143bn to any sector, the idea that there is a negligible risk of default is naive (at best).

The important question, however, may be how it is that Lloyds and the other big banks are allowed to lend such large multiples of their protective capital in the form of mortgages?

It is all down to our old friend, the Basel Rules, which attach risk-weights to different categories of loans. And in this instance, the culprit (if that is the right word) is the permission that was given under so-called Basel ll to the biggest banks to use their own internal risk models to determine the riskiness of categories of loans and - by implication - the amount of capital they need to hold as a protection against the souring of those loans.

The role of regulators, in this system, was to approve the risk models. But once that had been done, banks had discretion to decide the riskiness of different kinds of loans. And what won't surprise you is that banks' model all came to the conclusion that their own mortgages were significantly less risky than the standard Basel rules implied.

Just to remind you (needless I am sure), the current convention is that banks need in general to hold equity capital equivalent to around 10% of their loans. But this is not 10% of their gross loans and investments, but 10% of their loans adjusted for the putative riskiness of said loans.

So, for example, if all loans were perceived to be equally risky, then Lloyds would have to hold equity capital equal to 10% of that £143bn portfolio of high quality mortgages, or £14.3bn. But Lloyds believes that the probability of these loans going bad is negligible, as I have already mentioned, so its own regulator-approved risk model attaches a risk weight to the loans of 2.2%.

In other words, Lloyds - with the support of the Financial Services Authority - says that the risk-weighted value of these loans is just £3.14bn, and therefore it holds capital equivalent to 10% of that low number as a buffer to absorb losses on the entire £143bn gross value.

If you were to think that is slightly bonkers, you might not be alone.

Now this freedom given to banks to decide their own risk ratings, or what is known as the Internal Ratings Based Approach to determining capital, yields the following consequence for our biggest banks: they all hold relatively modest amounts of capital against their large books of mortgages.

So Lloyds, for example, attaches a risk weight of 16% on average against its entire book of mortgages. And in case you think Lloyds is being singled out as somehow taking an unusually optimistic view of the risk of mortgages going bad, that would be wrong.

According to Morgan Stanley, HSBC, Barclays, Santander and Nationwide all take a rosier view than Lloyds of the likelihood of default by homeowners. They respectively attach risk weights to their mortgage books of 15%, 15%, 14% and 11%. Only RBS, for reasons that are unclear, uses a much higher risk weight of 27% on its mortgage book.

Just to repeat, what that would mean is that when Nationwide, for example, lends £100,000, it attaches a risk-weighted value to that loan of £11,000 - and then holds capital equivalent to 10% of that £11,000, or £1100, to cover the danger of that loan going bad. Which would imply that Nationwide is frequently lending not far off 100 times the value of its capital.

Now the reason Morgan Stanley has been taking a keen interest in all of this is because of the noises coming out of the Financial Policy Committee - the new macro regulatory arm of the Bank of England currently working in an informal capacity but soon to have statutory powers - that the capital banks hold against mortgages is too low.

Or to put it in the jargon, the Bank of England may well try to reduce the so-called leverage in the mortgage market.

It would want to do this for three reasons:

  • It is not beyond the realms of possibility that the UK housing market could at some stage lurch downwards, foisting bigger losses on banks than their dedicated capital could absorb
  • When a category of loans, such as mortgages, benefits from such low risk weights, it can distort the economy, by giving incentives to banks to provide mortgages rather than other (potentially more useful) types of loans
  • If the housing market were ever to recover properly, the low risk weights could fuel another dangerous bubble

But there is a non-trivial problem with moving fast to remedy this alleged flaw. If banks were told, for example, to very rapidly increase their risk-weight for mortgages to the Basel standard of 35%, as has been recommended in Switzerland, they would either have to raise many billions of new capital (£17bn says Morgan Stanley), which would neither be cheap or easy right now, or - which is far more likely - they would simply shrink the amount of credit they provide in the housing market.

And at a time when a weak UK housing market is contributing to our economic malaise, a further tightening of credit conditions would be regarded as highly unwelcome by the Treasury - and it would go against the grain of government and Bank-of-England policy, in the form of their Funding for Lending scheme to provide more and cheaper loans to households and businesses.

So, as ever with the imperative of fixing what went wrong during the boom before the great crash of 2007-8, it is pretty obvious what needs to be done to provide a more stable financial system. Unfortunately, in the short term, the cure can hurt us all.

 
Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this
    +3

    Comment number 34.

    Any bet these high quality borrowers are bankers who get bailed out If the system collapses

    Yet again few elite well connected can borrow billions and yet average man on street is cash starved

  • rate this
    0

    Comment number 33.

    Yes!

  • rate this
    +3

    Comment number 32.

    So, bankers (UK ones in particular) not only have been acting, but continue to act, like total numpties who have no idea of risk.

    When are they going to wake up to the fact the world has changed on them? And that they're 'one-trick' monkeys who need to find different ways of doing things?

    They make the DfT contract people look clever and 'on the ball'!

  • rate this
    +2

    Comment number 31.

    The Gov will do whatever it takes to prop up house prices as the feel good factor for most who have equity gives them a sense of stability. Erode the value/prices of houses or a market crash will put most home owners in the same class as the have nots. the Gov fears this as they cant afford an angry middle class who would feel they have been betrayed.
    A house price crash will cause Anarchy.

  • rate this
    +1

    Comment number 30.

    26 Broken record reflecting your prejudices. The main factor is teat people are living much longer, something completely beyond the comprehension of a Tory tabloid.

    House prices were in any case deliberately inflated with cheap credit to give the casino banks a bigger bet in the international mayhem they clearly didn't understand.

    The only bit they do understand is who gets the bill

  • rate this
    0

    Comment number 29.

    26.IR35_SURVIVOR - ".......2) Imigration of 4_000_000 since 1997."

    Nope, wrong - there are 16 million MORE Brits abroad than foreigners living here.....more than off setting the immigration figures.

    People obsessed about living in their own flat/house etc is the real issue - why do so few consider sharing/lodging etc these days, or living with Granny & so on......

  • rate this
    +1

    Comment number 28.

    26.IR35_SURVIVOR
    #24 its not that simple , this is an island that is already far to crowded.

    ===
    It's not going to become less crowded in the short/medium term so we need to push ahead with the plan. An exodus from Spain, Portugal and Greece of a few hundred thousand will exacerbate the shortage.

  • rate this
    +4

    Comment number 27.

    I don't see a problem here. The liability appears grossly and recklessly under-reserved but as and when it goes pear-shaped the liability is carried by the taxpayer anyway. Don't you all remember agreeing to that?

  • rate this
    -5

    Comment number 26.

    #24 its not that simple , this is an island that is already far to crowded.

    There are 2 main resons for the massie demand for houses

    1) broken families effecting the size and types of houses

    2) Imigration of 4_000_000 since 1997.

  • rate this
    +5

    Comment number 25.

    In other words, banks have lent out money they don’t have and are essentially bankrupt if they need to cover losses on those loans.

    This is why we have had all of this quantitative easing and why none of it has filtered through into the wider economy.

    QE is not about getting banks to lend more it’s really about propping up the balance sheets of over exposed banks

  • rate this
    0

    Comment number 24.

    There are a number of correspondents on this blog who woke up after 2008 (and a couple beforehand) to the banks and the wreckage they will cause until they die.

    Correct the housing market, better we do it by building high vol of affordable housing (social and private) which will reduce the price of existing stock and then gradual increase int rates to realistic levels c4-5%. It is that simple.

  • rate this
    +3

    Comment number 23.

    7 - don't trot out that technical garbage. We all know precisely what will happen if house prices lurch downwards, who will get the bill - and who will escape entirely intact with their lovely tax-free bonuses.

    These loans are assets to the banks - and they have been used to prop up external debts of 600% GDP. To the enrichment of people who run up these obligations at no personal risk

  • rate this
    0

    Comment number 22.

    #21 they have been lending at 100%+ LTV rates and if the price of house moves down even by 1% per year these is going to be trouble.

    trouble is hosues are about 2 times the price of what is affordable and have a work life balance. if people can pay then there is not problem BUT mostof way overstreched

    this is the calm b4 the storm.

  • rate this
    -7

    Comment number 21.

    Am I missing something but surely with a property mortgage the lender only lends a fraction of the value of the property and hence if the borrower defaults the lender can be sure of getting back 'his ' proportion of the value of the property? Hence not a great risk? Almost no risk at all I would say.

    Ray

  • rate this
    +13

    Comment number 20.

    there is the mother of all corrections coming around the corner

  • rate this
    +1

    Comment number 19.

    So they hardly even have any skin in the game, and they will get wiped out by a tiny change in the wind. & dump the whole loss on the taxpayer as we have seen

    But they can continue to gouge the population and pump back up the bubble as soon as they get a whiff of a chance

    And the profits will be shipped out of reach of HMRC

    Well that seems like a wonderful deal for UK PLC

    Trebles all round!

  • rate this
    +2

    Comment number 18.

    Ohh dont worry it will be fine

    I trust the bankers and regulators and those nice politicians not to let things get in a mess

  • rate this
    +8

    Comment number 17.

    "In other words, Lloyds seems to have lent 455 times the value of the capital earmarked in its balance sheet to absorb losses, just in case these mortgages go bad."

    Similar odds:

    http://www.quirkybet.com/ufo-aliens-space-bets/obama-to-admit-moon-landings-were-a-hoax

    500-1

    Except the later is a single event. The former is an accumulator.

    Bankers bet big

  • rate this
    -1

    Comment number 16.

    Ah, so people are finally waking up to the fact that there are no 'free-lunches'. It all has to be paid for, by someone.

    That level of capital against mortgage loans would barely cover the legal fees/admin costs of recovery action!

    Remember that old anti-war protest song? "When will they ever learn, when will they ever..."

    UNBELIEVABLE!

  • rate this
    +6

    Comment number 15.

    People on here have been telling you this for years Robert and you have had many articles yourself....
    This is why people say the banks are bust, they are only in business because of our implicit guarantee and continual supply of cheap money for them.

    How are the bonus's looking this year i am sure creative accountancy will hide the real figures from us....

 

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