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, economics editor Article written by Robert Peston Robert Peston Economics editor

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This column may be a bit quiet for a bit, because I am away from the office.

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  • rate this
    -2

    Comment number 54.

    Are investment banks taking dangerous mortgage risks?
    After 2007/2008 banks continued to carry far too little capital as a protection against losses. They did it because they could, like Libor. Basel ll fundamental error - biggest banks to use own risk models i.e. amt of capital they needed as protection against bad debts.
    Being replaced by Basel III. Last I head US Fed Reserve still talking.

  • rate this
    +1

    Comment number 53.

    "Unfortunately, in the short term, the cure can hurt us all."

    Sometimes a recession is a necessary and rational response to past mistakes. A reduction in lending might facilitate that long overdue proper fall in house prices to more reasonable levels. A 50% fall in prices would address the risk balance for new lending.

    And that would help, rather than hurt, potential first-time buyers.

  • rate this
    0

    Comment number 52.

    What about the debt deferring ponzi schemes New Buy, First Buy and Lend a Hand. These are removing lending risk form banks and shifting onto us via our income tax and council tax. Though the council tax will ultimately be our income tax as well whent he councils need bailing out.
    These schemes are government sponsored liar loans. It's obvious people cannot afford to buy so debt must be deferred

  • rate this
    0

    Comment number 51.

    1) Banks could obviously not raise this amount of capital (nor pay for it given current agreed mortgage rates) so forcing them to so would bankrupt them all probably beyond the UK govts ability to bail them out so probably effectively destroying the economy for the sake of an unrealised risk of default. Whose interest would this be in?

  • rate this
    +1

    Comment number 50.

    48.Trevor

    "The reason why so little capital is required as the banks can reposess the properties if the loan defaults, so the chances of loss really are quite small."

    But id the property value does go down, that doesn't cover them, does it?

    Hence prices are being kept artificially high, no new homes are being built and first time buyers have to wait until their 40s to gather the money.

  • rate this
    0

    Comment number 49.

    #29 then we have a population problem and they should not have been allowed in in the first place then,

    optimul population of the UK is probably around the 40 million mark

  • rate this
    -2

    Comment number 48.

    Oh dear Bob - you really don't understand mortgages do you! The reason why so little capital is required as the banks can reposess the properties if the loan defaults, so the chances of loss really are quite small.

    But then you never did let reality get in the way of another headline attracting attention to yourself as a self-appointed financial guru.

  • rate this
    -1

    Comment number 47.

    By keeping the housing bubble inflated they are rewarding the BTL landlords that helped inflate the bubble in the first place. The gravy train is getting better for them as rents go up too.

    When are the bone idle rich going to pay the price, the money for nothing crowd blinded by greed who cannot see their I'm all right jack attitude caused most of the problem.

  • rate this
    0

    Comment number 46.

    almost every day another skeleton crawls of out of the finance closet...those of us who wondered how the business sector that should follow 'efficient markets' could pay extraordinary rewards to ordinary people year after year now have the answers. Its one big fat scam and its still going on.

  • rate this
    0

    Comment number 45.

    "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."

    According to what follows, this example would seem to imply a risk weight of 100% - is there a mistake here somewhere?

  • rate this
    +17

    Comment number 44.

    This article explains why the goverment is subsidising the house market and not allowing it to correct.

    BoE/Gov have sacrificed the economy, our savings, our pensions and future generations so they can save the housing market.

    End result is that the youth in their 20s/30s are forced to rent where they are squeezed by high rents and inflation. All these so we can save the banks and the BTL!

  • rate this
    -2

    Comment number 43.

    To clarify.

    The short sharp shock I refer to would begin with the collapse of the existing short-term oriented banking system.

    There are alternatives, politicians don't have the bottle to scrap the "worst of all systems" (Merv King admitted this!) and introduce a new model. As IR_35 said earlier, there will be monumental change. The sooner the better.

    www.positivemoney.org

  • rate this
    0

    Comment number 42.

    38 Yeah and guess who they have in mind to take the pain. Another £50bn QE handed to the banks to maintain their illusion of solvency.

    Meantime ATOS etc continue to cause collosal misery to hundreds of thousands to save a tiny fraction of that

  • rate this
    +1

    Comment number 41.

    Have I missed the point or for mortgages the banks also use the capital held within the home? i.e. value of home =£100k, mortgage = £70k. capital = £30k.

  • rate this
    -3

    Comment number 40.

    The problem with solving corruption,with the corrupt is they only understand or believe more corruption can solve the problem
    Has each cycle speeds up the collapse,these are not safe,where is their income coming from,privating the NHS etc,but that will soon be priced out of reach for millions and then the middle classes next stop another collapse

  • rate this
    +1

    Comment number 39.

    Sorry Robert but this is really bad analysis.

    If the entire mortgage portfolio has a risk weighting of 16% and some of it is effectively at 0%, some, by definition must be risk weighted much higher

    Now why would a bank assign a risk weighting of 0% to a mortgage?

    For example payments are 20% of mortgagee's income or it holds other collateral in excess of mortgagee or LTV is less than 40%

  • rate this
    +7

    Comment number 38.

    To your closing line: I'm afraid it's time we started accepting that we need to take short term pain for long term gain.

    Short termism is rife in banks and government and is very destructive in the long run.

  • rate this
    +6

    Comment number 37.

    Fractional Reserve Banking, nice idea, completely exploited by greedy bankers.

    House prices are over inflated. The BoE has kept interest rates low so mortgages aren't defaulted on simply to prevent the banks going bust (they already are actually).

    This means long term, slow pain for millions of ordinary people.

    A short sharp shock would be better than slowly bleeding the country to death.

  • rate this
    0

    Comment number 36.

    The UK has a population density of around six times the all-countries average. It has 244,000 Km2 land mass against World land mass of 148,940,000 Km2 and 70m pop part of World pop 7Bn.
    But the UK needs increasing pop to pay tax, keep demand for housing etc high, and vote for MPs. It's a merry-go-round.

  • rate this
    +10

    Comment number 35.

    The original financial crisis was caused by cheap credit and poor risk management.

    So what do we do? We make credit even cheaper and fail to address the risk factor.

    Time to stop this madness, increase interest rates and fast track the recommendations of the Vickers report.

 

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