A falling house of cards

The Crosby report shows that the market can't solve the mortgage crisis alone. It's time for the state to step in
September 27, 2008

One might have expected at least some political debate about the financial time bomb depicted in James Crosby's "Interim Analysis of Mortgage Finance"—a report commissioned by the treasury into the mortgage market crisis—published in July. Instead, it was quickly tagged as something too difficult to contemplate.

The hope is that markets will be able to ride out what will turn out to be short-term turbulence. But a year after the credit crunch began, some of the problems seem to be intensifying. Privately, business and householders alike are preparing for the worst—while everyone colludes in the fiction that no useful public action is possible.

Yet Crosby's review demands a proper response. It is one of the most sobering documents released by a British government in recent years. Crosby, the former head of HBOS, believes that the collapse of the markets for residential mortgage-backed securities (RMBS) and covered bonds—fixed-income bonds backed by home loans—which together provided an amazing two thirds of the finance for new mortgage lending in 2006, will lead to a mortgage famine lasting until the end of 2010, with only a gentle recovery thereafter. Crosby believes that even forecasts that mortgage lending will merely halve over the next few years are too optimistic. Net new mortgage lending for all but the most creditworthy borrowers could virtually end.

This collapse in demand will, of course, mean a further downward pressure on house prices. The most pessimistic forecasters expect prices to fall by 40 per cent by 2010 from their 2007 peak. But if Crosby's fears are realised, even that could prove optimistic. Confronted by a sharp fall in the value of their main asset, consumers will spend significantly less.
Meanwhile, banks and building societies will have to acknowledge greater loan losses as house prices fall, encouraging further deleveraging by banks, squeezing the supply of credit to an already hard-pressed economy (this process was described in "A perfect financial storm," Prospect, March 2008). This could turn a slowdown into a recession, with
big implications for government finances—let alone for employment and investment. Worst-case projections, I have been told, are for a government deficit in this financial year approaching £70bn—more than twice last year's £34.2bn—translating into a peak deficit of £100bn in 2010-11.

The problem is that between 2003 and the first half of 2007, the City, indulged by regulators and the government, exploited its role as a global magnet for footloose saving to issue £250bn of mortgage-backed securities. Issuance rose from £30bn in 2003 to a stunning £110bn for the year from mid-2006 to mid-2007, when the market suddenly closed. By 2007, Crosby says that mortgage-backed securities were financing a fifth of Britain's £1.2 trillion of outstanding mortgages.

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What was happening was that banks, building societies and specialist lenders to the buy-to-let market were no longer relying on deposits in the banking system to finance mortgages; like Northern Rock, they were bundling up mortgages in investment vehicles to be sold to money market investors, hedge funds and insurance companies. The avalanche of credit that they supplied was the biggest cause of the 2005-07 house price boom, which took prices as much as 50 per cent higher than all the long-term anchors of house prices justified. Now investors, largely foreign, have discovered that the securities they bought are hard to sell, and, what's worse, lose their value when house prices fall (or indeed when the pound sterling falls in value, as it has been doing). They have fled the market, and in Crosby's view will not come back. Over the last few months, issuance has stopped completely.

This leaves the British economy and financial system with a first-order adjustment problem. We first have to absorb the loss of the £110bn of housing finance that mortgage-backed securities supplied in the year before the credit crunch. Then there is a further problem: the investment vehicles which raised this cash were so short term (averaging three years to maturity) that for the next three years, the system will also have to find £40bn a year—possibly more, but Crosby is unable to uncover exact figures—to repay the securities as they reach maturity. This will siphon away what little money there is in the system—further exacerbating the mortgage and credit famine.

Unless the RMBS market can be re-opened quickly, the collateral damage could be severe. Crosby floats the excellent idea of a short-term government guarantee to new RMBS issuers—lasting, say, three years—until the market starts to get back on its feet, to tide it and the British economy over the refinancing crisis. This, along with a readiness of the Bank of England actively to superintend the market—assuming the role of a clearing house for deals along the lines of the US's National Deposit Clearing Corporation—should alleviate the worst of the crisis.

Critics says that this is using taxpayers' money to subsidise high house prices, to halt the necessary process of market correction and to sustain a business model that has not proved viable. The governor of the Bank of England, Mervyn King, has questioned the logic of a guarantee for the residential mortgage market that would never be offered to manufacturers. We must take our medicine, he argues. Sadly, Crosby seems to accept this view and pulls back from endorsing his own suggestion.

The arguments do not take account of the risk the economy faces. King is wrong; if another sector faced a short-term financial famine on the scale confronted by the housing sector, the government would act, because the risk of not acting would be so great. Nobody disputes the need for a market correction; the issue is is to manage it to minimise the damage to homeowners, consumers and businesses who had no part of the financial system that created the mess—nor a share in the bonus-driven culture. Those, like the Financial Times, who suggest that a temporary guarantee might exhume the housing boom of 2005-07 are living in a world far from the market reality. The risk is zero.

Today's house prices will be comfortably warranted in seven to ten years' time by the rise in earnings. So even if the guarantee is exercised in the short term, in the medium term the government will get its money back if it patiently holds the bonds it has redeemed. Every financial lifeboat the Bank has launched since the war, as King must know, has concluded with no net cost to the government—even when the Bank has held less solid collateral than residential mortgages.

A state guarantee does involve moral hazard. It creates the one-way bet of socialising losses while gains are privatised, but this only underlines the unique relationship of the financial system to the rest of the economy. The lesson is not that the state should let financial car crashes happen and shrug its shoulders, but that the risk of such crashes must be minimised by pre-emptive regulation. Financial markets cannot in future be allowed to move from feast to famine, as with RMBS, with such devastating implications for the wider economy. Mortgage-backed securities are perfectly good financial instruments; they simply need proper regulation and superintendence.

A temporary state guarantee for new RMBS issuance is only the first step. There has to be a new deal, with the City and the financial markets recognising their interdependence with the wider economy and taxpayer. So far nobody on either front bench has ventured such a plan. The government promises an economic package this autumn. Judge its seriousness by its willingness to act on Crosby's review.