Comment: Risks in housing finance

COMMENT BY CENTRALBANKNET

UK Credit Action statistics for September show personal debt stands at £1.11 trillion, up 10.7% over the past year. The savings rate in the USA fell to -0.6% in July, the lowest rate since records began in 1959.

The rise in borrowing, particularly in the USA, has been encouraged by easy credit availability, and the proliferation of new financing instruments. Consumers are now faced with a bewildering array of loan options, some of which might seem more suitable for derivatives markets.

Over 30% of new mortgages in the USA are now interest only, and there has also been a switch away from fixed to variable rate mortgages, in order to take advantage of low interest rates. Lenders have been more willing, both in the UK and USA, to lend at higher loan-to-value and loan-to-income multiples, a necessity if purchasers are to afford inflated house prices.

One of the more recent innovations is the availability of "negative amortisation" mortgages, where initial payments do not cover interest on the loan, and the difference is added to the principal, to be repaid at a later date.

For unsecured debt, too, borrowing has been easy and cheap, with pre-approved credit cards and 0% interest offers abounding.

The common factor in all of this is that consumers have increased their leverage and exposure, but with few immediate costs. Special offers have been easy to roll over, and increasing house prices have allowed equity extraction to pay down troublesome unsecured debts.

The risk, of course, is that consumers could find themselves overexposed if conditions change. House prices have started to decline in the UK, and cannot continue to rise indefinitely in the USA. Some banks are already looking uneasily at their portfolios and tightening their lending conditions. Many borrowers will find themselves having to deal with higher interest rates at the same time as coming off special deals.

The approach of central banks and regulators, until recently, has been to welcome financial innovation and work on the basis that consumers are capable of understanding their own finances, or at least that interference does no good.

Certainly, the new financial products on offer have their benefits, and even negative amortisation mortgages are a good option for borrowers who expect their income to increase significantly a few years down the line. But it is clear that many consumers do not understand the implications of the commitments they have taken on. Some have simply opted for the mortgage which lets them buy their desired house for the lowest initial monthly outgoings, with little consideration of whether they will be able to afford higher payments later. Rising house prices will take care of it, they say. Others have moved their balance from one 0% credit card to the next, without considering what might happen if such deals ran out.

The UK Financial Services authority has tightened up oversight of mortgage lenders since it took over the responsibility in 2004, and has stressed the importance of providing clear and fair advice to consumers. Federal banking regulators in the USA have been paying close attention to products like negative amortisation mortgages, and in June Alan Greenspan expressed his concerns about "the dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages."

But providing lenders are not misleading customers, and so long as they have adequate capital, central bankers and regulators have been reluctant to interfere in the market for loans. It may be too late anyway, as banks are starting to tighten credit of their own accord.

Whatever the fate of the experiment in the US and UK, other countries should take note and beware of the possible dangers that accompany the benefits of innovation in consumer credit markets.