November 21, 2017

If you allow banks to earn higher risk adjusted returns on equity on mortgage lending than when lending to entrepreneurs, bad things will sure ensue

Sir, Jonathan Eley writes: “in the UK…younger people especially are being priced out of the market while their parents and grandparents benefit from decades of above-inflation rises in home values. The ruling Conservatives, traditionally the party of home ownership, now finds itself shunned by millennial voters frustrated by spiralling housing costs” “Why Budget fix will not repair market” November 21.

And among the long list of factors that has distorted the market in favor of houses Eley includes: “Mortgage securitisation facilitated further growth, as did the Basel II reforms cutting the risk weights applied to real estate. This made mortgage lending less capital-intensive for banks.”

This Sir is one of the very few recognitions, by FT journalists, of the fact that risk weighting the capital requirements for banks distorts the allocation of bank credit.

Indeed, Basel I in 1988 assigned a risk weight of 50% to loans fully secured by mortgage on residential property that is rented or is (or is intended to be) occupied by the borrower, and Basel II reduced that to 35%. Both Basel I and II assigned a risk weight of 100% to loans to unrated SMEs or entrepreneurs.

But the real bottom line significance of “mortgage lending [being] less capital-intensive for banks”, is that banks when being allowed to leverage more with mortgages than with loans to SMEs and entrepreneurs, earn higher expected risk adjusted returns on equity with mortgages than with loans to SMEs and entrepreneurs, and will therefore finance houses much much more than SMEs and entrepreneurs, than what they would have done in the absence of this distortion.

As I have written to you in many occasion before, this “causes banks to finance the basements where the kids can live with their parents, but not the necessary job creation required for the kids to be able to become themselves parents in the future.”

And the day the young will look up from their IPhones, and understand what has happened, they could/should become very angry with those regulators that so brazenly violated that holy intergenerational social bond Edmund Burke wrote about.

I can almost hear many millennials some years down the road telling (yelling) their parents “You go down to the basement, it’s now our turn to live upstairs!”

Eley also quotes Greg Davies, a behavioural economist with: “People like houses as an investment because they are tangible. They feel they understand them far more than funds or shares or bonds.”

But the real measurement of the worth of any investment happens the moment you want to convert it into current purchase capacity. In this respect people should think about to whom they could sell their house in the future, at its current real prices.

PS. In June 2017 you published a letter by Chris Watling that refers exactly to this, “Blame Basel capital rules for the UK’s house price bonanza”.

What most surprises me is that regulators don’t even acknowledge they distort, much less discuss it… and that the Financial Times refuses to call the regulators out on this… especially since all that distortion is for no stability purpose at all, much the contrary.

It is clear that no matter its motto of “Without fear and without favor”, FT does not have what it takes to for instance ask Mark Carney of BoE and FSB, to explain the reasoning behind Basel II’s meager risk weight of only 20% to the so dangerous AAA rated and its whopping 150% to the so innocous below BB- rated.