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Up Against The Wall

5 September 2016 by Rob Ford

Back in 1989, my dear departed mother said to me “put your money in bricks and mortar son”.  I duly did – the market crashed – and just four years later the property I’d bought was only worth about 60% of what I’d paid for it – ouch – thanks Mum!

Of course, I’d bought it at the top of the market and then seen the next four years bring a deep recession and a property market downturn the like of which hadn’t been seen in the UK before.  It was horribly painful, but the economic cycle gradually recovered and after a further four years I sold the place for about the same price I’d paid for it, breathed a sigh of relief, and moved on.

Now, a little more than 25 years after the original purchase and according to a well-known house prices website, that property is now worth over 500% more than I paid for it!  Perhaps I should have held on to it, although the property I moved to has also seen similar appreciation and so I have still seen the benefit, just by being a property owner.

Last week, I was reading an interview in The Sunday Times with Andy Haldane, Chief Economist at The Bank of England, who said that owning property was probably a better bet than having a pension.  He said that house prices had been “relentlessly heading north” for the “better part of a generation” and that if the current shortfall in new house building persisted then we will continue to see that.

Furthermore, an enquiry from an investor prompted me to dig out some historic house price data and maybe Mr Haldane should have done the same before he made his comments, because actually, that trend in house prices goes back to at least the 1950s – almost 3 generations – and probably further.

The enquiry was actually about a favourite scaremongering story of the popular press that comes up with some regularity; the story goes that there is an upcoming “wall” of interest-only mortgages with no basis for repayment.  In reality the story has little foundation.  However, in order to properly dispel the myth, let’s first look at how the mortgage market is made up.

Most mortgages are 25 years in original term

Some will be shorter or longer for various reasons but 25 years is typical and will be the overwhelming majority

Most mortgages have a Loan-to-Value ratio in the 65% to 85% range

Again, some are higher or lower but this is the typical range

The typical homeowner remains in their property for approx. 7 years

Whilst obviously some people will own a property for a long time, others will move (or refinance) more quickly
As such the proportion of mortgages that run full term is relatively small

Despite what the doomsayers might have you believe, most interest-only mortgages will normally have some form of repayment basis – either an endowment, a pension plan or something similar.  There is a danger, that the growth from the endowment or pension plan will not be enough to meet the final mortgage payment, but even so there will usually be some form of capital to make at least a substantial capital payment.

So for us, as investors in both RMBS deals and also in pools of mortgages themselves, many of which contain interest-only mortgages, what is the worst case?  Maybe a whole pool of loans with:

No repayment plan (or ones that will fall way short of target)
A very high original LTV (possibly even 100%)
Significant house price weakness.

It’s highly unlikely that an entire pool would look like this as the penal cost of structuring a deal of those assets would almost certainly make it uneconomic.  However, maybe it could happen?

There have been several periods where house prices have fallen significantly – approx. 20% in both the late 80s/early 90s and again in 2007-2010.  However, these downturns have always been relatively short-term in the context of a 25 year mortgage.

Nationwide Building Society have quarterly house price data going back to 1952.  Looking at a rolling 25-year period (so starting from 1977) there has never been a period where house price growth over 25 years was less than 200% – and this “low” covers the period which included both the 1990s and the most recent house price crashes.

Source: Nationwide

Therefore, even in these worst cases, the property would be worth twice what it was at the start, and even a 100% LTV loan with no repayment basis would easily be able to be repaid with either a refinance or a property sale.

Quite simply, a loan would have to have the worst possible demographics to be unable to be redeemed after 25 years.  There will be some loans that suffer this, but real pools of RMBS are highly diversified from an LTV point of view, property values, loan sizes and geography, and therefore the likelihood of large swathes of loans being unable to be refinanced, either from property sales or re-mortgages is very small.

Even looking at the shorter term – loans that were originated at the top of the market before the recent crash – we know that house prices fell on average around 20% but here we are less than 10 years later and again property prices are now 10% above the highs in 2007, as can be seen again in the Nationwide house price index, now collated monthly.

Source: Nationwide, Bloomberg

And what about that “wall”?  Mortgages that need to redeem in the next 3-4 years were typically originated between 1992 and 1996.  A look at a longer series of the index shows how house price inflation has benefitted those mortgages to date. An 80% LTV mortgage in 1993/1994 with no repayments is now equivalent to a 20% LTV loan!

Source: Nationwide, Bloomberg

One further thought – whilst the scaremongering was originally directed at mortgages from the 1980s and 1990s when interest-only mortgages first became common, more recently they have also been directed at the Buy-to-Let sector, which are often interest-only loans.  I find this quite puzzling.  The sector has taken quite a lot of stick recently from politicians and regulators, with changes to mortgage interest tax relief for landlords, an increase in stamp-duty and several warnings from the Bank of England (which somewhat flies in the face of their chief economist’s comments about property, although he has always been seen as something of a contrarian).  However, with Buy-to-Let properties, ownership is much more likely to be long-term – benefiting from house price inflation, and at the maturity of the mortgage borrowers can quite happily sell the property to repay the loan without making themselves homeless in the process.

However, whether Owner-Occupied or Buy-to-Let, I think it’s clear that long-term property ownership is indeed a very worthwhile investment, and we as investors in both RMBS and the mortgages themselves should feel extremely comfortable that over the long run, the returns are very healthy indeed and our capital is well and truly protected.

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