BS b.s.?

I’m using BS to stand for Building Society, and b.s. for a more vernacular phrase!

One amusing cameo during the Northern Rock debacle was by the ONS, which ruled that the Bank of England loan and guarantees to the Rock should be counted as part of the national debt. Yet the national debt does not include the guarantee on all bank and BS deposits (up to £35K). This comes to much more, several hundred billion is my guesstimate. Is the taxpayer safe?

A few days ago, I received an annual statement from what I shall term, to protect the innocent, Piggy BS. As far as I know, Piggy is a typical BS. What with all this Northern Rock business, though, I thought I’d have a quick look, rather than filing the leaflet in the wpb immediately. And it makes surprisingly interesting reading.

Piggy helpfully provided some ratios:

  • the liquid assets ratio is a whopping 25%, that is, it could meet investor withdrawals of a third of the size of the mortgage book! Impressive.
  • its gross capital ratio is 6.2%. That is, shareholders capital is 6.2% of shares (i.e. account balances) and borrowings, and obviously about 8% of mortgages (since the liquid assets ratio is 25%).

8% doesn’t seem a lot to me (though I’m not claiming great expertise, merely trying to make some simple points), since this sort of capital ratio is considered appropriate for diversified banks. And Piggy only invests in one thing. “Huff, puff”, says the big bad wolf!

Anyway, if 16% (by value) of Piggy’s mortgagees hand in the keys, and it can recover only 50% of its loan on each property, it would be pork pie time.

Looking a little closer, it gets a little worse than this, since some of Piggy’s capital (OK, only about about 5%) is a “revaluation reserve” on – yes , you’ve guessed it – property, i.e. its own offices. Since it’s a reasonable guess that the market value of this property will be correlated with the property Piggy has kindly mortgaged, this reserve might go negative (from +5% to -5%) over the same period as its mortgage book deteriorates. So let’s say we only need 14% of our customers to default.

Still, not a very likely scenario even though Piggy has increased its mortgage book over the last year by about £1.5bn – three times reserves and more than twice total shareholders’ capital – implying that a lot of the mortgage book – maybe a third of the £10bn total – is recent lending and therefore vulnerable to a house price crash. But more than 1% defaults in a year would be extreme – in fact, catastrophic, since “impairment losses” are currently running at less than 0.02% of the mortgage book – so even a decade long housing bear market should be sustainable.*

Bricks not straw so far.

But Piggy also provides a couple of other ratios:

  • annual profit is 0.37% of total assets (i.e. of about £10bn mortgages + £3bn liquid assets);
  • management expenses are 0.56% of total assets. Seems a lot. If mortgages average £100K, management of each costs about £700/year!

Looking at it this way, it’s not quite so rosy. Defaults of 1% (by value) or more of the mortgage book would wipe out profits for a given year. A few years of this, and we would start to lose shareholder value.

It’s worse than this, though, since the fees on modern mortgages are front-loaded, i.e. they’re arrangement fees and so forth. So, profits will deteriorate even if there’s a downturn in activity.

And we’d all start to worry long before Piggy goes bust. I suspect Piggy would have to find a Miss Piggy to merge with if, over a period of time, its reserves halved (say) from current levels. If there is a housing market crash expect some action in a few years time.

It’s not Piggy we should really be worried about, though. No, Darling’s generosity on our behalf suggests it’s systemic problems we should be worried about. I’ve already mentioned how BS balance sheets could deteriorate if 25 year mortgages become faddish (remember endowment mortgages) and interest rates rise significantly. Of course, if all this is accompanied by a recession, falling house-prices and increasing delinquency rates (though long-term mortgages do militate against this, somewhat) the BSs would face a double whammy.

But what really gets me is that the BSs have no apparent means of rebuilding their balance sheets. They can’t ask their shareholders for more money, like the banks can. The Government would ultimately have to pick up the enormous tab. We only need the mother of all housing crashes once and the BSs are all toast, (or bacon). I just don’t see how they could sustain losses year after year indefinitely. And some markets do drop 70% or more. There’s absolutely no reason why this can’t happen to the housing market in the UK. And, as I said before, it has happened in the US.

As I say, though, I’m not claiming to be an expert. This could all be b.s. You decide. Me, I’ll look at Piggy’s next annual statement even more carefully.

* Postscript (1): Maybe a long bear market would not be quite so survivable after all. I now read in the FT that “1.1 per cent of mortgage borrowers were in arrears at the end of 2007”. Crikey! This can’t be right, can it?

Postscript (2): And the default rates in some parts of the US are quite hair-raising (AP via Yahoo):

“During the past year, 30 states saw an increase in the number of homes that had received at least one filing.  Nevada led the nation, with 6,087 properties receiving at least one filing, up 95 percent from a year earlier but down 45 percent from December, the firm said.  That translates to a rate of about one foreclosure for every 167 households.” [My emphasis.]