Mortgage guarantees: are you getting a good deal?

A lot of people have asked me recently about local authorities giving guarantees to banks over local residents’ new mortgages. The two most common questions are “what are the risks of doing this?” and “how do we account for it?” There’s sometimes a feeling that IFRS is there to make our lives difficult, but what it’s really trying to do is ensure that the answer to both these questions is the same. That is to say, authorities should calculate the risk of these guarantees being called, and then recognise this risk as a liability on the balance sheet.

Before 2007, local authorities only had to recognise guarantees as liabilities when there was a significant risk of the guarantee being called. Following the introduction of new accounting standards that year, government legislated to ensure that existing guarantees remained off balance sheet. However, they also made it clear that authorities entering into guarantees after that date do so in full knowledge of the impact such transactions will have on their accounts.

So what is the risk of a mortgagee defaulting and the local authority being required to pay up? Well, we can see from the Council of Mortgage Lender’s quarterly bulletin that there were around 250,000 repossessions in the past seven years (the typical length of a guarantee). That is around 2.2% of the 11.3 million mortgages outstanding in the UK today. So assuming the past seven years are as good a guide as any to the next seven, you might be tempted to assume that the value of £1 million of mortgage guarantees is £22,000.

Not all defaults lead to repossessions though. Ministry of Justice figures show that banks took 700,000 homeowners to court for non-payment in the last seven years. That is 6.2% of all UK mortgages, valuing the guarantee at £62,000. But both these figures are likely to understate the true cost, as they assume that the people taking advantage of the guarantee are going to be average homeowners.

However, the average includes people with large amounts of equity in their homes, those who can downsize rather than be repossessed, and people on very cheap variable rate mortgages agreed before banks raised their margins dramatically in 2008. In fact, today’s historically low interest rates are one reason why repossessions are at half the level they have been in previous recessions. So today’s first time buyers with small deposits paying 3 or 4% above base rate will be significantly more likely to default, especially when the Bank of England finally raises interest rates. Those unable to obtain or afford a mortgage without resorting to the council for assistance are probably even more at risk.

Another way to value the guarantees is to look at what a commercial organisation, like an insurance company, would charge to offer a similar level of protection to the lender. Mortgage Indemnity Guarantee insurance went out of fashion in the UK during the early 2000s when banks were in a rush to lend money to anyone who would take it. But in Canada, insurance has been compulsory on mortgages of over 80% loan to value (LTV) since 1988. Central Bank of Canada Governor Mark Carney, who will soon be in charge of regulating UK banks, might claim that that’s one reason why Canada’s banks survived the global financial crisis much better than ours did. A typical premium for a 95% mortgage in Canada is 2.75% of the amount lent, which would put the value of £1 million in guarantees (enabling £4.75m of mortgages to be lent at 95% rather than 75% LTV) at £130,000.

The Canadian economy is doing rather better than ours though, so for a UK example, we can look at the difference between interest rates on 75% and 95% mortgages. Nationwide Building Society, known for being one of the more socially responsible lenders, raise their five year fixed rate from 3.59% to 6.09% for the highest LTVs. That’s over 12% of the sum borrowed over five years (even allowing for some repayment of principal), putting the value of £1m guarantees on £4.75m of mortgages at some £580,000.

Of course, none of these estimates will be exact. The last figure in particular includes the value of some tail risks that banks’ losses on repossessions will exceed the 20% guaranteed by the local authority. There are also regional variations to take into account – figures for 2011/12 show that repossession claims per household in the London Borough of Barking and Dagenham were seven times that in the Cambridge City Council area, for example.

Once the fair value of the guarantee has been established, this will be recognised as a liability on the balance sheet. In the commercial world, a cash payment would be received to cover this, but with local authorities providing guarantees for service purposes instead, the double entry is a charge to housing services expenditure. The liability is then amortised back to zero over its life, until a call under the guarantee becomes more likely than not.

As part of the guarantee arrangements, many authorities are also making a long-term deposit with the bank for the same value and term as the guarantee. This raises the spectre of losing your money twice – in an extreme housing crash, the bank could default on your deposit while the administrators will still expect you to make good on your guarantees.

To avoid this situation, some authorities have arranged for the mortgage guarantee to be embedded in the deposit, so that the cash returned under the deposit depends on the number of defaulting mortgagees. The downside of this approach is that this meets the definition of an embedded credit derivative in IAS 39, which will require separating from the host instrument and measuring at fair value through profit and loss over its life. This could mean gathering data on each homeowners’ personal financial circumstances – people stop becoming average when you know who they are!

George Osborne announced in the Budget that central government will be providing very similar guarantees under the Help to Buy scheme from next year. The scheme outline has a number of key differences to the local authority version though. Firstly, banks will retain 5% of the risk in the guaranteed portion, “to ensure that lenders are not incentivised to originate poor quality loans.” Banks will also need to pay a full commercial fee to compensate the Government for the expected default losses, the cost of capital of providing the guarantee, and the administrative costs of the scheme. It looks like local authorities are getting a rather poor deal in comparison.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.