The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (21 page)

If it is regrettable that the regulators have been so slow to act, it is almost incredible that, in the first place, the British banking system handed over the frontline control of mortgage credit to an industry – the mortgage brokers – who had such a buccaneering disregard for the kind of prudence one would expect from a steward of one’s money. Not so long ago, a mortgage applicant would have saved for years merely for the opportunity of a meeting with the local branch manager who decided on mortgages. The boom-time bankers must have known this was happening. Their confidence in pushing the boundaries of mortgage provision arose from their computer models, and their ability to offload the risk to other parts of the financial system. The crackdown that followed the bust, however, focused on the foot-soldiers such as Mr Button and Mr Apicella rather than the generals in the smart offices in the skyscrapers.

HBoS was by far the biggest player in the mortgage market, by virtue of its origins in the Halifax Building Society. HBoS also inherited Charles Dunstone as a non-executive director. In testimony to the Parliamentary Committee on Banking Standards in 2012, Mr Dunstone (now Sir Charles) revealed how fevered were the competitive pressures in the mortgage market. ‘The difficulty was that the traditional mortgage market had become so unprofitable due to people remortgaging so quickly, which was driven by mortgage brokers. By the time I left, the average mortgage that we signed lasted thirty-six months. You would take a mortgage, get an incentive, have it for three years and then go straight on to the next deal. It was becoming increasingly difficult to write traditional mortgage business.’

The credit feeding frenzy in suburban Britain during this time was feeding off itself. But one innovation casts a particularly long shadow. Increasing multiples, decreasing deposits, allowing self-certification and stretching the term of a mortgage are all rather tame compared to never actually expecting the repayment of mortgage debt. That was the strategy behind ‘interest-only’ mortgages. In finance, a loan where the entire principal of the loan is due at the end of the term is known as a ‘bullet loan’, but that name might have conjured the wrong image. Interest-only loans are controversial. Forget trying to get one in Canada. In India, you’ll need to hand over a piece of gold. A version of the interest-only mortgage, the endowment mortgage, was popular in the UK in the 1980s and 1990s, but was sold with an investment to repay the loan at the end of the term.

Endowment mortgages were scandalously mis-sold by the banks. This only became apparent in the early 2000s when it became clear that the investments designed to pay off mortgage loans did not have a cat’s chance in hell of realising the necessary capital at the end of the mortgage term – let alone the additional bonuses the sellers had suggested were a strong possibility. To compensate for their large-scale mis-selling, the banks were ordered to pay out billions of pounds to disgruntled clients. One might have thought that would have given the banks pause for thought. But no. In place of flawed repayment plans, bankers developed a type of interest-only mortgage that had no requirement for the client to have any kind of verifiable way of repaying the mortgage at the end of the term. Again, competitive pressure amongst banks further eroded standards.

Interest-only deals boomed from 2002 to 2007, providing another fillip to the housing market. In 2007 a third of all mortgage sales were interest only. And for the first months of 2008, the majority of new mortgage lending was interest only. It had briefly become the norm. Interest-only deals were particularly popular with single-earner households. For many it was the only way to compete with dual-income households. Monthly mortgage bills for a £150,000 loan would have been roughly £800 per month at normal interest rates of 4 per cent. An interest-only mortgage would have slashed that to just £500.

Rob McGregor from Reading has spent eight years paying up to £900 per month for his mortgage, except he hasn’t paid a penny off his loan. He feels trapped in a dangerous situation: ‘In eighteen years’ time I’ve got no chance of paying off the capital amount. If my salary grows in line with inflation I’m never going to have the opportunity to save enough to pay off the debt.’ Half of all interest-only mortgage holders have insufficient plans for capital repayment. Ten per cent, that’s 300,000, have no plans whatsoever.

The FSA, which waived through what should have remained a niche product into the mass market, warned in late 2012 of a ‘ticking timebomb’. By May 2013, the Financial Conduct Authority, which took over the FSA’s old premises, restated this ‘wake-up call’. Martin Wheatley, the Financial Conduct Authority’s chief executive, told me: ‘The big concern is the ten percent that as of today could get to the end of their mortgage and simply have nothing to repay the loan.’

Is this mis-selling? ‘This is more about credit,’ Wheatley told me. ‘Mis-selling usually comes about when there is some confusion about what the product is. An interest-only mortgage does what it says on the tin. You’re only paying the interest, so I don’t think people can really say: “I didn’t know what I was getting into.” I hope the banks wouldn’t have gone on the basis that it didn’t matter. I think the expectation, frankly, was that house prices would carry on rising.’

The bulk of bankers and lenders were relying on selling the property, and therefore on property prices continuing to rise. The industry Mortgage Code required lenders to send out a reminder once a year to these borrowers to ensure there was some means to repay the loan. But that was it. When regulators suggested in late 2012 that lenders would be required to verify these repayment plans, most interest-only mortgages were pulled.

Interest-only mortgages were introduced to new markets such as Australia, Denmark, Finland, Greece and Portugal. In Denmark, by 2007, just four years after their introduction, interest-only mortgages represented 43 per cent of outstanding owner-occupier mortgages. The medium-term fallout, is, however, yet to be seen.

All of these innovations had one aim: reduce the early upfront costs of credit, and thus accommodate house prices rising well above traditional levels of affordability. These innovations stretch buying power. Boom-time bankers called it the ‘front-end pricing’ strategy. But for consumers it’s basically an illusion. For nearly a century economists have called this type of delusion ‘money illusion’. A government report had shown even in 2004 that most borrowers chose a mortgage solely on its front-end price. While low inflation and low interest rates did bring down the initial mortgage costs, high property prices and low inflation meant a much larger stock of debt. With low inflation, the real value of mortgage debt does not diminish as rapidly as it would if inflation were higher.

This ‘front-end pricing’ strategy is not dissimilar to that employed by drug dealers. Hook them in cheap, get them addicted, and then fleece them. Indeed, this very analogy was used by an industry insider, Antony Elliott, the former director for group risk of Abbey National. ‘Lenders used to be viewed as doctors,’ he told me. ‘You went to the doctor and he would know what you needed, he would prescribe the appropriate drug. He would also know how it would interact with other drugs. I’m afraid to say now the lenders are more like bartenders serving drinks to people who’ve already had too much.’

Mr Elliott was particularly concerned with the plethora of credit cards, store cards and personal loans being thrown at Britain’s masses. The story of Britain’s mortgage madness is connected to its general consumer credit excess. Both were underpinned by the same wave of easy money coursing from the East, accommodated by low interest rates from the Bank of England and financial deregulation. The bigger picture was the use of credit to artificially boost stagnant and then falling pay packets for middle earners.

The sophisticated abuse of unsecured debt reached its nadir with the habit of lenders actively increasing credit-card limits on customers who ‘max out’ their plastic each month, only repaying the minimum repayment. Quite quickly, such methods create large debts, subject to massive recurring interest payments. The result? A battery farm of low-income debtors laying a monthly batch of eggs to be gathered in by the banks. As the British economy boomed, Mr Elliott calculated that up to 4 million Britons faced debt problems. At that time the credit industry was spending £1 billion a year marketing and advertising its products on TV and in newspapers, with expensive free press trips, and with ‘experiential marketing’ strategically placed at the nation’s shopping centres. Antony Elliott left his job at the bank to spend a year gathering evidence of the British public’s dysfunctional relationship with credit. In one case study, a mature university student from Manchester described to him how he was flirted with by an attractive young woman in the Trafford Centre. ‘We’re so thick. If you’re blonde, gorgeous… bang, you fill out the form, and before you realise it, you’ve got a credit card in the post.’ He then recounted his naive descent into crippling fees, high interest payments and unnecessary consumption – all down to that credit siren at the shopping centre.

Louise Gowens, then 26 years old, accepted responsibility for incurring her £29,000 debts. But she got hold of her first credit card at the age of 16. ‘One quickly turned into two,’ she remembered, ‘and then you’re into the trap of moving it round and by the end it was six with consolidation loans on top of that. There should have been an alarm bell ringing somewhere at the banks. But there never was.’ Another troubled borrower noted that in the application form for a new credit card there was only space for listing two existing cards, rather than the seven cards he already used. He lent money to his two step-children, even though he was hiding the state of his own debts. His bank gave him a loan that they can never have expected him to repay. ‘They sent me a letter, can you call in sometime? I called in and I walked out £20,000 richer. Well, I weren’t richer. I’d got £20,000 off them basically in an hour.’

I put some of these concerns to leading British bankers at the point where the boom was turning the Square Mile into a farmyard for record profits: in 2004 they made £30 billion, £1,000 per second. ‘People come through our doors and ask for money,’ Sir John Bond, then chairman of HSBC, told me in 2005. ‘They borrow money. I’m sure when everybody borrows money they believe they can pay it back.’ Then he added: ‘The second point I would try to make is that successful economies need successful banks.’ The then Labour government listened to voices such as Sir John’s from within the banks rather than to outsiders like Mr Elliott. Government action focused on the transparency of marketing information, rather than an intervention in the market itself.

‘Credit has been democratised in this country,’ HBoS director Shane O’Riordain told me in 2005. ‘And that is a good thing. When handled wisely, credit is an enabling factor that helps people to lead better lives… We’re in the business of prudence.’ Just three years later a weary Mr O’Riordain would be seen in the headlines of the evening news bulletins, desperately pleading that his bank was stable and safe – at the very same time as an invisible deposit run raged, and the Treasury desperately tried to find a buyer.

A flavour of what was actually going on inside HBoS was revealed by Charles Dunstone’s testimony before that parliamentary committee. Despite being a successful mobile phone retailer rather than a banker, he became the chair of the doomed bank’s Retail Risk Committee. HBoS responded to competition from the likes of Northern Rock by moving into riskier types of lending. ‘We had an enormous amount of experience in the housing stock: quality of assets, surveying, collections. We proceeded cautiously at first, but then we became increasingly confident about buy-to-let and the self-certified marketplace.’

HBoS and Northern Rock went particularly mad lending through those brokers at the top of the market. Of the £73 billion lent by HBoS in 2006, £60 billion was through intermediaries, according to calculations by Datamonitor. That figure represents 26 per cent of gross new mortgage lending in the UK that year, and 33 per cent of the funds channelled through brokers. Second on the list was Northern Rock. All but £3 billion of its £29 billion lending was channelled through brokers. For the US financial services company GMAC, all £12.1 billion of its mortgages were directed through brokers. For Barclays it was a third, and for HSBC it was zero. The prudent retail bankers planned to keep mortgages on their own balance sheet, and clearly wanted to see the whites of the eyes of their long-term borrowers. It’s difficult to escape the conclusion that the other banks, built on the securitisation model, simply did not care about the quality of their borrowers enough to actually meet them. If their mortgages were going to end up in a jokily named Cayman Islands conduit – such as Granite, Grampian or Aire Valley – then why should they have cared?

Computer models might have provided some comfort that loan losses on mortgages were sustainable. The data on arrears, defaults and repossessions were, however, all based on the 1990s UK recession. This posed a problem for banks such as HBoS, Northern Rock and Bradford & Bingley that had pushed into entirely new risky product areas. ‘These products – buy-to-let and self-certified products – did not exist in the early 90s,’ one HBoS director told Parliament, ‘so whatever we were doing in using those data was more judgemental.’ For ‘more judgemental’, read ‘more a matter of taking a gamble’.

Clearly the fundamental factor underpinning this whole house of cards was rising property prices. Northern Rock’s chief executive Adam Applegarth would cite the dearth of housing supply as one of the reasons property prices would stay high and investors could remain confident in the bank’s profitability in 2003: ‘The economic fundamentals of low interest rates, low inflation, low unemployment and
a very limited supply of new housing stock
will continue to underpin the market… our virtuous-circle strategy is in very good shape.’ HBoS’s Andy Hornby, in an article for the
Daily Telegraph
in 2007, said pretty much the same thing, at the same time encouraging ordinary Britons to save more (which would have helped the soon-to-fail bank’s funding problems). In three successive financial results just prior to the crash, Bradford & Bingley insisted that the UK housing market would continue to be supported by the shortage of housing supply. All of these banking disasters were relying on an inadequate supply of housing as a selling point or even the foundation for their failing financial strategies.