Latest project: mortgage craziness

UK mortgages: financial innovation run amok.  Source: Google images.

UK mortgages: financial innovation run amok. Source: Google images.

In a never-ending saga, I’ve spent quite a lot of free time these past few weeks studying the UK mortgage market.  In sum: crazy:

  • Where I’m coming from: US mortgages.  In particular, the fixed-rate 30-year mortgage guaranteed by Fannie Mae or Freddie Mac.  When my wife and I bought a house in the US, the choices were pretty much either a 15-year or 30-year fixed rate mortgage. Simples.
  • How about a 30-year fix in the UK? Nope, not available.  If only Americans fully appreciated how sweet the government support of housing is in the US.  No dice in the UK.  BTW, for those wondering – mortgage interest is tax-deductible in the US, but not in the UK.  But anyway.
  • What do Britons do?  Fix for 2 years.  The standard mortgage here seems to be a 2-year fixed rate, which then reverts to a penal ‘Standard Variable Rate (SVR)’ charged by the bank.  Given low rates, there are several offerings for 3-, 5- and 10-year fixes these days.  In practice, the assumption is the mortgager refinances by the end of the fixed rate period – spending another £1,000 or so on fees for the privilege of keeping a discounted fixed rate.  Or they move, or pay off the debt, or…
  • How to take advantage of low rates?  Variable/tracker mortgages.  If you believe rates will continue to fall, there are mortgages which either reflect changes in that SVR (‘variable’) or changes in the Bank of England base rate (‘tracker’). Those smart cookies who successfully predicted the massive fall in BoE base rates entered a strange world of negative mortgage payments in 2008/9.  With the base rate at 50bps, I’m guessing there isn’t much further to go.
    • Extension: but what if I wanted to ‘fix’ my own 30-year mortgage?  The SVR is completely at the discretion of the mortgagee – they can change at will, so very hard to hedge interest rate risk on a variable, or indeed 2-year fixed, mortgage.  The tracker is more interesting – BoE interest rate decisions generally take place at meetings announced well in advance, so could in theory be hedged.  I’m looking into solutions involving Short Sterling and/or UK gilt futures to achieve the fix.
  • Brilliant UK innovation – offset mortgages.  It’s well-known that paying off mortgage principal early is a good thing, to build equity and lower total interest paid.  But what if you come across a load of cash (a bonus, perhaps), with a potential need for said cash in the future (early retirement, perhaps)?  The offset mortgage allows your cash savings to offset the mortgage principal; you can still access your cash if needed, but otherwise you only pay interest on the net amount of principal outstanding.  I like that feature, though it comes at the cost of higher interest expense.
  • But wait – don’t you loathe the UK housing market?  Hmm… yes, particularly in London area.  Upon further research, housing in the Midlands and North of England (+ Scotland and N Ireland) isn’t as overpriced/undersupplied as the dreaded Southeast.  This is reflected in gross rental yields: London yields are a joke (3% p.a. before fees/fixes?  Happy to rent with that.), while yields elsewhere are much more reasonable.  So maybe worth investigating a purchase further afield.

What fun, investigating financial products.  Ah, to have a 3.8%, 30-year fixed mortgage with a tax credit to boot instead.

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The Savers’ [of the bubble] Budget, by UK Conservatives

Let the campaign begin.  Source: Google Images.

Let the campaign begin. Source: Google Images.

I’m a bit late to the UK Budget commentary – I wanted to hear more experienced/knowledgable opinions before setting out my own.  Anyway, here are some quick thoughts that came to mind while watching the source material + reading summaries of those commentators:

  • The UK actually has a budget.  Not well-known among UK folks, but the US is utterly incapable of passing a budget.  Perhaps a triumph of separation of powers, or perhaps a prime example of how sensible things can’t pass Congress, but idiotic things can.
  • A clear campaign tool.  It seemed to me there were a few programs/expenditures selected for budget inclusion purely to make snide comments about the opposition.  Still, if I were in the ‘internet of things’, I’d be happy with the new subsidies nonetheless.
  • Savers win…I think.  A few items that were interesting to me:
    • Lower income taxes.  Yup, still a Conservative government, even if the policy was a Liberal Democrat policy.  The increase in tax-free allowance will mainly help middle-class folks; those who should be saving more.
    • Tax-free interest.  WOO HOO!  Middle-class earners now get £1,000 of tax-free interest a year; higher earners now get £500 tax-free.  With today’s average savings account rates of about 1%, that means accumulated cash savings about about £50-100k will earn tax-free.  Sweet – this is basically a 20% subsidy on bank interest.  Hopefully an incentive to save more.
    • More flexible ISAs.  For the non-UK’ers out there, one of my favourite programs in the UK is the Individual Savings Account (ISA).  They are tax-free investment/savings wrappers which can be used by any UK resident.  Like a US Roth IRA, but you can withdrawal funds at any time.  The new rules mean you can withdraw from an ISA, then put back the money in the same tax year.  Previously the withdrawals couldn’t be put back.
    • The Help to Buy ISA.  Ugh.  Continuing my rant on UK housing, the next ruse to prop up house prices is a 25% savings subsidy for those saving for a house down-payment.  The saver puts in £200/month; the government puts in £50/month, until a maximum £3,000 subsidy (so £15,000 total in the account).  Great – again using demand subsidies to treat a supply issue.  <humph>
    • Sell-back your annuity.  I see this as a big problem down the road, but one I hope doesn’t hurt too many folks.  I’ve written before about the new pension rules in the UK; now those who have recently been forced to buy an annuity can resell for cash.  Given annuities are basically individual insurance contracts, I can’t see a very liquid secondary market being setup.  That will lead to poor prices for pensioners, who in turn will be easy to scam.  Hopefully I’m wrong.
    • Pensioners – less savings for you.  Despite the above, the lifetime maximum allowance for tax benefit (i.e. tax-deferral) has been further decreased to £1m from £1.25m.  Given today’s annuity rates, the lower cap allows for a lifetime income of about £2,000/month (assumptions: retire at 60, joint, inflation-indexed, no guarantee, no tax-free lump sum).  That’s a bit lower than UK median income.  So seems a bit stingy to me – it’s a cap which many ordinary savers will probably hit.
  • What I didn’t hear enough of: infrastructure investment.  I’ve written before how I view the situation: use record-low government borrowing rates to build infrastructure (and more social housing, while we’re at it).

In sum: I’m looking forward to tax-free interest (even with peer-to-peer lending, apparently), and the lower taxes.  The rest is kinda ‘meh’, aside from my bad thoughts on HTB ISA and new pension rules.

UK housing: Let’s choke our own people

Where can I live on my median income?  Source: londonrents.org.uk

Where can I live on my median income? Source: londonrents.org.uk

I’ve written before about my confusion/frustration/anger at the UK housing market. This view was reinforced by a recent Dispatches episode (for US readers, think 60 Minutes).  Now I could get very investigative about the issue myself – given I feel strongly about this issue, I may well in the future – but for now some thoughts from various readings/viewings/stats:

  1. There seems to be an obvious market failure going on in UK housing: lack of supply. The Dispatches episode quoted the need for about 240,000 new homes each year to meet basic housing formation, with only about 100,000 being built.  The figures are the same for London, in terms of housing built as proportion required.
  2. Call this a lack of understanding, but even Enzo Ferrari knew that you only needed to produce 1 unit less than demand to ensure pricing power.  This gap seems completely self-defeating for property developers.  In economics 101 terms, surely the marginal revenue isn’t maximised at this level of production; producers could still improve their (surplus) profits by producing more units.
  3. Why aren’t developers producing?  It’s probably a similar situation to cities like San Francisco/NYC, whereby geographic limits constrict supply.  In London’s case, however, these limits are self-imposed: green belts keep the property available within reasonable commute contained.  Planning permission is a big issue, as well –  London is a pretty low-rise city, and though that adds to the city’s charm, it lowers the city’s residential capacity.  Developers must play expensive games with planners to build more, which probably leads to more production of expensive, high-margin housing than higher-capacity housing.
  4. The influence of foreign investors.  Look, not every foreigner buying property in London is money laundering.  There are loads of folks seeing London for what it is: a supply-constricted market with lots of professionals making decent cash.  What I wonder about is buy-to-let hurdle rates: with mortgage rates at all-time lows, I suppose folks can be happy with a rental yield of 4-5% net of management fees.  That would set a cap on property prices, unless of course rents increase at a faster pace.  But if the latter occurs, who’s going to rent?  Most of London is already unaffordable.
  5. What about those on the ladder?  A frequent topic of London conversation is ‘getting on the property ladder’…maybe escalator would be appropriate here.  The idea is that one just needs to buy any property, get some gains, then flip into a bigger property.  Hmm… so one just keeps doubling down in the property sector.  For those trading up the ladder – be aware that both losses and gains are magnified.  In any case, I can see how this ladder situation puts politicians in a very tight spot: their constituents probably couldn’t handle a correction in property prices, as mortgages get called in.
  6. How about property tax?  The UK has a sort-of property tax, like the US: it’s called council tax.  The main difference, to me, is that the latter caps out at a pretty low level; US property tax is generally a set % of assessed value, with no cap.  Here’s an idea for the UK, which would probably be an easy redistribution from rich -> poor: take away the council tax cap.
  7. What about mortgage rates?  All time lows – check.  UK mortgages primarily variable rate – check.  Affordability based upon these low rates – check.  So look out when rates rise.  Again a politically difficult situation – why would the BoE ever raise rates, as so many people would probably find housing unaffordable.

In sum: UK housing is a classic asset bubble, in my opinion.  So much unproductive investment pouring into land values.  The fact the ‘housing ladder’ is ubiquitous should be a red flag that folks buy property because it always goes up…very dangerous.  And these inflated prices mean ordinary (middle class!) workers can no longer afford to live and work in London and elsewhere.  If the UK believes in equality of opportunity (and I think we do), why do we let this transfer of wealth from the lower-paid (stuck renting) to higher-paid (buy-to-let, with homeowners sharing positive externality) happen?  Seriously?

End soapbox.

Median incomes and housing affordability

Housing: get it while it's hot?  Source: Google Images.

Housing: get it while it’s hot? Source: Google Images.

Today’s Bloomberg has an article about housing affordability in various US cities, with some harrowing statistics.  Apparently an average Brooklyn residence would cost 98% of median income in mortgage payments (10% down payment; 30-year fixed mortgage).

So that got me wondering about London.  A quick calculation, using the same methodology as RealtyTrac in the Bloomberg article:

  • London median income: £23,800 p.a.  Source: London Datastore
  • London median house price: £322,000.  Source: same as above
  • Average mortgage payment: £1,770 per month.  That’s a 90% LTV, 25-year 5.5% mortgage.  Source: MoneySupermarket
  • Therefore, mortgage payment as % of median income: 95%

BUT WAIT

  1. A median income couldn’t borrow that much: The same mortgage calculator limits borrowing to around £100,000 for the median income.  Smart, seeing as 95% would be taken by the mortgage payments.  I assume this would be the same as the US.
  2. UK doesn’t do truly fixed mortgages: The nice things about US mortgages are:
    1. Tax-deductibility of interest (at highest marginal rate)
    2. 30-year interest rate fix.  Today’s rate is around 4% p.a. (Source: bankrate.com)
    3. Therefore: if UK mortgage rates went up (and let’s be honest: they’re unlikely to go down much from here), the median income would quickly be insufficient altogether.

In sum: I guess we already knew this.  Housing is VERY unaffordable.  I’m sticking with other options.

Trouble getting on the housing ladder? There’s an ETF (or several) for that.

Ah, the likely murmurs of stone-faced City workers I pass in the morning: just keep earning the paycheque; have to pay the mortgage.

I’ve written before about my general thoughts on buying a house.  I was burned in the bubble-pop of 2009, so perhaps I’m jaded.  In any case, here are my general thoughts:

  • Pros of buying a house
    • Decorate it as I (or more likely, my wife) see(s) fit
    • A nice feeling
    • A diversifying investment, with the opportunity for very high leverage
    • A real option: if things get very bad, I can try to convince my wife to allow a lodger or two
  • Cons of buying a house
    • Continuous repairs + taxes + insurance
    • Huge capital outlay
    • Extreme illiquidity, such that valuation is very tricky and transaction costs are high. These effects are multiplied by the leverage used
    • Reduced financial and physical flexibility: harder to move for whatever reason

I like the diversifying aspect of housing, so can I get the good without the bad?  The short answer is yes, I can get the investment characteristics of housing without buying a house.  A good example is the iShares Dow Jones Real Estate ETF (IYR), which contains a basket of real estate holding companies, REITs, and developers.  The performance of the fund tracks the Case-Shiller 20-city Housing Price Index quite well:

No need for bricks or mortar.  Source: Quandl and S&P.

No need for bricks or mortar. Source: Quandl and S&P.

The fund is a bit more volatile than the index, which is probably at least part due to the illiquidity of measuring house prices.  In any case, the correlation is reasonable, and the major trends are captured.  The ETF is liquid, with OK-ish liquidity on the options for those wanting a leveraged investment.

As a kicker, the dividend yield for IYR is about 3.5%; that’s probably a bit lower than the net rental yield on a buy-to-let, but at least no one calls in the middle of the night needing a toilet unblocked.

Let’s party like it’s 2007… Fannie and Freddie return to power

I was interested in this article by the Economist over the weekend.  In the latest ‘WTF?’ moment I’ve had when reading the financial/economic news, various US Government agencies have evidently removed the more stringent requirements on what qualifies as a government-guaranteed mortgage.  Remember the heady days of 2007 and before, when ‘stated income’ (a.k.a. ‘liar loans’) and < 5% deposit mortgages were the order of the day?  Welcome back, I guess.  In another ‘WTF’ moment, evidently banks no longer need to have ‘skin in the game’ for RMBS they’ve structured from Fannie/Freddie mortgages; they can go back to underwriting mortgages to whomever they please, confident Fannie/Freddie will guarantee the loans for structuring.  Again, back to the fun times!

The only somewhat relieving factor this time around is the US Government’s explicit ownership of Fannie and Freddie.  I mean, the Government/taxpayer were on the hook for the costs of mortgage blow-up in 2008; at least this time the taxpayer gets a 100% profit sweep.  It just makes explicit what has been common knowledge for a VERY long time: US taxpayers like people owning homes so much, they’re willing to subsidise each other’s purchases through the tax system.

I can borrow HOW MUCH??

Maybe it’s time to get on the housing ladder…I mean, everyone in the UK is doing it.  From the latest inflation figures, interest rates may not be on the rise for a long time; why not go for a big variable-rate mortgage??

I’m being a bit sarcastic here, but something compelled me to look at mortgage rates in the UK over the weekend.  Aside from the bad feeling I get from a variable-rate mortgage as a concept (aside for Americans: it’s incredible the amount US taxpayers subsidise home ownership, between Fannie/Freddie and tax-deductibility of mortgage interest), I wanted to see how much a regular schlub could borrow.  Using one of those fancy calculators one of the major high-street banks offer on their website, I put in something like:

  • Borrowers – 1
  • Salary for borrower – £35,000 p.a. (around the national average)
  • Other liabilities – £0
  • Result: I can borrow £168,000 

So around 5x gross income?? At average UK rates (keep in mind – no tax-deduction for interest here), that’s £850/month for a standard mortgage.  Assuming standard UK tax rates, after-tax income for this would be around £2,500/month; therefore the mortgage is around 1/3 of income.

I guess that’s alright, when rates are low.  About 4% for this scenario, which is about 3.5% above UK base rate.  Suppose the margin (3.5%) stays the same over time, with all the variability in the base rate.  The latter has been around 5% for an awful long time – so a ‘normal’ mortgage rate would be around 8%.  My mortgage payment would then be around £1,300/month, or just more than 1/2 of income.

Again, this signals 2 things for me:

  1. Americans are soooo lucky: fixed interest mortgages are a god-send, particularly for less financially-savvy consumers.  I’d much rather know that I’m paying 4-5% p.a. for 30 years than have the situation outlined above.
  2. I think I’ll hold off getting on the housing ladder: yes, house prices keep rising in the UK.  How can people afford it?  Rolling equity from their previous houses (the ‘ladder’ bit), and paying low interest (which, incidentally, helps build equity through raising house prices).  I think I’ll wait until interest rates rise towards equilibrium, then see who can no longer afford their mortgage payments.  When will that be?  Who knows.  Thankfully rental yields seem to be about the same as interest rates on a mortgage, so I’m not out too much.

End soapbox.