My daughter, who knows a thing or two about the human body, keeps on telling me “Breakfast doesn’t count”, as we sit opposite each other of a morning eating our opposing meals – macerated fruit (me) versus two chocolate croissants (her). The point – her point – is that early on in the day you could chug down a cup of duck fat without consequence because you are going to burn it off anyway as you go about your day. It’s what you eat the rest of the time that makes the difference.
If you were setting up a bank from scratch today (for convenience let’s call it Stewart Cowley Unlimited Mortgage Bank – SCUM Bank for short) you would think pretty much the same way – you could eat as much risk as you wanted at the beginning because within not very long you would burn it off – all you need is rising property values as you go about your day. For instance, if house prices were going up at 5 per cent a year for five years then the loan you made would be only 78 per cent of the value of the house. As a banker your only thought would be – "If the borrower stops paying I could sell the house and get my money back even after all the other fees – happy days. Is that a bonus I see before me?"
Do the same calculation for 7 per cent house appreciation and the value of the loan is now only 70 per cent of the house value. And don’t forget this is with a 100 per cent mortgage; make the borrower put down 20 per cent up front and, after five years, these loan-to-value ratios drop to 62 per cent and 56 per cent respectively. In other words the cushion you have as a banker from making a loss is simply enormous. You understand why it is in just about everybody’s interests, in a functioning capitalist economy, that house prices keep on rising at a more or less steady pace; banks win, homeowners win, regulators win, politicians win.
More to the point, should things go wrong for some borrowers the chances of losing the money of the people you borrowed off in the first place (depositors) is minimal and what’s more, as a bank, you don’t have to put too much money aside for a rainy day to cover any losses that may arise from bad loans.
And so the system gets bigger and bigger – depositors are blissfully unaware of the risks being piled up and banks begin to function on wafer-thin reserves of money. And why shouldn’t they? In the US on rolling five year periods house prices rose by about 5 per cent for 30 years. Here in the UK it was just under 9 per cent with barely a pause for breath. It is a situation with some risks, many virtues and even more vested interests all aligned to keep it going.
You also understand why banks and bankers don’t self-limit; experience tells them that it isn’t necessary. Setting legislation that increases the amount of money bankers put aside for a rainy day, like those being introduced by the US and under the Basel III criteria, is against their instincts and experience. It has even led JP Morgan CEO Jamie Dimon to declare them “Un-American” because the idea of control is anathema to them.
So if you really want to control bankers you have to control the borrowers. Increasing interest rates to penal levels will stop the mathematics working. But we have had a generation of central bankers that colluded with the system and invented excuses not to rail in the excesses of either the lenders or the borrowers; interest rates were kept in single digits whilst house prices were rising by double digits in the run up to the peak in 2007, bolstered by the convenient theory that risks were being smeared around the system so thinly that no one would get hurt.
In fact risk was being concentrated in the hands of a few with disastrous consequences. Alan Greenspan, the Federal Open Market Committee and Sir Mervyn King and the Monetary Policy Committee of the Bank of England are all culpable in that sense of being unwilling to dish out the harsh medicine when it was needed. It’s something that shouldn’t be forgotten as we reignite the credit cycle, especially in the US, and watch as house prices rise, once again, far above the cost of borrowing. We need a new generation of central bankers prepared to lead, not follow.