Cicero Policy Briefer

Issue 23, April 2008

Mortgage market policy: Dealing with a black swan

By John Rowland

Alistair Darling delivered a performance on Budget day that would have been worthy of Hypnos, the Greek god of sleep. As Mr. Darling stood delivering his oratorical dose of ketamine it was clear he had rediscovered his talent for turning what might otherwise be high political theatre into a snoozefest, even while all hell was breaking loose in the financial markets.

It is fair to say the Budget was not exactly received with rapture by political hacks. The Guardian’s Larry Elliot said, “If the global economy really is teetering on the brink of the precipice, you would have been hard pressed to realise it…riveting it most certainly wasn’t.”

While one can appreciate that a racy Budget is probably not appropriate in such circumstances, there was a feeling that perhaps Darling had taken it to the other extreme. For this was a budget of total caution, even timidity, and nowhere was this more evident than with respect to policy on the mortgage market. There had been reports that the Government was going to introduce a kitemark scheme for mortgage backed securities. In the end the Government did not go nearly as far as this, limiting action to setting up an industry working group and saying that a “gold-standard market is best taken forward as industry initiative”.

Moreover those hoping to see some decisive measures elsewhere in the Housing Finance Review (HFR), published alongside the Budget, were to be disappointed. The HFR was launched in October, primarily with the task of identifying barriers to the provision of long-term fixed rate mortgages. This agenda has been rumbling along since the Miles Review of 2004. Progress to date has been pretty limited and reaction from industry and public bordering on somnolent.  

But from a public policy perspective there are very good reasons to advocate wider uptake of long-term fixes and the Government should redouble its efforts here. Highly leveraged consumers simultaneously taking a punt on interest rates and house price inflation, and lenders obliging this blind optimism by relaxing criteria and relentlessly pricing for market share rather than sustainable, profitable business is hardly a recipe for financial stability. We can be quite sure that the Treasury would be happy to see an end to it. While the most egregious examples of these practices have been tempered by the market conditions, anyone who thinks that we will not see at least some return to imprudent market practices in the future is simply naïve.

So while some say that market events have overtaken the Miles agenda, it proves quite the opposite—now is the time to really take stock of how we provide housing finance. Market meltdown makes a rather strong case that for some of us, a nice safe (boring?) long-term fix might be better for our health than the interest rate roller coaster that we as a nation seem to insist on riding. It is time for humility —if the brains of Long Term Capital Management (remember them?), Northern Rock and Bear Stearns can get things so spectacularly wrong why do ordinary borrowers think they can do better?

These kinds of issues are dealt with in Nassim Nicholas Taleb’s best selling book The Black Swan. A ‘black swan’ is an event that displays the following characteristics: rarity, extreme impact, and retrospective predictability. I would say that the current market events fit in this mould. But we as humans seem to be very poor at taking such black swans into account in our decision making. Even bankers running the most sophisticated models can’t forecast them: in fact, Taleb has a big beef with the tunnel vision these models engender.

Those punters taking out a short-term fix a couple of years ago when loans were cheap could hardly conceive that sub-prime loans in the USA would cause their repayments to spike at the moment they were due to refinance. All most borrowers see is that they can save a percentage point or two now, rather than the fact that at some point in the future a financial crisis might mean they might not be able to service their mortgage at all.

Perhaps it is time to seriously consider how we can adapt to these black swans, which in a highly interdependent and complex global financial system are quite possibly going to turn up with greater frequency and with greater impact. They are, if we are honest, beyond the power of even the US Treasury to control. So we simply need to ensure that institutions and borrowers can take more easily quantifiable risks and get away from picking up pennies in front of steam rollers. Long-term fixes are not suitable for everyone, but they have to at least be part of our armoury.

This article was originally published in the April 2008 edition of Lending Strategy.

John Rowland can be contacted on +44 (0)20 7665 9539 or click here to email.

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