Since its announcement in Budget 2013, government has faced pressure from media claims that Help to Buy risks creating another housing bubble. So far it seems that media attention has focused on the negative risk aspect of rising prices. But normally, when economists talk about risk, they talk about risks balancing. Implying that, if there is a negative risk involved as prices rise then there must also be a corresponding positive risk. The question the media is yet to ask is, just where has this positive risk fallen?
Without delving too deeply into economics 101, with a mortgage, the positive (upside) and negative (downside) risks are as follows. The contract for the mortgage involves two entities, a debtor (homeowner) who takes out a loan to purchase a property with a loan from a creditor (usually a bank or building society). Let’s ignore the risk pertaining to default and instead focus on the decision to take out the contract. By the time the final mortgage payment is made if the property price has increased, then the homeowner takes a profit (upside risk), and the banks loses out (downside risk) because it would have been better off purchasing the property instead of issuing the loan. And if the property loses value then the opposite is true and the risks are switched. But risks overall for both entities balance across both outcomes, since neither can know for sure, nor can influence where final prices will end up.
With Help to Buy the government is attempting to kick-start the market by entering the contract as a third entity; effectively acting as a second creditor to subsidise mortgages. But where has it positioned itself relative to risk, given that it has the capacity to influence prices through policy?
Here’s a snippet from gov.co.uk (including the example)
With a Help to Buy equity loan; you’ll need to contribute at least 5% of the property price as a deposit, the government will give you a loan for up to 20% of the price, and you’ll need a mortgage of up to 75% to cover the rest.
Click here to enlarge image
If the home in the table above sold for £210,000, you’d get £168,000 (80% from the mortgage and cash deposit) and pay back £42,000 (20%).
So, the repayment to the government relates to the proportion - 20% - not the initial value - £40,000- of the loan. The government gets a profit if the property increases in value and presumably loses if the property decreases in value. But, unless you were filing for bankruptcy, where are the incentives to sell a property in negative equity? Chances are, the government will make a profit on the bulk of the loans since prices are set to increase over the medium-term (with a little help from policy)…Hmmm…….
But just in case house prices do begin to fall…..Here’s another snippet;
You won’t be charged loan fees for the first 5 years of owning your home. In the 6th year, you’ll be charged a fee of 1.75% of the loan’s value, after this the fee will increase every year. The increase is worked out using the Retail Prices Index plus 1%. Fees don’t count towards paying back the equity loan.
So the fee relates to the value of the loan, not the proportion. It could be argued that the effect of falling or rising property prices affects the government and homeowner symmetrically, but still, shouldn’t government be looking to absorb risks in a weak market to boost confidence? Surely homeowners would have benefited more from fees relating to proportion so that costs fall if the property loses value. Flat fees effectively act as a hedge for the government if the property falls into negative equity.
In current circumstances, perceived market risk is high; with the future uncertain the government needed to step in and support the housing market. However, Help to Buy equity loans appear to have been set up with the positive risks associated with rising prices going disproportionately toward government and downside risks of falling prices disproportionately toward homeowners.
So whilst the headlines have focused on the risks of market instability deriving from inflated house prices, the government is set to make serious profits as prices increase, whilst banking on the fact that if prices fall, who is likely to sell? And if prices do fall, more than likely, flat fees will be paid until the house price recovers. Why has the media ignored this?
Instead of behaving like a normal creditor, which gains when the prices fall and loses when prices rise, the government (which can influence the market) has instead positioned itself favourably… prices go up, government wins, prices go down, homeowners lose. It’s a good deal if you can get it!