It's a while since I posted here, but I think you'll find this interesting. We are hearing about some specialised BTL lenders in trouble, in part because banks no longer want to lend to them. For example, one lender which has ceased BTL lending (though there is no indication that it specifically cannot find finance) is Molo. There appears to be two things happening.
1) These lenders appear to have been lending at fixed rates without covering their interest rate risk. In finance, we call this the "carry trade". It comes in many forms, but in this case it means lending in a fixed rate mortgage over a long period (anything from 2 years out) and financing over the short term at a lower rate. This can be incredibly risky because if interest rates rise, you start to have negative net interest margin and you go out of business.
What one should do is lend long then hedge the risk in an interest rate swap. This involves paying a long fixed rate to match the term of the mortgage, and receiving a short rate which resets say every 6 months to match the term of the bank funding. You should price the mortgage at some rate above the swap. The problem is that this space has become extremely competitive so specialist BTL lenders have been doing the carry trade in order to make their mortgages competitive and to make money.
In Molo's FAQ, it says:
The fact that the firm is even mentioning interest rates shows that they have been taking interest rate risk. If it had hedged their risk via swaps, it would largely (though see point 2 below) not have cared what happened to interest rates . This is a massive indictment of its risk controls, the due diligence of the banks lending to it and the regulation covering these firms.
To give an idea of how this works, think about if you had been lending 2-year mortgages at the 2-year swap rate and financing it with a 6-month loan, which rolls over every 6 months. In November of last year you would have lent the mortgage at about 1%. This is the 2-year swap rate over time:
Your financing cost was 0.30% for the first 6 months. That means you have made 0.70% in "carry" over the first six months (these are all annual rates, so if you had lend £100,000, you would have made £350 net interest margin). Happy days!
But now, 6 months later, you come to refinance that 6-month loan. That now costs you 1.60%. But the money you lent is still only earning you 1%. So now you have negative net interest margin. Not only that, but unless interest rates come screaming down again you will have it for the rest of the term of the mortgage. Indeed, the rate could go a lot higher.
6-month lending rates:
2) The creditworthiness of these mortgages is deteriorating. After the 2008 financial crisis, a lot of the very frothy speculation went away. BTL investors looking simply to rent while they wait for their property price to rise are no longer in the market. Instead, remaining and new BTL landlords have concentrated on "cash flow" - this just means that their monthly rental income beats their mortgage costs. But they own a long-term asset, the property, so are engaged in a form of carry trade themselves. They can only charge what the rental market will allow and that is not even keeping track of inflation, let alone interest rates. So now many (depending on how they are financing, how much equity they have etc) will have net negative rental income when they come to refinance because a) the rates have gone up and b) the rates will have gone up even more than market interest rates because the lenders do not want to lend in the way they have any more (e.g. Molo). This will either cause landlords to sell, that is repay the mortgage early (which would help the interest rate situation of the lender above), but some might slip into negative equity and the lender might not be able to recover all its principal amount. There have been stories in recent years of BTL investors borrowing against any new equity (coming from house price rises) to finance the deposit on more BTL properties - in other words, leveraging to the max. They will be hurting a lot when they come to refinance.
This is definitely a secondary problem for the lenders compared to (1) above, as property prices have not fallen by much yet. But equally it has implications for property prices, particularly in areas where BTL activity has been high over the past few years.
All of this of course is contributing to a real estate market in which the cost of owning property is rising for everyone.
A good thread has emerged on Twitter on exactly this subject. Here: