BTL lenders & landlords in trouble

[Extradry Martini]

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.

EDIT: UPDATE

A good thread has emerged on Twitter on exactly this subject. Here: 

 

 

 

Edited May 4, 2022 by Extradry Martini

[winkie]

Hi Extra Dry.....almost like deja vu.

[Si1]

Bloody h3ll!

[msi]

Nice write up @Extradry Martini and good analysis.  Makes a change reading something educational, completely on topic, and not wailing about WoKe, ImMiGrAnTs, CoRbYn etc etc

 

I'm def getting Northern Rock vibes  (despite the Tory FanBoyz trying to pin that as caused by Brown breathing)

[Extradry Martini]

1 minute ago, msi said:

Nice write up @Extradry Martini and good analysis.  Makes a change reading something educational, completely on topic, and not wailing about WoKe, ImMiGrAnTs, CoRbYn etc etc

 

I'm def getting Northern Rock vibes  (despite the Tory FanBoyz trying to pin that as caused by Brown breathing)

Thanks for the kind words. I don't think this is anything like on the scale of Northern Rock, and even less the financial crisis which accompanied that. But it might have big implications for the real estate market.

[Si1]

1 minute ago, msi said:

Nice write up @Extradry Martini and good analysis.  Makes a change reading something educational, completely on topic, and not wailing about WoKe, ImMiGrAnTs, CoRbYn etc etc

 

I'm def getting Northern Rock vibes  (despite the Tory FanBoyz trying to pin that as caused by Brown breathing)

Well they regulated consumer mortgages but not BTL. So the balance of spiv activity moved to where it could in the BTL space. I wonder where Adam Applegarth is working these days?

[Extradry Martini]

12 minutes ago, winkie said:

Hi Extra Dry.....almost like deja vu.

🙂

Been a while, I know.

[JimTheHouseCat]

Seems like the energy companies where the ones with the worst practises went bust first.

Molo is just the first of many, as rates rise more will get their borrowing restricted by banks.

[spyguy]

1 hour ago, Si1 said:

Well they regulated consumer mortgages but not BTL. So the balance of spiv activity moved to where it could in the BTL space. I wonder where Adam Applegarth is working these days?

https://find-and-update.company-information.service.gov.uk/company/07362296

Slumlording with his son by the looks of it.

 

[reverand_cat]

Holy sh**

 

Probably the most interesting / important post on this site in decades and it starts to float to the bottom.

Do we know how much of the BTL market is covered by practices like this?

 

Also, contagion, if these BTL mortgage lenders go bust, do those with large portfolios have to suddenly get funding from elsewhere? Could we be looking at a ton of lending suddenly with either no one willing to lend on? Or with even higher SVR? Forced sales?

 

This could be huge.

[Si1]

2 hours ago, spyguy said:

 

 

 

Edited May 4, 2022 by Si1

[msi]

3 minutes ago, reverand_cat said:

Holy sh**

 

Probably the most interesting / important post on this site in decades and it starts to float to the bottom.

Do we know how much of the BTL market is covered by practices like this?

 

Also, contagion, if these BTL mortgage lenders go bust, do those with large portfolios have to suddenly get funding from elsewhere? Could we be looking at a ton of lending suddenly with either no one willing to lend on? Or with even higher SVR? Forced sales?

 

This could be huge.

It's worse. BTL isn't classed as Residential lending, so the FCA rules on treating customers fairly don't apply.

 

It's commercial lending - you'd be lucky just to fall back onto  SVRs.  Expect margin calls.

[reverand_cat]

4 minutes ago, msi said:

It's worse. BTL isn't classed as Residential lending, so the FCA rules on treating customers fairly don't apply.

 

It's commercial lending - you'd be lucky just to fall back onto  SVRs.  Expect margin calls.

Wow, this could be big.

 

Wouldn't this also take in a large amount of recent second home / holiday lets at inflated prices??

 

I know quite a few people with skin in this game. They could not make a margin call! And they'll already be struggling with other inflation factors.

[Si1]

2 hours ago, spyguy said:

https://find-and-update.company-information.service.gov.uk/company/07362296

Slumlording with his son by the looks of it.

 

Extremely appropriate

In fairness he's creaming off profits from other people's risky leverage, so in a private risk sense no difference from his old job at Northern Rock

[Si1]

6 minutes ago, reverand_cat said:

Wow, this could be big.

 

Wouldn't this also take in a large amount of recent second home / holiday lets at inflated prices??

 

I know quite a few people with skin in this game. They could not make a margin call! And they'll already be struggling with other inflation factors.

From EDM's post I'd believe it's limited in scope so might not be contagious. But it's still relevant.

[Extradry Martini]

32 minutes ago, reverand_cat said:

Wow, this could be big.

 

Wouldn't this also take in a large amount of recent second home / holiday lets at inflated prices??

 

I know quite a few people with skin in this game. They could not make a margin call! And they'll already be struggling with other inflation factors.

You would only get margin calls if equity fell, which would need a fall in house prices. I don't believe they do it (or could do it) because of negative cash flow for the landlord. Some kind of fall with interest rates rising like this seems likely, but it might take time.

[Gurgle]

@Extradry Martini Maybe you could highlight what you think the consequences would look like if the lender is no longer able to operate?  What would happen to the loans, what would happen to the properties ?  How might that play out ?

[Horseradish]

Awesome post @Extradry Martini.

I saw this Twitter thread via Neal Hudson (@resi_analyst) which seems directly related to this.

 

[Extradry Martini]

2 minutes ago, Gurgle said:

@Extradry Martini Maybe you could highlight what you think the consequences would look like if the lender is no longer able to operate?  What would happen to the loans, what would happen to the properties ?  How might that play out ?

I don't have any specialist knowledge of BTL mortgage contracts, so there might be clauses in them which I know nothing about. But assuming that they are like most other loan contracts, the lender goes bust and the banks which are currently financing it lose a proportion of the money they have lent to it. Not a big deal if the lender is small.

The problem becomes if they are large, there are many of them and the bank lending to them is small. But even if a small bank fails, it is still nothing like 2008 - the market for this is not big enough to bring down the bigger banks, which are of course nothing like as leveraged as they were then.

From a borrower perspective, nothing changes - he/she has to keep repaying the loan. The problem comes when they need to refinance as the rates are all a lot higher and competition is leaving the market as lenders like this pull out.

[Extradry Martini]

3 minutes ago, Horseradish said:

Awesome post @Extradry Martini.

I saw this Twitter thread via Neal Hudson (@resi_analyst) which seems directly related to this.

 

Thanks a lot! Yes I saw the same one and linked it in my original post earlier on.

[Freki]

First, thanks like msi I appreciate the thoughts and work behind this post

Second, there is a tiny violin somewhere, I need to dig it out.

Third, let's see how this will impact the market in the future. Today we should have the FED increasing pressure on the BoE to follow in IR hikes. So far the main lenders have not preemptively moved their IR, I imagine this means they are not engaging in some "carry forward" practices as brilliantly explained by OP.

Fourth, a house price (or anything exchanged) is set at the margin, let's see how deep the housing market is.

[Horseradish]

23 minutes ago, Extradry Martini said:

Yes I saw the same one and linked it in my original post earlier on.

Ah yes, I see you've updated. I guess this kind of news spreads fast...

[Gurgle]

4 hours ago, Extradry Martini said:

I don't have any specialist knowledge of BTL mortgage contracts, so there might be clauses in them which I know nothing about. But assuming that they are like most other loan contracts, the lender goes bust and the banks which are currently financing it lose a proportion of the money they have lent to it. Not a big deal if the lender is small.

The problem becomes if they are large, there are many of them and the bank lending to them is small. But even if a small bank fails, it is still nothing like 2008 - the market for this is not big enough to bring down the bigger banks, which are of course nothing like as leveraged as they were then.

From a borrower perspective, nothing changes - he/she has to keep repaying the loan. The problem comes when they need to refinance as the rates are all a lot higher and competition is leaving the market as lenders like this pull out.

Thank you.  So essentially the bank defaults and goes out of business.  The borrower is largely unaffected.  The loan contracts presumably get taken on by another lender, probably initially at a loss in order to pick up the refinancing later which then becomes profitable at that point ?

[msi]

Fed has increased rates by 0.5% and giving expectation of at least another similar rise, if not 2.

The tide is receding and lots of naked players about to be exposed.

[spyguy]

8 hours ago, Gurgle said:

@Extradry Martini Maybe you could highlight what you think the consequences would look like if the lender is no longer able to operate?  What would happen to the loans, what would happen to the properties ?  How might that play out ?

Molo isnt a bank.

A quick skim of 

https://molofinance.com/

And youll see no mention of 'bank'

Molo is  a finance house. They have to raise all capital they lend. Theres no drawing down from the BoE.

As IR fell, yields conoressed and all these wierd and wonderful finance animals became viable. Investors chasing an extra percentage ir two having to swallow all that extra risk.

As rates rise  - poof! - there's no viable space for them- cost of capital is far too high.

What happens? The book shutdowns, existing mortgages run off, ant defaults are borne by bond holders.