Peter Jones: Hubble, bubble, mortgage trouble

Financial regulation should cut both ways, customers as well as lenders need to be carefully monitored

BETTER regulation of financial service firms to both prevent them collapsing and causing crises, and to stop them ripping us off with dodgy products, is clearly something we all support. But I can't help thinking there is something missing. Should there be rules to regulate what we, the consumers, can get, especially in the form of property loans, from banks and other lenders?

It is time to go back to a general principle that used to be applied in the days when bankers were cautious and prudent people - that loans should never exceed a certain percentage of the value of the property being bought. I also think that this is a principle that should apply to both the lenders and the borrowers.

The thought has emerged from studying two important documents published in recent days on how to prevent future financial crises and bad behaviour. The first is the annual report of the Bank of International Settlements (BIS - an organisation of central banks) and the second is the prospectus for the new Financial Conduct Authority (FCA), intended to regulate financial institutions' behaviour. Sad, I know, but somebody has to do it.

The BIS report contained some alarming things. It pointed out that property markets in some countries are now behaving in exactly the same way as they did in Britain, America, Ireland, and Spain before the crash - they are inflating rapidly. Since it was the bursting of these property bubbles which were at the root of the recent crisis and recession, it implies that we are on the way to creating the conditions for the next crisis.

Moreover, the new bubbles are occurring, not in little places, but in big countries. Charts in the BIS report show that property prices have nearly doubled in Russia since the beginning of 2007. Lesser amounts of inflation, but still enough to worry the BIS, are occurring in China, Indonesia, South Korea, and Mexico. Mainly, it seems that the money to finance the new enthusiasm for property in these countries has come from inflows of foreign capital, a consequence probably of recession causing limited opportunities for investment returns in traditional western economies.

Should we worry if a lot of Russians and some foreigners lose their shirts in a bursting property bubble? Yes. Because we now know that the international financial system is so interconnected that a crisis in one place causes problems, if not crises, in other places. And since growth in China is one of the few engines pushing the world economy forward, there would be serious repercussions if it suddenly went into reverse.

One consequence is already set out in the BIS report. It thinks that global interest rates will have to rise to stop the property inflation. It notes that this would cause problems in economies like Britain's where the recovery is sluggish. But it clearly seems to think that a bit of stagnation is preferable to the upheaval of the bursting property bubble.

I think, however, that this points to a serious problem with interest rates as a financial management tool. They are far too blunt. In order to deal with a problem in one corner of the economy, it seems unduly harsh to penalise other parts, manufacturing industries for example, which are behaving properly.

A preferable solution would be to restrict property lending. The BIS report dismisses this too lightly. The most commonly used restrictions take two forms. One is to limit the amount of money that can be used to buy a property by stipulating that a loan can be no more than, say, 80 per cent of a property's value. The other is to set out that only a certain percentage of an individual's or institution's income, say, a third, can be used to service the costs (loan repayments, insurance, and maintenance) of owning a property.

Both of these mechanisms are used in countries like France and Canada, neither of which have experienced property bubbles. They also used to exist in different guises, but in a voluntary fashion, in Britain. But in the madness of the decade before 2007, they went out of the window as mortgage lenders became prepared to lend in excess of 100 per cent of a property's value and ridiculous multiples of income, leading to a property price bubble.

Looking through the FCA's prospectus, there is no talk of these things. Perhaps it is too early in the genesis of the new regulatory regime, but I think is time to talk about bring back such restrictions on a rather more formal basis than before. I also think that they should be extended to commercial property lending.

Banks and other financiers of commercial development should be limited to lending, let's say, 80 per cent, of a development's eventual value. That would have the handy effect of building in a buffer protecting a bank's loans from having to suffer losses if there was downturn in property values.

Now, of course, it seems pretty clear that this is in effect what banks are already doing, which is why developers are amongst those complaining that banks are not doing the lending that the economy needs in order to sustain the economic recovery.

But the hard lesson, especially from Ireland where the skeletons of unfinished and empty developments now haunt the land, that commercial property booms and their consequent busts wreak far more damage to the economy than developments which remain gleams in people's eyes because finance to build them cannot be raised.

This sort of regulation, especially in the domestic property market, would also raise new barriers to entering the property market.

First-time buyers would have to have satisfactory incomes and a quite a large deposit before they could get their first home.In effect, sub-prime mortgages would disappear.

Again, the hard lesson from the financial collapse is that lending money to people who could not afford the repayments is a recipe for a disaster which causes financial suffering to many more people.

There would be some benefits, for example, that once on the property ladder, new homeowners would be much less likely to suffer from the negative equity problem of their home being worth less than the money they borrowed to buy it. It would tough to explain that to homeless young people. But the other dreadful lesson of the crisis is that we, the public, cannot be trusted to behave with financial responsibility if there ridiculously risky money can be had from apparently reputable institutions.