Stability of the fixed interest, convertible annuity in RE mortgage finance.

By Tom
Updated on

Actually all the elements of the heading are necessary for stability:

  • 1.    Fixed interest is crucial for the debtor, as they will know what they are to pay biannually or monthly.
  • 2.    Convertibility is the ability for the debtor – at will – to pay back the loan in full or buy the bonds on the market and by handing them over redeem their debt.
  • 3.    The annuity with its constant service again gives the debtor predictability.
  • 4.    Real estate: The house of the debtor is put up as collateral/security – up to 70-80% of property value.
  • 5.    Mortgage banking in this context means that the building society is actually owned by the debtors – who actually guarantee the creditor in solidarity in case of default by one or more of their members.

Such a loan can be managed by a debtor with no financial skills – except balancing a check book. It means credit can be granted without straining the bank’s ability to evaluate creditworthiness of debtor. With the actual and historical terrible track record of banks business skills it is necessary that building societies are not owned (or own) banks. Naturally banks will try by hook or crook to expand into territory they know nothing about – with predictable disastrous results in so far as they are successful.
The convertibility gives all the benefits to the debtor:


  1. If interest rate is lowered the bond gets over parity – which means the debtor pays off the loan at parity (usually by a new loan ideally with same maturity). This gives the debtor a lower interest rate on the same debt.
  2. If interest is raised the price of the bond goes down and can be bought by the debtor and exchanged with a reduction in debt from the par value – again this normally happen with raising a new loan at lower debt and higher interest.
  3. Now is that unfair to the investor? Not in the least. An institutional is (should be) able to handle the risk of interest rate variations and inflation (deflation). That all too many major investors aren’t able is not the fault of the debtor or the security.

What a creditor cannot handle is the fluctuations in individual debtor’s fortunes and it is precisely that service the mortgage provides.
All these advantages and drawbacks are naturally priced into the quote on the exchange.
The investor will normally try to buy a series into illiquidity with rising interest rates. Fine! Then the investor is stuck with an underperforming asset. The up side of it for the investor is that disastrous drops in price do not occur: There are always plenty of greedy debtors ready for letting the market service their debt.
It means the bond is much closer to cash than promised. A thirty year bond normally only has a life of ten a year before the loan is converted. Not only that, but as everybody knows the score such mortgage bonds can be treated as cash among investors – there are always buyers at a fair market price.
The annuity has the advantage that the amortisation moves the loan/debt ratio inwards as time passes by. That is not the concern of the creditor, but of the owner owned mortgage bank: The mortgage bank levies an “administration” fee to cover not only the cost of stamps; but also of the defaults that inevitably occurs among the debtor.
Most mortgage banks have a sliding scale (depending on loan/value ratio) for the administration fee, which benefits reliable and solid debtors. They are generally not very good at adjusting the administration fee; but a conversion resets the clock to a more realistic level. Asking for the phone number of another building society generally gives the necessary attention to a detail that had slipped the administrative mind.
Administrators HATE lowering their loan/value ratio – as investors do pay attention to that.
The drawback is that any adultery on the principles is courting Disaster – and as she is a very promiscuous and active lady: She WILL come calling!
Change to flexible interest is a particularly dangerous policy: Debtors are always overestimating their future ability to pay and the solidity of Devine assurance of continued low interest rates. It is always stupid to load people with risks they have no ability to evaluate or indeed to counter. The bankruptcies of 2008 in credit default should be a lesson – but institutions never learn anything.
The result is a well founded distrust among institutional investors to mortgage banks and their issues. As if that wasn’t enough: Housing prices are very dependent on interest rates as house buyers in the real world ONLY look at the monthly payment. So an artificial lower interest rate – due to higher risk – will drive house prices up – and the building of overpriced new houses (which eventually will remove the floor under the prices).
These are the exact reasons for not introducing fixed-interest, convertible annuities at the present time:

  • Housing is grotesquely overpriced in these years. The service of a decent loan is so expensive that very few (especially in relation to the unsold stock) can actually afford them.
  • The supply to the market of houses has through building and renovation oversaturated
  • The natural buyers of homes – those that want to move to get a new job; well they can’t move as they are insolvent – and if they move, they can’t buy.

Isn’t there any hope of getting out of this crisis? Just a tiny sliver of light at the end of the tunnel? NO, the light seen is the express train heading right for you.
The investors will run away from adultered securities leaving banks to buy their own junk. The banks won’t survive it, as quantative easing does not remove debt. QE adds the money to extend credit to debtors that will actually service debt.

Unserviced debt will remain on the books of banks (one way or the other – putting them off-balance fools nobody but themselves – the obligations remain) until the banks default as the accumulated losses have to be financed.
The banks have not the capital stamina to take the losses and adding new capital is generally not an option as financial idiots are a self-exterminating endangered species.

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