Stephen Knight, Executive Chairman, Checkmate Mortgages Limited

Recently Alan Greenspan, former chairman of the US Federal Reserve, and generally considered to be one of the leading economists of his generation, said the the current, worldwide liquidity freeze was a ‘once in a century experience’ which had taken him ‘by surprise’. On that basis, what chance do we mere mortals have in understanding how it happened, and when it’s going to end?

I’m going to have a go in this blog. But the extent to which my view is better than yours, or anybody else’s, is a matter for conjecture.

As many predicted, house prices are falling, and arrears and repossessions are rising. But I now know what a maths examiner feels like when candidates have got to the right answers through the wrong workings.

Take house prices. Economists and commentators predicted house price falls based on an out-dated and inaccurate formula called the house price/earnings ratio. This relates average house prices to average earnings. The problem with it is that the majority of mortgages are funded by two incomes, not one, moreover, the average income figure includes those who are not, and never will be, homeowners. The CML affordability measure, which relates the first monthly payment to the initial income, while not perfect, showed that matters had not in fact reached a tipping point for most.

The truth is that house prices are falling due to the liquidity freeze, under which people cannot borrow at the LTVs they need or, in some cases, at all.

Let’s look at arrears and repossessions. I chaired a conference recently at which politicians and consumer group representatives continually repeated the mantra that lenders and borrowers had acted irresponsibly, until I pointed out that, according to the CML, less than 2% of loans were 90 days or more down. That does not support the accusation of irresponsibility. The reason that arrears and repossessions are now starting to rise is because the liquidity freeze is creating higher interest rates (based off LIBOR) and higher unemployment through recession.

Although the UK was indebted to record levels, it would have been manageable absent the liquidity freeze.  So, what caused the freeze, and when will it end?

Sub prime lending got massively out of control in the US. Imagine blowing up a balloon and not stopping. Eventually it will burst and scatter its pieces everywhere. Some players felt that the ‘gravy train’ could never end and bonds supported by sub prime collateral were sliced and diced so many times to create new investment vehicles that, in the end, there were more AAA issues in the market than there was AAA collateral to back them.

The US balloon burst. Arrears went through the roof. It was clear that large numbers of borrowers should never have been offered such mortgages and were going to default. Some of the collateral had no value. And, due to the US-invented mark-to-market accounting policy, where the value of investments held in the books must reflect what you can sell them for, as opposed to what they might be worth over the longer term, the fallout started to produce big book losses for financial institutions. So much so that banks stopped lending to each other for fear of undeclared exposure to sub prime collateral.

Two other factors made the initial US problem into a worldwide crisis. The first was a general impression in the US that their institutions had ”fessed up’ to their exposure to sub prime whereas European institutions had not. I don’t know how much truth there is/was in this. Having been in Director positions with two US financial institutions I know there is a tendency, even among very bright US executives, to assume that all markets work like the US, whereas the UK, for example, was much more regulated in our product design and underwriting processes, with sub prime lending not even reaching a quarter of US exposure. That has got to be sorted out.

Then Lehman Brothers collapsed. When historians look back at this period, the decision to let Lehman swing will be seen to have been disastrous. On top of the issue of sub prime exposure, there were then concerns about exposure to Lehman, either directly or through credit default swaps. All banks borrow short and lend longer, so a determined run on any institution will bring it down. Due to Lehmans, the world suffered a banking crisis that has now seen unprecedented nationalisations and takeovers.

The UK Government has to be applauded for the lead it has given the world in this area. The trouble is that a nationalised bank, or one benefiting from significant and expensive government capital, has conflicting interests. The Government wants increased new lending, but the banks concerned feel that repaying the Government’s loans and capital is a higher priority. The Government would like base rate reductions passed onto consumers, whereas the fully or partly nationalised banks want to keep margins high to rebuild capital and encourage borrowers to move away. That will take quite a while to sort.

So, when will it end? I’m tempted to say ‘ask Mr Greenspan!’. But instead I’ll have a go.

The world is in recession caused by the liquidity freeze. Can this go on for years? I don’t think so. A specific event has caused it. Governments around the world are being very front-footed in their actions to support banks and reduce rates. I think that, by Q2/Q3 ‘09, we could be at, or at least be seeing, the bottom. Once you can see the bottom, that is the time to act, and take advantage of the under-supply in the UK mortgage market.

I’ve always found that, if you try to sell exactly at the top, or buy precisely at the bottom, of markets then you will lose out unless you are very lucky. Instead you need to read shapes. I sold Private Label in 1998, a few years before the decline of the prime market design and distribution model, because I felt that this was an emerging shape. I subsequently resigned as chairman of GMAC RFC in April 2007 because I could see a massive supply-side adjustment emerging (not a liquidity freeze!) and it wasn’t my style to dismantle something that I had largely created. I created Checkmate because I can see a major opportunity to launch, at the first sign of thawing, an intermediary-focused, innovation-led new mortgage lender.

We are therefore quietly building our business so that we are ready to launch when market conditions permit. Opportunity always accompanies adversity.