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Dark menace of the black swan

John Rowland, analyst at Cicero, castigates Alistair Darling’s lack of urgency over long-term fixed-rate mortgages, arguing that while some say market events have overtaken the Miles agenda the truth is quite the reverse as ‘black swan’ events must now be borne in mind

Alistair Darling gave a performance worthy of Hypnos, the Greek god of sleep, on Budget day. As he de-livered his oratorical ketamine it was clear he had rediscovered his talent for turning what might otherwise be high political theatre into a snoozefest, even while hell was breaking loose in the financial markets.

It’s fair to say the Budget was not exactly received with rapture by political hacks. The Guardian’s Larry Elliot said: “If the global economy really is teetering on the brink of the precipice, you would have been hard pressed to realise it… riveting it most certainly wasn’t.”

While one can appreciate that a racy Budget is probably not appropriate at this time, there was a feeling that Darling had taken things to the opposite ex-treme. This was a Budget of total cau- tion, even timidity, and nowhere was this more evident than with respect to policy on the mortgage market.

There had been reports that the government was going to introduce a kite mark scheme for mortgage-backed securities. In the end, it did not go nearly as far as this, limiting action to setting up a working group and saying that a gold standard market is best taken forward as an industry initiative.

Moreover, those hoping to see decisive measures elsewhere in the Hous-ing Finance Review, published along- side the Budget, were to be disappointed. The HFR was launched in October with the primary objective of iden- tifying barriers to the provision of long-term fixed-rate mortgages. This agenda has been rumbling along since the Miles Review of 2004. Progress towards wider uptake has been limited to date, with the reaction from industry and the public bordering on somnolent.

But from a public policy perspective there are good reasons to advocate a greater uptake of long-term fixes and the government should redouble its eff-orts in this regard.

Highly leveraged consumers simultaneously taking a punt on interest rates and house price inflation and lenders obliging this blind optimism by relaxing criteria and relentlessly pricing for market share rather than sustainable, profitable business is hardly a recipe for financial stability. I’m sure the Treasury would be happy to see an end to it.

While the most egregious examples of these practices have been tempered by market conditions, anyone who thinks we will not see a return to imprudent market practices in the future is naive.

So while some say that market events have overtaken the Miles agenda, the truth is quite the reverse. Now is the time to take stock of how we provide housing finance.

The market meltdown makes a strong case that for some of us nice, safe long-term fixes may be better for our health than the interest rate roller coaster we insist on riding.

Is it not time for humility? If the big brains at Long Term Capital Management (remember it?), Northern Rock and Bear Stearns can get things so spectacularly wrong, why do ordinary borrowers imagine they can do better?

These are the sorts of issues dealt with in Nassim Nicholas Taleb’s best selling book, Black Swan.

In the book, a black swan is an event that displays the following characteristics – rarity, extreme impact, and retrospective predictability. The current market fits this mould.

But as humans, we seem to be poor at taking black swans into account in our decision-making. Even bankers running the most sophisticated models can’t forecast them. In fact, Taleb has a beef with the tunnel vision these models engender. Punters taking out short-term fixes a couple of years ago when loans were cheap could hardly have conceived that problems with some sub-prime loans in the US would have caused their repayments to spike just as they were due to refinance.

All most borrowers see is that they can save a percentage point or two now, rather than the fact that at some point in the future a crisis might mean they can’t service their mortgages.

Perhaps it’s time to consider how we can adapt to black swans which, in this interdependent global financial system, are likely to turn up with greater frequency and increasing impact.

Black swans are beyond the power of even the US Treasury to control so we must ensure that institutions and borrowers can take more easily quantifiable risks and stop picking up pennies in front of steamrollers. Long-term fixes are not suitable for everyone but they must be part of our armoury.


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