Origination, Trading, and Investment
by George Hatjoullis
Consumers spend a great deal of time researching durable purchases such as cars, computers, and white goods. They read reviews and articles by independent consumer organisations such as Which? magazine. Nobody goes into a car showroom and buys the car the salesperson pushes. When it comes to durable consumer goods people seem pretty savvy. Why then, when it comes to financial products, are people so careless? At best they pay for expensive independent advice and leave the judgement in the hands of someone who assesses their needs and risk profile from an intrusive questionnaire. They let someone else tell them who they are in financial terms. At worse they take the first financial product they come across without much thought. They do not buy the first computer they see so why the first mortgage or ISA?
Part of the problem seems to be lack of ability and/or willingness to think about personal finance. You earn £x after tax and NIC. You have liquid savings of £y (where y might be negative). You have net assets of £z ( again z might be negative). This defines your basic budget constraint. You have fixed outgoings each month (things you must pay, like mortgage payments, rent, food etc). Is it really so challenging to sit down and put this all all on paper (or a spreadsheet) and look at it. I suspect most that do not do this fail to do so not because they are incapable but are frightened of the reality it presents. Denial is the most common cause of financial myopia.
Another problem is fear, specifically fear of making a mistake. Occasionally this is overtaken by fear of missing out which can lead to even more catastrophic decisions. This fear is compounded by the plethora of financial products available and the alien language in which they are presented to the public. A systematic and patient approach can overcome these psychological problems (because that is what they are) and put you in control. Step one is to eschew the visit to the pub or club one weekend and sit down and write down your basic budget constraint and non-discretionary outgoings. This will define what you need and what you can afford. You may not like what you see (95% of the population will not) but it is the starting point of being in control.
Once you have determined what you need then, and only then, do you begin a search of what is available to find the most suitable product. This search must be a continuous exercise and not something you just once. Not only will your circumstances change but so does the range of products and the terms on offer. It is a continuously evolving market place. The purpose of this blog is to explain how this market place evolves in simple terms in the hope that it might help those that can help themselves. The example to be used is the mortgage market.
The range of mortgage products is huge and this has to be multiplied by the number of providers. You can go to a broker and present your budget constraint and outgoings and the property you wish to buy and let the broker present you with options and even recommend one. The broker may not of course look at all providers (they should tell you this). Moreover, once a product is selected the process may end there (to your relief) but if the house purchase is delayed a review might be expedient. Things change and in particular the lender that blanked you one week might be keen the following week. Why is this so?
The mortgage market should be seen as consisting of originators, traders, and investors. The originator is the institution that initially sets up the mortgage loan and that you deal with directly. However, the originator may not want to keep the loan on its balance sheet and may include it in a package of mortgage loans which it sells into the secondary mortgage loan market. Traders buy and sell these loan packages as a business (it may be another section of the originator organisation) and investors buy mortgage packages from traders and directly from originators. The three agent categories overlap and the distinction is made only to emphasise that the functions exist in some form. Secondary trading is very important because it provides investors with liquidity and the existence of investors helps originators offer mortgages beyond their own capital base. The world of finance, of which many are so contemptuous, is what makes your mortgage possible, and the choice available.
Mortgages involve interest rate, prepayment, and default risk. Packages are often sliced up into these risk categories and sold to different investors. So whilst you may pay Barclays a mortgage payment each month, the money may end up in many different hands. Barclays may have sold off the mortgage in a package and have no beneficial ownership or liability, beyond servicing the cash flow. Barclays, and other originators, are constantly reassessing the demand for mortgages (and demand for the individual component risks) and this drives the product range and mix on offer. The mortgage terms are not determined solely by the Bank of England base rate. To understand what is on offer you would need to know the sterling swap curve out to ten years and this moves continuously.
Banks no longer make loans which simply sit on their balance sheet until you repay or default. They act as originators and managers of packages which are sold on and make secondary markets in these packages. This has greatly increased the flexibility to offer mortgages though as we saw in 2007, it can go horribly wrong. One assumes lessons have been learned and it will not all go wrong again (and least not in the same way). This is the regulator’s problem. My concern is with the borrower.
Denial and fear do not help. The best way to be in control is to confront your finances and face up to their reality. If you need advice you will need to do the basic arithmetic in any event to inform the advisor and lender. You may as well think about what you need at the same time, as this will help you understand the advice and outcome of attempts to borrow. If you understand what you need it may be you can check the market for yourself and you can keep checking it to see if terms are changing. This will confirm if you have a good deal or can get a better one. Actively engaging in your own finances is the most important thing you can do. It will tell you if you afford the car you spend so much time researching.