Lenders suffer from lack of confidence

The daily news headlines seem to carry frequent shock stories about how much money the large banks have lost as a result of the crash in sub-prime lending. Many of these losses are attributed to a devaluing of mortgage-backed assets rather than any actual losses, but these lower valuations are hurting not only balance sheets but the confidence indicators that drive the industry.

The business of making loans is largely one of risk assessment and margin calculation. Lenders borrow money from one source, add on an adminstration overhead and a margin of profit then lend on to another borrower. It looks like a fairly straightforward transaction until you factor in the possibility of non-repayment and it's here where our big banking brothers came unstuck.

For lower risk loans like secured loans, an asset with a recognised value is used as collateral in the loan agreement, providing the lender with a second chance of recouping their cash should the borrower fail to repay. This asset is then acquired by the lender and sold on to cover the outstanding debt. Normally the value of these assets is assessed such that the loan amount is adequately protected.

In the specific case of a typical secured loan the asset is normally a property and unless that property falls in value the lender should be fairly confident of recovering the loan value.

However in the last period of rapid house price growth, as seen in the US initially, and the UK more recently, lenders started to get over-confident. They resorted to lending sums in excess of a property's value in the expectation that property prices would increase to cover the loan in time, but when house prices started to fall, and fall much more quickly than expected, lenders were left very exposed. The debts they thought were well protected became very vulnerable and that's where the drop in mortgage-backed asset valuations originated.

Now lenders are being ultra-cautious about making the same mistakes again and with property vaues expected to fall by around 15 per cent this year in the UK, loans offered are set to be smaller. That doesn't rule out the chance of finding a low cost loan for the right borrower. As long as they have sufficient assets to secure their borrowing, borrowers should be able to find the right loan with relative ease once the confidence indicators return to normal levels.

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