Communities and Local Government CommitteeWritten submission from Castle Trust

Executive Summary

1. Castle Trust offers a long term, sustainable, private sector solution to many of the problems in the housing market, without the need for taxpayer assistance.

2. This submission focuses on new solutions to help the housing market as a whole, not just new housing because

2.1the housing market as a whole experiences six times as many purchase transactions as the new housing market alone;1

2.2the mortgage market is currently valued at over £1,200 billion;2 and

2.3the value of housing in the UK is approximately £4,000 billion3 which is greater than the sum of listed equities, government bonds and corporate debt outstanding in the UK.

3. These three factors mean that solutions to the housing and mortgage market as a whole have significant macro-economic benefits for the UK economy and cannot be ignored. By making the overall housing market stronger, safer and more efficient, this will also improve the attractiveness of building and financing new housing supply because new and existing housing are economically substitutable goods and are therefore inextricably linked.

4. The housing market is very highly leveraged (in the form of mortgages) which, in addition to increasing the risk to individual homeowners, contributes to the boom and bust cycles in house prices (see previously published blogs in Appendix 1). Our intention is to enable part of the mortgage debt in the housing system to be replaced by equity. We do this by allowing homeowners and retail investors seeking exposure to housing to transfer funding and returns between each other, thereby reducing risk in the housing market.

5. Our business not only reduces the risk to homeowners, but opens up a potentially enormous, and previously untapped, source of funding for the mortgage market, with all that would offer to homeowners. Castle Trust’s funding (via HouSAs) is arguably better suited than existing bank deposit funding, which is a funding model that is almost unchanged since the first “permanent societies” appeared over 150 years ago4—the basis of modern building societies and mortgages.

6. Key issues facing homeowners today include:

6.1The risk of their home being repossessed. The Financial Services Authority’s (“FSA”) Mortgage Market Review (“MMR”), published in December 2010, indicated that approximately 50% of mortgage borrowers struggle to make mortgage payments at least from time to time.

6.2The risk of negative equity (due to house price declines and high leverage), which impedes the homeowners ability to move home or remortgage onto favourable rates.

6.3The risk of rising standard variable rate mortgages (“SVRs”) (which is driven by lenders’ cost of funding via global credit conditions, not just the Bank of England base rate).

6.4Pressure on post-tax incomes (ie inflation).

6.5Job insecurity.

6.6Lack of mortgage availability.

7. A key issue facing those not yet on the housing ladder (aspiring homeowners), is finding a suitable and accessible investment such that their savings grow in line with (or ideally better than) the housing market generally while they are building up the necessary deposit.

8. A key issue faced by lenders (banks and building societies) is satisfying the dual requirements of government to (i) increase lending and (ii) maintain and improve their capital strength (often in conflict with the interests of their shareholders).

9. Castle Trust intends to offer two new products, which we believe can help homeowners, aspiring homeowners and lenders with the issues above:

9.1The Partnership Mortgage—a shared equity mortgage which provides homeowners with a safer way to buy a home and reduces monthly payments by about a third. Details can be found here: http://www.castletrust.co.uk/mortgages

9.2The HouSA—an investment product which makes it easier for aspiring homeowners (savers) to build up a deposit for a house, by offering returns in excess of the housing market for as little as £1,000 (available in an ISA and a SIPP). Details can be found here: http://www.castletrust.co.uk/investments

10. We believe market demand is very significant. Over the last two years, Castle Trust has conducted extensive market research and product testing.

10.1.Approximately 80% of consumers surveyed thought that the Partnership Mortgage would be helpful for the mortgage market generally (regardless of whether they were personally interested)

10.2.50% of consumers surveyed were interested in taking a Partnership Mortgage

11. The government already supports shared equity mortgages (FirstBuy and historically other offerings such as HomeBuy Direct), however these mortgages are targeted at different customers (lower income/essential workers/first time buyers) and FirstBuy is only available on new build properties. The Partnership Mortgage, in contrast, is a product which is only available to responsible, good credit quality customers and is not available on new build properties. In other words, our shared equity mortgage is complementary to, not a substitute for, the government’s shared equity mortgages.

12. We believe that the government should provide support and endorse privately financed shared equity, in the same way that it does for the government’s own subsidised shared equity offerings—with the key difference being that private shared equity doesn’t require a financial subsidy. Government support for private shared equity will facilitate the cooperation of a number of the large incumbent lenders (to provide traditional mortgages alongside the Partnership Mortgage), who currently have little incentive to be the first to do something new, and find it easier to adopt a “wait and see” attitude. The cooperation of the larger lenders would benefit homeowners by (i) allowing more Partnership Mortgages to be provided to aspiring homeowners; and (ii) providing increasing competition and thus more choice to customers.

Key risks and problems associated with buying a home

13. For most people, their home is their biggest asset, by far, and they buy it with very high levels of leverage (ie a mortgage of, say, 80% LTV, which is usually many multiples of their salary). Servicing this mortgage is a long term commitment that can typically last for up to 25 years or longer. The biggest risk to the homeowner is their inability to service this mortgage, which ultimately could lead to their home being repossessed. Over the mortgage term, some borrowers may experience life events that could lead to a reduction in their income or to an increase in their expenditure. The FSA’s Mortgage Market Review references a survey of borrowers which indicated that 32% had been made redundant at some point, 26% had experienced a relationship breakdown; and 15% had been seriously ill or had an accident, all of which are strong indicators of financial distress. Another survey referenced in the Mortgage Market Review indicated that just under 50% of mortgage borrowers had less than six months’ worth of savings to cover mortgage payments.

14. Although the housing market as a whole is relatively stable (for example compared to the equity market), individual properties are extremely volatile (risky) assets. This volatility, compounded by the high amount of leverage that many homeowners take on, means that they are highly exposed to the risk of negative equity in the event of falling prices. In fact the chance of a homeowner falling into negative equity even with a 20% deposit is one in six, and approximately 800,000 households in the UK are already in negative equity. See http://www.castletrust.co.uk/blog/what-are-the-precise-chances-of-losing-money-on-the-average-home for details of the analysis.

15. Mortgage payments can often be over 50% of a household’s income after tax (because interest rates might have risen faster than income, because borrowers have stretched their affordability as far as possible at outset or because inflation puts other, more pressing, demands on household finances) and leave homeowners vulnerable to rising mortgage rates (driven by banks’ cost of funding, on which stresses in global credit markets have recently been placing further upward pressure). Around 90% of homeowners either already have variable rate mortgages or have fixed or tracker rate deals ending soon and they face rising mortgage payments as they switch to lenders’ standard variable rates (“SVR”).

16. Mortgage availability is currently poor, with the most attractive deals only available for ≤60% loan-to-value (“LTV”) mortgages

The Partnership Mortgage

Description

17. A Partnership Mortgage is a loan for 20% of the value of a property, which is taken out alongside a traditional repayment mortgage to purchase a home. The borrower must have a minimum 20% deposit, so the repayment mortgage is for no more than 60% of the property value. There are no monthly payments on the Partnership Mortgage. Instead, when the property is sold, or at the end of the mortgage term, the borrower repays:

17.1The original amount borrowed plus 40% of any increase in value, if the value of the property has risen; or

17.2The original amount borrowed less 20% of any decrease in value, if the value of the property has fallen (ie the borrower repays less than they originally borrowed).

18. The repayment principles behind the Partnership Mortgage are that if the borrower’s home doesn’t increase in value, the customer repays no more than they borrowed when they sell their home and the loan costs them nothing. If the borrower makes a profit then we share that profit with them. Castle Trust receives more than 20% because we don’t charge the borrower rent or interest. The borrower always retains the majority of any profit (ie 60%).

Benefits to Homeowners

19. By replacing part of their traditional mortgage with equity via the Partnership Mortgage, homeowners can receive the following benefits:

A safer way to buy a home

19.1It reduces the risk of repossession by about one third. If the borrower’s financial circumstances change unexpectedly, for example if they lose their job, the lower monthly payments can provide a helpful cashflow buffer to allow their savings to last longer until the borrower finds a new job. If a borrower had enough savings to service their traditional mortgage for six months without a job, we estimate that with a Partnership Mortgage they would have been able to live off their savings for an additional two months without having to change their lifestyle.

19.2It reduces the risk of negative equity by about a half when purchasing a home (because the Partnership Mortgage shares 20% of any loss with the homeowner).

19.3It reduces the borrower’s exposure to rising SVRs, which is arguably the most widespread risk currently facing all homeowners with a mortgage. SVRs can be up to 3% higher than initial mortgage rates. SVRs rise and fall at the lender’s discretion and are therefore dependent upon lenders’ borrowing costs which are driven by the conditions in global credit markets. We believe that few homeowners are aware of the risks embedded in an SVR.

A reduction in monthly mortgage payments of about a third

19.4This monthly cash saving can allow homeowners to use some of their income to achieve other life goals, such as paying for their children’s education or to assist with the financial strain of a new child.

In most circumstances, a cheaper way to buy a home

19.5If the value of a customer’s home falls, or rises by less than 3.5% a year, using a Partnership Mortgage will be a cheaper way to buy a home. In fact, in the current environment, we estimate that it will be a cheaper for over half of all homeowners than a traditional mortgage alone.

19.6From both a risk and reward perspective, using a Partnership Mortgage can in many ways be considered to be between buying and renting. A customer with a Partnership Mortgage is effectively buying 80% of the home and having Castle Trust take all of the risk on the other 20% of the home. The customer does, however, retain 100% of the title in the home, as a Partnership Mortgage does not share the ownership of the property.

Costs to Homeowners

20. The main potential cost to borrowers is that, if their home rises significantly in value, a Partnership Mortgage will cost more than a traditional mortgage. However, the borrower is always free to repay some or all of the Partnership Mortgage at any time without penalty (for example by remortgaging or using their existing savings). If the customer’s home has increased in value this should be relatively easy to do as their total loan as a percentage of the property (ie LTV) will have fallen.

21. Further information on the Partnership Mortgage can be found here: http://www.castletrust.co.uk/mortgages

Benefits to Traditional Lenders (Banks and Building Societies)

22. As well as securing high quality, low risk borrowers, a very important side-benefit to banks of lending alongside Castle Trust is that they can provide mortgages to around 2.5 times as many customers for the same amount of equity capital.

23. The interim Financial Policy Committee of the Bank of England wants lenders to increase their equity capital and liquidity buffers, but NOT to constrain lending. These goals are normally somewhat contradictory; however, an important side-benefit of lending alongside Partnership Mortgages is that it allows banks and building societies to do just that.

24. Lenders providing traditional mortgages alongside a Partnership Mortgage will be able to lend to approximately 2.5 times as many homeowners for the same amount of equity capital. This is for two reasons:

24.1Each eligible customer only requires a 60% LTV mortgage to buy a home, rather than an 80% LTV mortgage—so each £1 of funding enables 33% more people to buy a home; and

24.2The traditional mortgage provided alongside a Partnership Mortgage will be risk weighted exactly the same as any other ≤60% LTV mortgage. The capital requirement for an 80% LTV mortgage to the same customer without a Partnership Mortgage (for an internal ratings-based lender) would be several times higher, depending on each bank’s own internal capital model. This reflects the much lower risk of the house price falling by 40% (the index has not fallen by this much in living memory) compared to the risk of a house price falling by 20% (which, as we have explained above, is roughly one in six over five years). For every £1 of equity capital, lenders can therefore multiply their lending back into the real economy without increasing their risk.

HouSAs

Description and Benefits

25. HouSAs provide retail investors with returns in excess of the Halifax House Price Index (HHPI). There are two types of HouSA, both available from as little as £1,000, which can be invested via an ISA or a SIPP:

25.1 Income HouSAs provide a fixed income every three months as well as the full returns of the HHPI; and

25.2 Growth HouSAs outperform the HHPI in a rising or falling market, providing investors with a multiple of any rise in house prices or reducing their losses if house prices fall.

26. HouSAs can be important investment options both for aspiring homeowners saving for a deposit and for savers and investors more generally (ie as a diversifying investment to reduce portfolio risk while keeping portfolio return constant). An Office of National Statistic survey in December 2009 found that 60% of people below State Pension age believe investing in property is the best way to save for retirement. Currently their only real option is through buy-to-let investment, which requires a significant investment amount (necessary for a deposit), and is risky because the investment is in an individual property, not the national index; there are material cashflow risks associated with tenancy vacancy (“voids”) and repairs; and finally there is the financial risk of a traditional mortgage.

Funding Model

27. The majority of HouSA investments are used to fund Partnership Mortgages, with the rest invested into gilts. The business model is most analogous to a building society with two exceptions:

27.1Castle Trust’s assets (Partnership Mortgages) and liabilities (HouSAs) are linked to house prices rather than interest rates as in the case of building societies.

27.2Castle Trust’s liabilities (HouSAs) are long term funding—three, five or 10 years, which is significantly longer than the duration of building societies’ funding (which must be rolled over on a very regular basis to fund the long term mortgages), and therefore safer.

An Extremely Brief Academic Background

28. Partnership Mortgages are not a new concept; the idea of shared equity was proposed by Professor David Miles (member of the Bank of England’s Monetary Policy Committee and previously a non-executive director of the FSA) in 1994 in his book, “Housing, Financial Markets and the Wider Economy”, and by Professor Andrew Caplin of New York University and others in their 1997 book, ‘Housing Partnerships: a New Approach to a Market at a Crossroads’, which describes the problems caused by the indivisibility of housing and the lack of options currently between completely buying or completely renting. The solution proposed was a partnership between the owner occupier and an external investor.

29. In 2010, Professor Christine Whitehead wrote the following in “Shared ownership and shared equity: reducing the risks of home-ownership?”

“the focus of shared ownership and shared equity needs to change—away from encouraging people to spend more towards assisting those who are able to pay for their housing over their lifetime but not able to cope with the risks involved”

and later in the same report, goes on to state:

“Evidence suggests that there are market and regulatory failures which have made it difficult to develop market-based products in any scale…Government support can take many forms that do not involve subsidy, including regulatory adjustments to reduce costs and increase the incentives to provide both dwellings and finance”

30. The situation outlined at the start of this evidence is neither an indication of new problems we are facing, nor new conceptual solutions. Turning sound academic theory into a practical and financially viable reality, however, is difficult. The practical implementation of such solutions would benefit from government support.

Key Challenges and Benefits of Government Support

31. The government can demonstrate its support for innovation and promote competition by encouraging traditional lenders, or at least those with government funding, to cooperate with Castle Trust. As mentioned previously, our research confirms that there is significant customer demand for our products, but in our discussions with traditional lenders to date we have found that there is no incentive to be the first to support new propositions. This is despite the fact that it would be economically beneficial for them to lend alongside the Partnership Mortgage. One primary lender specifically said that the only reason that they support FirstBuy is because of government pressure, and that they would certainly lend with Castle Trust if we received government support, however in the absence of such support, it was easier just to carry on doing what they did yesterday and not to innovate.

32. We believe this complacency by incumbents is driven by multiple factors including:

32.1the inertia and bureaucracy in large institutions;

32.2the fact that new lending is currently profitable for banks and so there is little incentive to do other than to stick with their knitting;

32.3the perception that there is little downside in continuing with the status quo.

33. The simple fact is that unless the larger lenders support shared equity, many consumers will fail to benefit. We have the support of several building societies and smaller banks, who are more nimble and customer focused, but until the larger lenders provide support, the number of customers who can benefit from our products will inevitably remain limited.

One Recommendation for How the Government Can Assist

34. The government can make clear to the present suppliers of mortgages the need for further innovation in the mortgage market, over and above those offerings the government has itself promoted and to which it has committed financial support. In particular, we believe the government should make clear its strong support for privately financed shared equity for the housing market, as a complement to the governments’ own shared equity offerings. We suspect the government underestimates the influence such a recommendation would have: we know of major mortgage providers which have only accepted innovations as a result of government recommendations, and believe that public government support for private shared equity would substantially facilitate its introduction and accelerate its adoption, with all the benefits this would bring to customers.

About Castle Trust

35. Castle Trust was established to

35.1Provide responsible, good credit-quality homeowners with a new and safer financing choice, unlike anything else previously available to them; and

35.2Provide savers and investors seeking to invest in housing with a way to access the returns to the national housing market with less capital than is required for a deposit and without the risks of buying a single investment property.

36. J.C. Flowers & Co. has provided the equity funding to bring Castle Trust to the UK mortgage and investment markets. The Chairman of Castle Trust is Sir Callum McCarthy, a non-executive director of the Industrial & Commercial Bank of China, IntercontinentalExchange and former chair of the Financial Services Authority and Ofgem. Independent non-executive directors of Castle Trust include The Rt Hon. John Gummer, Lord Deben, a former Secretary of State for the Environment, Transport and the Regions (including the Ministry of Housing and Local Government) and Dame Deirdre Hutton, non-executive director of HM Treasury, former chair of the National Consumer Council and deputy chair of the Financial Services Authority. Further information can be found here: http://www.castletrust.co.uk/about-us

APPENDIX 1

How to price equity loans 22 December 2011

http://www.castletrust.co.uk/blog/how-to-price-equity-loans

Shared equity and consumer protection 21 December 2011

http://www.castletrust.co.uk/blog/shared-equity-and-consumer-protection

Shared equity and financial stability 16 December 2011

http://www.castletrust.co.uk/blog/shared-equity-and-financial-stability

Paralysed UK housing market requires a new model 17 November 2011

http://www.castletrust.co.uk/blog/paralysed-uk-housing-market-requires-a-new-model

UK housing system must reform, say experts 31 October 2011

http://www.castletrust.co.uk/blog/uk-housing-system-must-reform-say-experts

The consequences of failing to address the UK housing shortage 13 October 2011

http://www.castletrust.co.uk/blog/the-consequences-of-failing-to-address-the-uk-housing-shortage

Mind the gap—how UK housing supply is critically short of demand 4 October 2011

http://www.castletrust.co.uk/blog/mind-the-gap-how-uk-housing-supply-is-critically-short-of-demand

Time to relax planning regulations? 13 September 2011

http://www.castletrust.co.uk/blog/time-to-relax-planning-regulations

Even sensible mortgages contribute to housing bubbles 29 July 2011

http://www.castletrust.co.uk/blog/even-sensible-mortgages-contribute-to-housing-bubbles

Are current LTVs too high or too low? 13 July 2011

http://www.castletrust.co.uk/blog/are-current-ltvs-too-high-or-too-low

What are the precise chances of losing money on the average home? 4 July 2011

http://www.castletrust.co.uk/blog/what-are-the-precise-chances-of-losing-money-on-the-average-home

Why a Partnership Mortgage is different to previous shared equity offerings 20 June 2011

http://www.castletrust.co.uk/blog/why-a-partnership-mortgage-is-different-to-previous-shared-equity-offerings

January 2012