Is Royal Bank of Scotland's Big Growth A Sustainable Trend or a Risky Bet?

Source: Company.

Mortgage lending at Royal Bank of Scotland (NYSE: RBS  ) grew 21% in the first quarter. The bank has already enjoyed more net mortgage lending in the first three months of 2014 than it did for the second half of 2013. Is this just a one-time spike, or a sustainable trend?

UK housing market 
The British housing market is noticeably taking off as low interest rates spur a drive for borrowing. Housing price inflation, now 10.9%, has reached a seven-year high, and one in 15 homes in London is now selling for GBP 1 million or more.

None of this has escaped the notice of the Bank of England, where the bank's Deputy Governor recently said: 

[There is a risk of] a major overshoot in prices and buildup in debt, followed by a sharp correction with negative equity and an overhang of debt for many households... Unfortunately, there are more precedents in the UK for periods of a rapidly growing housing market to end this way. 

Driven by these concerns, the Bank of England announced that it will impose new stress tests on banks to see if they could manage a 35% decline in housing prices. The Guardian points out that such a crisis would be "unprecedented in the UK."

The Bank also promised to find ways of cooling mortgage lending without raising overall interest rates. Some possible measures include stress-testing borrowers against a rise in interest rates, increased capital requirements, or limits on the amount that homebuyers can borrow relative to their income.

What's next? 
It's nice to see that the Bank of England is paying attention to the housing boom instead of enjoying the flurry of growth and ignoring the possible long-term consequences. Absent any direct action by the Bank of England to limit borrowing, though, my next question would be whether the banks themselves can avoid the temptations of over-lending. There are two areas that I'm watching.

First, I'd like to see the growth rate of mortgages underwritten by banks like RBS, which is enjoying a most agreeable start to the year. 20% growth is already profound; if it continues apace or grows, what would that say about the bank's lending practices? Is it just meeting a market demand, or is it becoming careless?

The second thing I'm curious about is the level of securitized mortgage debt the British banks start offering. Securitized mortgage debt is low in the UK: it dropped 77% in 2013, partly due to the "Funding for Lending" program that lowered lending costs for banks. The program, originally scheduled to end in 2013, was extended to January 2015. What happens when this cheap source of risk-free backing for mortgages dries up? 

RBS hasn't sold securitized mortgage debt since October 2011, and Barclays hasn't sold such bonds since June 2012. Will the banks tune into the siren song of securitization if the housing market continues to heat up? Doing so would be, in my mind, a reversion to the strategic thinking that got banks into hot water in the first place. One hopes that they stick with today's reportedly finicky lending habits.

What to do
Perhaps the risk of over-lending is low, especially considering the consistently beleaguered state of both RBS and Barclays. On the other hand, it's something to keep an eye on. The Bank of England's actions to ensure stability in the housing market should also prove interesting. Thus far, the UK is the largest economy in the world to take measures against a housing bubble in the post-crisis era. 

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Anna Wroblewska

Anna began her career in finance as a college intern at a hedge fund, and she hasn’t been able to escape its siren song ever since. She’s done academic research at Harvard Business School and UCLA, was the COO of a wealth management firm, and now writes about finance, economics, behavior, and business.

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8/31/2015 4:01 PM
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