20 February 2018

UK welfare is a CDO with property as its junior tranche

By Tom Brammar

At the turn of the century banks got involved in a new product called a collateralised debt obligation, or CDO for short. These are basically lots of bits of loans packaged up into contracts that can be sold and bought.

As a product it makes total sense  —  it provides one of the key elements to good risk management: diversification. However, when they were transitioned from corporate loans to mortgages they became a conduit through which banks could derive significant profits whilst convincing regulators they had a handle on risks. We all know how that ended.

Anyway, the basic structure of a CDO looks like this:

Now, ignore all the finance jargon and concentrate on the word ‘Equity’ in the bottom right corner of the image. This is what’s called a tranche, and the equity tranche is the most junior of them all.

Basically, if these loans start going bad then this tranche takes the first hit. Think of it like a crumple zone in a car — in the case of an accident they take the majority of the kinetic energy and thus protect the more valuable passenger compartment.

Now you’re probably thinking: “If they’re the crumple zone, why the hell would anyone want to own them?” Well, because they were offered at a huge discount to the other tranches and, if everything went as expected, would receive a nice income from the underlying loans.

How does this relate to the UK welfare state? It is a well-known fact that the largest cost to the UK welfare state is looking after its citizens in old age. Whether it’s residential care or nursing homes a large percentage of this spending is tied to services related to looking after retirees. What is perhaps less well known is that these services are means-tested. In other words , the government is paying only for individuals who can’t afford to pay themselves.

To see how this works in practice, here’s a real-life example. (Though if you’re somebody of an anxious disposition you may want to skip the figures at the end.)

Recently a friend’s widowed grandmother had to move from her own home in to an old people’s home. The home she’d owned was one of those much sought-after Victorian properties. She had a small private pension, but like most British people her life’s savings was basically her house.

The reason she’d had to move was that, although she was relatively fit for her 78 years, she’d recently had a stroke and with both children living too far away and unable to take the time off work or arrange childcare to visit her she needed to be in a home that could now care for her.

The hospital that she’d been rushed to after the stroke was keen to discharge her as she was no longer an emergency case and its staff needed the bed for other patients. They recommended a home nearby that would provide the facilities for her.

When my friend visited the home he thought it was a little shabby but comfortable. Then he was giving the contract to sign.

Whilst she was recuperating from the stroke and required close attention charges would be £1,000 per day. Once fully recuperated normal care home charges would be £920 per week.
Knowing his mum’s savings would only cover two days worth of these charges he phoned the care home assistant at her local council. He was told that as her house was worth more than £23,000 she would not be entitled to any financial assistance.

Her house went on the market and sold within two weeks ensuring the money was in place to pay the first invoice.

Fast forward three months and she’s still requiring close attention. So far, the total charges are north of £90,000. They’re hopeful that she’ll be fully recuperated this month.

It’s a crude way to look at it, but if she recuperates this month the money left from her house sale will only cover the care costs for about another 10 years.

Now, hopefully you can see from this example what’s going on. The individual is means-tested and whatever wealth they have is used first to pay for the care. Only after this has been exhausted does government step in and make the rest of the payments. Now, leaving aside moral arguments about this approach, hopefully you can see how this is very similar to a CDO. The individual’s wealth is the crumple zone  – the junior equity tranche. It takes the first hit. The government is effectively the senior tranches, providing support only when the junior tranche has been exhausted.

OK, but so what? Well, this is where it starts to get a bit worrying.

The reason why CDOs blew up in 2008 was because the investors holding them thought they were diversified. They thought that, because each loan was different and tied to mortgages in different geographical locations, if an issue struck one group of loans it wouldn’t spread to the others. What they had missed was that the majority had one thing in common: they were all mortgages backing residential property. When the credit fuelling that property boom dried up and individuals started defaulting, all the loans behaved in the same way.

Now, think about the UK welfare system as a CDO and imagine the government are the investors. They own the senior tranches and have been making all their decisions (economic policy) for a period where UK house prices have risen almost unchecked for over 26 years. Basically, the stability and continued growth of that junior equity tranche has been taken for granted and therefore entirely factored in to the UK’s economic roadmap.

But what if it doesn’t keep growing or, worse, starts to shrink?

Nearly 40 per cent of adults now face house prices that are more than 10 times their annual income. Do we honestly think this can continue or is at least stable enough to build economic policy on?

To put it another way, let’s imagine a significant house price correction happens. (I know, it’s not possible, houses only ever go up in value — but just humour me.) Taking the example I outlined above the implication for UK government’s liabilities for the welfare system would be horrendous. If an individual’s house were worth much less, government contributions to care costs would begin earlier, continue longer, and make up a larger proportion of the total bill.

In thinking about what that means, there are a few things to consider. First, the UK government is all-in on UK residential property. There’s no way it can afford for house prices to correct significantly. If things were to get really get out of hand I could see an end to the Bank of England’s independence and a debasing of the currency before the government would allow property prices to fall.

Equally, the UK banking sector is also all-in on UK residential property. The unfortunate side-effect of post-2008 financial regulations has been to concentrate banks’ exposure into UK residential and commercial property.

Finally, UK citizens are also all-in on UK residential property. They have little diversification in their savings and have yet to work out how exposed this leaves them. In summary, I think that anybody who thinks that the “wealth” they’ve built up in their property is going to be passed on to their kids is living in cloud-cuckoo land. Either it’ll get eroded away as property values go sideways, or the government is going to make a beeline for an easily raidable tax bucket.

Tom Brammar is a board member of Global Source Partners, a firm delivering the highest quality macroeconomic and political analysis to emerging markets investors worldwide. Previously he was Managing Director of the Financial Times' emerging market news service. These are his personal views, and do not represent those of the organisations he is involved with.