LLOYDS Banking Group recently announced it will expand its business activities with the aim of becoming the UK’s largest landlord by 2025.
It aims to buy 50,000 homes by 2025 and this purchase will turn Lloyds into the largest landlord in the UK.
But is this landlord scheme really about profits? When we look at the numbers in detail, this scheme would currently run at a financial loss if it were in place today.
When you look at Lloyds Banking Group’s share price relative to other share prices for banking institutions you can see Lloyds has had troubles for a very long period of time. Lloyds’ average profits over a five-year period was £2.9bn and its book value is £49bn, at a current share price of 43p and a market cap of £31 billion.
I would say the Lloyds share price is good. Someone could buy Lloyds today and it would cost £35bn at a 10% premium on the current price. They could sell off all Lloyds’ assets and pay all of Lloyds’ debts off and they would make a profit of £14bn.
Quantitatively speaking, as we can see, Lloyds bank seems very valuable and profitable. But that is not the case when it comes to Lloyds’ balance sheet and its problems lie there in the form of £871bn in assets, much of which is bad subprime debt. This subprime debt includes hundreds of billions of mortgage debt and notional derivative exposure.
So in summary, Lloyds may seem valuable and profitable, but its books are not strong and it does have a lot of exposure to the subprime mortgage market. It is making money but it is also financially in trouble, and its share price going all the way back to 1996 reflects this reality.
If the events of 2008 were to repeat themselves and default rates on mortgages were to break 8%, Lloyds would most likely be forced to ask the UK government for a bailout to avoid bankruptcy induced by defaults on mortgages.
Lloyds needs to hedge itself against possible bankruptcy, especially when interest rates rise. Lloyds is the biggest mortgage lender in the UK, so when the next housing crash comes it will be the most exposed when it comes to defaults on mortgages.
Lloyds entering the landlord market can look like an attempt to find new ways of making profits in a market already oversaturated with financialisation. But if we look at the numbers we can see it does not seem financially prudent.
The UK has 23 million homes and 50,000 homes is nothing compared to the grand scheme of things – it is just 0.21% of the UK housing supply. The average rent in the UK is now at a record high of £1,029, so if we multiply this by 50,000 we get £51.45m per month or £617m per year.
Lloyds’ revenue in the last five years has averaged £33.2bn. If Lloyds owned 50,000 homes now, Lloyds’ income would grow by £617m, which is just 1.85% of Lloyds’ yearly revenue. Lloyds’ profits in the last five years have averaged £2.9bn and the average ROI on real estate will provide Lloyds an annual profit of roughly £67m. This equates to 2.3%. If this scheme was completed now, Lloyds’ income would grow by just 1.85% and its profit would grow by just 2.3% – at current inflation levels this ROI would result in a 0.2% loss (inflation-adjusted return).
So why would Lloyds go through such hassle to become a landlord for just an estimated increase of 2.5% on profits, which would result in a 0.2% inflation-adjusted loss?
THIS SCHEME IS ABOUT PROTECTION, NOT PROFITS
I believe this scheme is a hedge (financial protection) against the coming housing crash and the numbers point in that direction. Lloyds completes many deals and loan agreements that make much more profits than £67m and they are way more easier and quicker than managing 50,000 homes. Lloyds is going through the hassle of becoming a landlord because it is protecting itself from a coming housing crash – it’s not about profits.
When the next housing crash comes, mortgage defaults will put Lloyds into a position where they will have to foreclose on thousand of properties and this would put them in bad financial position. It will reopen the same wounds that nearly bankrupted Lloyds in 2008.
So why would Lloyds bank become a landlord on homes they foreclose on when they could just sell off the homes like in 2008? This is because the market will dry up far more severely than in 2008 – there will be no buyers of the homes Lloyds forecloses on, as the money will simply not be there.
Lloyds will be unable to sell properties into the market when most people cannot get a mortgage because banks and brokers aren’t lending. So they will resort to renting them out.
When Lloyds forecloses on homes in the future it will have to resort to reducing the valuations of the mortgages on those homes – including residential mortgage-backed securities – and this will create billions of losses in capital and valuations on Lloyds’ properties and bonds.
The more they reduce the valuation and price the more the chance they have of entering bankruptcy; in the markets we call this a ‘write-off’. Banks writing-off loans and bond valuations in 2008 forced many banks into bankruptcy and created a credit crunch.
So, in order to write-off as little as possible so Lloyds can avoid bankruptcy, they will then rent out the houses they foreclose on, in return providing an income. They will then wait for the market to come rally and then sell off the houses to try and retrieve back the losses.
This is kind of what happened after the crash of 2008. The difference is after 2008 banks didn’t rent out homes they took back from owners, they sold off the mortgages and the ones they couldn’t sell were purchased or covered by central banks. This will not happen after the next crash because interest rates cannot go lower and if they do go up then Lloyds will still have the same problem.
Public opinion will not allow for another banking bailout and it is political suicide for any government that does bailout more banks. Lloyds knows that when the next property crash comes, the mortgage bond market will dry up and investors will give a big two fingers to the whole market and liquidity will rapidly dissolve.
Governments will put a line in the sand and they will prioritise their citizens before their banking sectors, which are private. Lloyds’ landlord scheme has indirectly factored in this political and liquidity risk and Lloyds has created a financial tactic to cover part of the coming losses in valuations on bonds and properties.
The next financial crash will create a long credit crunch fuelled by a rise in interest rates
Here is an example of the landlord hedge. If Lloyds is owed £200,000 for a mortgage and the lender defaults because they have entered negative equity of £50,000, Lloyds will have to take back that home as part of the foreclosure process. Lloyds would then revalue that home to £150,000 and would have to write off a loss of £50,000 in the valuation of the mortgage on that home. But that does not have to happen if they convert this mortgage asset into a property asset – they ultimately become a landlord not a borrower, and the property goes into its landlord scheme as part of the real estate portfolio.
Converting from a borrower into a landlord is the key to allowing Lloyds to protect itself and to hedge the £50,000 loss. It accomplishes this through creating assets in the form of a debtor figure entered into their balance sheet; this debtor comes in the form of a new tenant who rents this foreclosed home from Lloyds.
But why would becoming a landlord create an asset that could cover the loss on the mortgage? Because debt is an asset. So if this home is foreclosed upon, Lloyds revalues it and then puts it on to the market for 7% of the value. Lloyds can then rent out that home out for £10,500 pa. If after three to six months on the market a customer then comes along and decides to rent out the home and they sign a 3-year contract for £31,500. That signature on that contract automatically creates a £31,500 asset that Lloyds can enter into its balance sheet. This asset can then hedge much of the loss on the revaluation on the home Lloyds foreclosed on. Lloyds does not even need to foreclose on the home it takes back – the bank can just take control (ownership) and rent it back to the same person who defaulted on the same home, and it only requires some paperwork and some signatures – one savage mafia style tactic.
Lloyds has now revalued an asset (the home mortgage) and lost £50,000 on it, but created a new asset in the form of a debtor (the renter) and that £50,000 loss now becomes an £18,500 loss. On a four-year contract that loss turns into £8,000 and on a five-year contract that loss turns into a profit of £2,000. Welcome to the world of hedging aka financial protection.
With this landlord scheme tenants effectively become assets that can financially hedge Lloyds against bankruptcy induced by losses on mortgage bonds.
From a numbers perspective – speaking as an equity trader who dissects balance sheets on a regular basis – I see this tactic as genius and the financial alchemy has been beautifully brewed up. I assume someone in Lloyds, or a team, is set for a big bonus for successfully creating a new financial instrument that can insure potential losses by creating new debtor assets.
The tenancy agreement has indirectly become a hedging instrument for Lloyds. Signed tenancy agreements will become debtor assets for Lloyds bank, and these new assets will hedge the losses on other assets.
The tenancy agreement is the new credit default swap (CDS)
But from a personal perspective I am iffy on this one. When the next property crash comes it will be the middle and the upper class who will get hurt the most – they are going to get crucified and I will be happy to short the whole market from housing stocks to real estate funds.
The working class and youth will welcome the next housing crash because rent and home prices will fall and this will help the working class and youth to get on to the ladder and will boost their disposable income (from the savings received on rent). Their upper and middle class landlords and sellers won’t be happy, but that is how free markets work – the same people are not moaning about reaping from the free markets now.
However, when interest rates rise and the housing market tumbles this will create more centralisation of wealth because landlords and homeowners will end up passing over many properties to Lloyds bank, and most likely other banks who become landlords, who will then rent them out and more capital will be redistributed towards banks.
So on one hand the crash will be good for the least well off, but on the other hand it will increase wealth concentration via properties transferred from landlords/owner/speculators to the banks.
Within the next few years it is highly likely other banks will announce they are becoming landlords too in order to allow them to create assets that can financially protect them from losses on mortgage bonds, therefore avoiding entering bankruptcy territory.
We must not forget that much of the subprime debt that created the 2008 meltdown has not gone away. The debt pile has grown bigger, and weak subprime debt is everywhere.
