True, Mr Carney is right to be concerned. The UK's economy continues to be distorted by a chronic shortage of housing and the consequent obsession with house prices among the middle class. What's particularly worrying is the effect that this has on consumers' debt. As the UK struggles free of the post-financial crisis recession, it does so with average levels of household debt to incomes far higher than in the rest of the developed world - not a healthy way to get started.
Yet for some private investors mortgage finance plays a vital role in their portfolio, even if they are unaware of it. So both changes to its cost and limiting its supply can have a big effect on investment returns. To understand why, it's important to grasp that I'm using the word 'portfolio' in the wider sense of all the assets and liabilities that an investor carries (how the word should be used anyway). In that context, mortgage debt does for a private investor exactly what commercial borrowing does for a company's profits or a hedge fund manager's performance - it gears returns up or down.
More than that, it is only by using mortgage finance that a private investor can hope to bring profitable leverage to a portfolio’s performance; all other forms of debt are always too expensive. For instance, in the past 15 years, sterling overdraft rates have never been below 14.5 per cent. No one can borrow at that rate, invest the proceeds and expect to make a profit. It is debt priced solely for the benefit of the lender. Yet over the same period, variable mortgage rates for a loan-to-value ratio of up to 75 per cent have never been above 7.7 per cent and for the past six years have been below 3.5 per cent.
That's more like it - the sort of finance cost on which it is reasonable to expect that investment returns can be levered up profitably. To see that, let's make some fair assumptions and see what happens. Assume that the annual average price change in a portfolio of UK shares is 10 per cent, that the dividend yield is 3.5 per cent and that there is a 0.6 probability that returns will meet that threshold in any year. That brings an expected return of 8.1 per cent (13.5 per cent times 0.6) - what we can expect from a portfolio using no debt. Now assume that the same portfolio is funded with equal amounts of equity and debt, where the latter has a cash cost of 3.5 per cent. That levers up returns to equity to 12.7 per cent. And even if mortgage rates rise to the top of their 15-year boundary, expected returns still remain soundly profitable.
It gets more interesting if an investor diversifies a portfolio's returns by holding government bonds as well as shares. It's axiomatic that long-term returns from bonds are lower than from shares, but that those returns come with less 'risk' (ie. less variation from year to year). However, using leverage can equalise returns from bonds and shares. Suppose - and I'm sort of making up these figures - the average total return (change in value plus income) from government bonds was 7.5 per cent a year, with a probability factor of 0.7, making an expected return of 5.25 per cent. That's way short of the expected return from shares. But if mortgage debt costing 3.5 per cent effectively funds 60 per cent of the bond portfolio, that would lever up the return on bonds virtually to 8 per cent, almost the same as the return from shares.
So introducing debt into the equation can equalise returns from shares and bonds when it is used to give both assets the same structure. Shares come with an element of leverage embedded into them because they are part ownership in a company and most companies employ debt which levers the returns on their own equity. Government bonds don't have this characteristic - not unless it's bolted on.
What's true for bonds can hold good for other classes of assets. Introducing debt into the equation - or sometimes taking it away - can equalise returns without commensurately adding to risk. It's what portfolio theory is all about and low-cost mortgage finance made it portfolio practice, too. Higher interest rates will make it more difficult - an increase in the cost of debt raises a portfolio's profitability threshold and simultaneously returns from bonds will fall as their values drop in response to the higher rates.
True, it may be tricky to spot this happening, but that's only because few investors imagine that their mortgage is helping to fund their stocks and bonds. It is, however - think of sources of finance being fungible and it becomes clear that only technical niceties dictate that your mortgage finances the purchase of your home rather than your stocks and bonds. And, as we said a moment ago, putting that mortgage to profitable use is about to get more difficult. Hard times, indeed.
