Flaunting bad to distract from worse: the zero-deposit diversion

A dangerous old mortgage product is picking up steam again amongst Australian banks: the so-called ‘zero deposit home loan’. The offer is usually some variation on the same general themes: borrow up to 120% of the house sale price, no deposit required, instant or fast-tracked approval and available to anyone with a job and a guarantor – usually the parents. It isn’t all that surprising that a lot of people disapprove. In Australian culture buying a house is a rite of passage into adulthood in much the same way as getting married and having kids. It is a sign of growing up, a mark of maturity earned by the struggle of saving for the initial deposit. So far as a zero deposit home loan erodes this tradition, the bulk of the criticism that the banks will receive will be focussed on this aspect of the product.

It is a masterful ploy. The standard response is predictable, effective and absolutely right: everyone is different, the barrier to purchase (the deposit amount) is fairly arbitrary and not a good indicator of a person’s ability to make payments years down the track – ‘past performance is not a good predictor of future performance’. Why should responsible adults be waiting while they are forced to jump through some arbitrary hoops when a) they need a house and b) the faltering housing market needs them? Why should we constrain ourselves to outmoded ideas about who “deserves” to be a home owner, when a future where every family can own their own home is for the first time now within reach?

Why indeed. By framing the main product feature as enabling zero deposit home loans the bank gets to choose the terms of the debate. To the bank the size of the deposit is totally irrelevant. Some even offer essentially negative deposits, paying out a percentage in addition to the house price to cover furnishing costs. The real question is ‘how?’ and the short answer is ‘by having parents guarantee the loan repayments.’ The long answer requires us to think about the role of banks in society.

The function banks provide to the community is to match short-term lenders (deposits) with long-term borrowers (loans). The banks take a slice of the interest payments from borrower to lender in exchange for shielding the lender from default. The difference between the interest rate earned on your deposit account and the interest rate paid on a home loan could be thought of as an insurance payment to the bank so that if the borrower defaults your money is safe. It is in the bank’s interest to lend money responsibly, because it bears the cost of any loans that fail to be repaid. Responsible lending allocates idle savings to safe investments at fair interest rates while risky projects and speculation are discouraged with higher costs. A bank’s social responsibility to the community is therefore inseparable from its financial responsibility to its shareholders. Both fall apart whenever the bank finds a way to offload this risk back into the community, which is exactly what writing a guarantor into the mortgage contract does: since the bank can liquidate the guarantor’s assets if the borrower defaults, it bears no risk in the loan. The bank has no financial incentive to be discerning in who it lends money to and gets to write the value of these indiscriminate loans on its balance sheet as being virtually risk-free. The risk that once justified the bank’s slice of interest is gone, and the new bearer of that risk doesn’t see a cent of it.

The function of the bank becomes nothing more than a middle-man taking a substantial cut of a transaction it has no interest in. It is the bank’s unique position of having essentially unlimited access to cash that enables it to profit at both the risk and expense of society. It is a pure example of an arrangement where the rich get richer just for being rich. If these types of loans become widespread enough it opens the frightening possibility of a crisis which could rival the Great Depression. All the key ingredients are there: a massive and highly overvalued asset market, high and widespread private debt and the potential for rapid price deflation following mass liquidation of assets. Irving Fisher coined the term ‘debt deflation’ after the Depression to describe the cycle through which prices are depressed by the sale of assets, which raises the real value of the debt and makes it more difficult to repay, which in turn causes more assets to be sold off. Indiscriminate lending combined with the potential for self-perpetuating mass sell-offs certainly appear to lend themselves to another period of debt deflation.

If you are considering entering one of these mortgages as either borrower or guarantor I urge you to reconsider. If you simply must buy a house with no deposit you can do it much more safely by having your would-be guarantor lend you the amount of the deposit by borrowing it themselves against their house or mortgage. You still get to buy a house immediately and after you pay the deposit off to your guarantor then you expose them to no further risk. Should the worst happen and you do find yourself unable to make your repayments to the bank your guarantor can still help you – the difference is that they will be doing it by choice, not because the bank is threatening to take their own house away.

5 comments to Flaunting bad to distract from worse: the zero-deposit diversion

  • Renter in Perth

    As a potential first time home debtor I found this quite interesting. My parents have supported me in countless ways, but I could not ask them to guarantor a home loan. If I found I was unable to make any more payments due to some disaster it would leave them in an untenable situation.

  • Remonlin Goreandarm

    Extremely useful piece of information one would have to say. Luckily being ethnic as I am my parents own all the property for the family and I can work for them or pay rent, there is little debt and an expansive portfolio, families for the win, yes?

  • Ivo Vekemans

    You draw the conclusion that a banks financial responsibility to it’s shareholders is inseparable from it’s social responsibilities which is not what follows from your previous reasoning which is that a banks responsibility to it’s shareholders lines up with it’s social responsibilities. The new loan type changes that as the banks are still meeting their responsibilities to shareholders (the loans are even safer than most as in the majority of cases the guarantor’s assets will be greater than the loan).

    What justifies the interest is the demand for the loan. And the opportunity cost to the banks (and hence the shareholders) of tying their money up in the loan.

  • [law]

    > You draw the conclusion that a banks financial responsibility to it’s shareholders is inseparable from it’s social responsibilities which is not what follows from your previous reasoning which is that a banks responsibility to it’s shareholders lines up with it’s social responsibilities.

    …those seem like equivalent statements to me? Perhaps you misread, my point is that guarantor loans break the connection between financial and social responsibility. It is socially irresponsible to make risky loans simply because the risk is borne by the parent instead of the bank.

    > What justifies the interest is the demand for the loan. And the opportunity cost to the banks (and hence the shareholders) of tying their money up in the loan.

    1. The money used for loans does not belong to the bank and it certainly does not belong to the shareholders. The money belongs to the holders of debt assets at the bank – eg: the depositors, but also the bondholders.
    2. The money is not in any way “tied up” in the loan. It ends up in someone else’s bank account ready to be lent again. Bank lending is never constrained by reserves, banks can always lend as long as there are people willing to borrow. I’ve explained this in detail in my big post about inflation.

  • Old MMT Bloke

    “The function banks provide to the community is to match short-term lenders (deposits) with long-term borrowers (loans).”

    I’m not sure this is correct. I’ve always understood that banks do not lend depositor’s funds, contrary to the commonly held belief: the purpose of deposits is to keep the payments system in positive balance, and to meet any reserve requirements (and possibly new Basel 3 liquidity requirements).

    Banks “create” the money they lend out of thin air, and the only constraint on that process is the Basel rules, that is, the leverage ratio of the bank’s loans over the bank’s capital (with some flexibility allowed for different classes of capital and risk weightings for different classes of loans).

    The interest paid to depositors is a cost but easily recovered I imagine by the bank’s bond traders.

    Banks perpetuate the myth that they are just intermediaries because they want us to believe that their only reward is the small spread between deposit rates and lending. Same observation re the return on their “assets”, assets being (in the upside world of bank accounting) the value of outstanding loans, all secured.

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