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.