Directors who got it wrong
First Published 14 January 2017
So, finally, the fixers have been proved wrong, argues
Just now, housing associations are complaining bitterly about next year’s £100 million rent reductions. The cuts, they say, will lead to fewer new homes, less stock investment and cuts in housing services.
But it’s the not the coming rent reductions that are the real cause of housing association discomfort. Rather, it’s their failure to hedge against the risk of deflation and falling rents by adopting flawed Treasury management policies throughout the past 20 years or so.
Far too little attention has been paid over the years to deciding which is worse: inflation or deflation.
When you think about it, there shouldn’t be much to argue about. If inflation increases, inflation-linked rents will increase as well. And, since gross rental income is much greater than interest cost, the increase in income will eventually improve operating profits and cover for interest payments.
So you don’t need to be obsessed by the impact of rising interest rates. Rental income will increase to meet higher interest costs. But look what happens with the onset of deflation and falling interest rates. When rent reductions lower your gross rental income, you need to enjoy the benefit of lower interest costs to offset your lower income.
Unfortunately, most associations have been much more concerned with countering the risk of inflation than managing deflation risk.
Their flawed policies are reflected excessive amounts of long-term fixed interest rate debt in loan portfolios to fend against the risk of inflation.
At the last count, long-term fixed rate loans amounted to nearly £17 billion, almost half the sector’s aggregate loan book. Average interest on those loans is over 6.5 per cent, costing more than £1 billion a year.
By comparison, variable rate loans amounted to £12.5 billion. Interest as low as 1 per cent is now being paid on these loans, depending on bank loan margins, amounting to barely £100 million.
If all the long-term fixed loans were at floating rates, associations would be paying £800 million, more than covering the cost of next year’s rent reductions.
You don’t have to be a maths genius to see that floating rate loans are currently much less costly than long-term fixed ones. And you didn’t need to be maths wizard in years gone by to appreciate that floating rate funding was inherently less risky than fixing as it provided the ideal hedge against deflation and falling rents.
Yet only a small minority of housing association finance directors have been arguing down the years that floating is much, much better than fixing.
Up against them, in the long-term fixing camp, have been the finance directors and treasury managers of most housing associations and their financial advisers getting fat fees from their flawed advice.
Big associations such as Places for People, Guinness Trust, Sanctuary and Peabody have filled their boots with long-dated fixed rate debt, setting a bad example to other social landlords.
The Housing Corporation is greatly to blame for the sector’s obsession with long term fixed rate funding. For a long time, it was hooked on the oxymoronical belief that long-term fixed assets should be funded by long-term fixed liabilities.
Associations had to be over-weight in fixed-rate long term loans to qualify for its grant funding and new stock transfer landlords needed to have business plans with similar heavy weightings to get its seal of approval.
Now, what’s strange is that associations are back in the bond market, raising long-term loan funds at well over 6 per cent, rather than borrowing variable rate loans at much lower interest rates.
Possibly, that reflects the belief that the current deflationary conditions will soon give way to a new burst of inflation and surging interest rates. But it could prove very costly for associations if, as seems possible, the economy lurches along with low inflation and low interest rates for several years to come.