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Building Societies

It used to be an accepted principle over 20 years ago that if you wanted a mortgage you went to a building society, and if you wanted a loan you went to your bank. The building society was owned by its members, who were those who either lent money to the society or borrowed from it, and it raised its money by taking deposits from members of the public, and paying them a reasonable rate of interest on their money; they would then lend it out at a slightly higher rate of interest in the form of mortgages, and the difference between the two interest rates was meant to cover their overheads and hopefully show a small surplus. This was quite an excellent system during periods of financial stability but it did have the one major weakness; building societies borrowed money which could be withdrawn at quite short notice, but it lent it out for long periods, often as much is 25 or even 30 years. During periods when the economy dipped a little the inflow of funds could dry up or even become a net outflow, so there were often quite long periods when mortgages could be very difficult to get hold of. This was of course a double edged sword in that this situation tended to depress house prices which made them more affordable for young buyers.

Banks worked of course in an entirely different way. Much of their funding came from clients who kept a little money in their current account from month to month; the banks used their liquidity to make loans to clients who repaid them with interest over a fairly short period, usually up to about five years or 10 years as an absolute maximum. This was a far more stable system because in many cases the money held in current accounts (as against the funds in interest bearing savings accounts) cost the banks little or nothing in interest!

In what was really a major change in policy a number of banks began to offer mortgages during the 1990s and even the Post Office entered the market in 2003 and one worrying trend was the way in which many of these banks borrowed the money on the short term money markets. Nevertheless, at a time of relatively high interest rates this was a very profitable business for them to be in and they very quickly started to take a substantial amount of business away from traditional building societies.

Simultaneously a number of these building societies decided to play the banks at their own game and began to borrow funds from the money markets themselves, and they even began to offer personal loans as well as mortgages. Some building societies went the full distance and converted themselves from mutual societies into new public companies, selling their shares on the open market; since they were owned by their members this meant that many of them were able to share in substantial windfalls, and there was a rush for a while from people who invested in multiple building societies in the hope that they would demutualise and provide a substantial windfall; these people were known as carpetbaggers. Eventually the mighty Nationwide Building Society held out against the pressures to form a new public company and the domino effect slowed down substantially and eventually stopped.

Many of these demutualise societies then became extremely aggressive in selling mortgages and loans, again borrowing much of their funding from the money markets. Building societies were debarred from borrowing more than 50% of their capital in this way and so were partially insulated from what turned out to be a very high risk business; borrowing short and lending long when the loan was secured against property was a profitable proposition while house prices were rising; unfortunately once they started to fall after completely unprecedented house price increases had pushed even the most modest homes way outside the reach of the average first time buyer arrears and subsequent repossessions began to climb, helped along considerably by the fact that a number of societies had lent money against extremely high loan to value ratios, sometimes in excess of 100%, and correspondingly high loan to income ratios. The result could have been foreseen by anyone who was not blinded by over optimism; collapsing prices led to a lack of confidence in the money markets, liquidity dried up, the underlying securities fell in value, and all of a sudden a lot of banks and building societies found their solvency in considerable doubt! The rest is history; the taxpayer is now the main shareholder of the UK's major banks and quite a number of building societies are finding their solvency under question.

Eventually of course this recession will end in the same way that all the others have done in the past, and no doubt house prices will begin to rise again in due course. It is to be hoped that the hard lessons of the last few years have been learned and that the same mistakes will not be made again!


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