For decades banks in many countries have benefitted from a massive, under the radar government subsidy that is little understood by the public. It’s made to look like a handout to voters, but actually it’s a clever transfer of money to banks. In fact these schemes operate like giant, legalised money laundering operations, with unsuspecting private citizens acting as go-betweens. It’s time to end them.
We all know that politicians are a wily bunch. They know they need to do just enough to buy sufficient votes to stay in power. But they also like to keep their palms greased by powerful corporations.
Buying a politician can take many forms. There are contributions to election campaigns, donations to their favourite charities, contracts with connected family businesses, jobs for relations, the promise of juicy consulting jobs once they have left office, or just the old school favourite – straight cash bribes.
Any of these methods can help an industry lobby group to ease favourable legislation onto the books. Some are permitted under the law, some aren’t, and some fall into a grey area in between. But they all amount to the same thing: corruption. That is, the abuse of public power for private gain.
Politicians constantly play a balancing act between voter support and lining their own pockets.
Politicians constantly play a balancing act between voter support and lining their own pockets. Because of this there is one kind of policy that is a law maker’s dream. This is anything that has the appearance of providing a benefit to the voters whilst actually benefitting big business.
Step forward tax relief on residential mortgage interest.
I know, I know…that sounds technical…even dull. Which is precisely why the banks and governments get away with it. But bear with me. It turns out this is a major scam and a great example of crony corporatism.
In short it’s the process whereby homeowners can deduct their mortgage interest payments from their taxable incomes. The more you spend to borrow, the more it appears that you save in tax.
According to The Economist this type of tax relief is allowed in half of all developed countries. Countries that permit it include the USA, Switzerland, Norway and the Netherlands, but not Canada and the United Kingdom.
On the surface that sounds great, right? If you want to buy a house you can take out a mortgage and the government will help you with the interest cost by cutting your tax bill. Who wouldn’t want that?
But not so fast. It’s not that simple. In reality it’s an amazing and subtle con job that passes money from the government to the banks.
This is because the result is that both house prices and the interest rates on mortgages move to a permanently higher level. Home buyers end up having to borrow more money to buy the same house, and pay more for each dollar they borrow to do it. They end up with a bigger debt at a higher cost.
Put another way, home buyers think they are getting a big tax benefit. But they end up with little or no gain over the life of the mortgage. In fact they probably end up worse off, but have no idea that they’re being ripped off.
The government gives up some tax revenue, meaning it has to find the money elsewhere (from other taxes or borrowing). And the banks make vast additional profits. They get to lend more, at a higher rate, and probably for a longer time.
In other words, voters think they are getting a generous helping hand from a government policy, whereas in reality it’s a subsidy to the banks.
In other words, voters think they are getting a generous helping hand from a government policy, whereas in reality it’s a subsidy to the banks. It’s the perfect legal con.
Because no direct payments are made from the government to the banks, and because it’s difficult to understand what’s really going on, there is no public outcry. It’s like some giant, government sanctioned money laundering scheme. And home buyers are the unwitting middlemen.
It wouldn’t be so bad if the activity was at the margin. But there are vast amounts of money at stake here. Around 60% of all bank lending in developed countries is for mortgages (again according to The Economist).
In the USA alone, according to the Federal Reserve, residential mortgage lending amounted to nearly US$11 trillion at the end of 2014. To put that into perspective that’s a market almost as big as the US$12.5 trillion of tradeable US Federal government debt (treasury bonds and bills). The mortgage business is truly huge.
Perhaps you don’t believe me. Maybe you’re thinking, how can giving someone a tax break leave them worse off? How can it actually result in a subsidy to the big banks?
To get to the bottom of it we need to compare what level of mortgage someone could afford with or without the tax break in place. Calculating actual numbers is quite involved, but let me try to explain the mechanism.
The way mortgages usually work is that you make a fixed payment each month to the mortgage lender over the term of the mortgage. At the start of the term the debt is large, which means the interest is large. In turn only a small amount of the fixed payment goes towards paying down the “principal”, or the underlying loan amount.
Over time the loan becomes smaller. This happens slowly at first but then more quickly as the interest portion becomes smaller as the loan shrinks. In other words, over time a bigger slice of your monthly payment goes towards paying off the loan and a smaller amount goes towards interest charges on the remaining loan. Eventually the whole debt is paid off.
Calculating what someone can afford in mortgage payments starts with knowing how much they can afford to pay each year to the mortgage lender. Then if we know the interest rate on the loan and how long the borrower has to pay the loan off (the mortgage term) then we can calculate the maximum loan amount.
Working out specific figures under different scenarios is quite a complex process, but I’ve built a model to do calculations. I’ve used it to calculate a range of different outcomes under different scenarios.
For example, I’ve analysed a 30 year repayment mortgage with an interest rate of 5% for someone with a budget of $15,000 a year. The table below shows the maximum affordable loan in the first year at different rates of tax relief.
30 Year Repayment Mortgage Model
With no tax relief the maximum loan is $230,600, fully paid off after 30 years with mortgage payments of $15,000 a year. With 20% tax relief the maximum loan is $272,500, which is 18.3% larger. The mortgage payment increases to $17,725 a year, but net of $2,725 tax relief on the interest at 20% the net cost is still $15,000.
The higher the rate of tax that is saved the bigger the affordable loan for a given spending budget in year one, and vice versa.
The issue is that where the tax break exists then everyone is incentivised to take out the biggest mortgage that they can afford. This is so they maximise the tax break in the here and now. They’ll calculate what they can afford based on the gross interest cost of the mortgage less the tax break it gives them.
It’s well understood in investment circles that if you throw a huge amount of money at any asset market then prices will rise.
It’s well understood in investment circles that if you throw a huge amount of money at any asset market then prices will rise. So bigger mortgages mean more money washing around the housing market, which means higher house prices.
This lift in house prices is only a one time effect when the policy is introduced, but it means house prices are permanently higher – at least as long as the tax break stays in place.
In turn this means the banks get to lend more money, which means they make fatter profits. Meanwhile home buyers end up trading a tax cut today for having to make higher mortgage payments over time on the bigger loans.
When I was running scenarios I discovered that the net interest savings to borrowers (that is after taking account of the tax relief) were tiny – typically working out at just a few hundred dollars a year when spread over the full life of the mortgage.
In fact, if you add in the extra cost of buying a higher priced (but equivalent) house in the first place, it’s likely that people are actually worse off if their country offers the tax break.
It would typically take house prices to be just 15% to 20% higher to leave people worse off over time. That kind of increase is likely in an environment where people can afford to borrow 20%, 30% or 40% more due to tax breaks. (Presumably rents are higher too, due to higher house prices. So renters get hit as well.)
But there’s another wrinkle. Borrowers end up willing to pay a higher rate of interest on their mortgage loans because it can be offset against current income tax. In other words the banks can suddenly charge a bit more for the same type of lending, meaning they make more profit at lower risk.
Overall the banks benefit from both higher house prices and higher lending rates. This tax policy creates a manipulated market where lenders can make bigger loans and at higher rates.
So let me be clear. Home buyers are being duped by governments that offer this “tax break” into believing they are better off. But in reality they are worse off over time.
The truth is it’s just a transfer of money from the government, which gets less tax income, to the big banks, which get bigger profits.
But the money doesn’t flow directly. Ordinary people are used as the unsuspecting middlemen. The money mules. It’s like a giant, government-sanctioned money laundering scheme.
And don’t think it’s impossible to remove it once it’s in place. The UK managed to phase it out in the 1990s. Other countries should follow suit.
Unfortunately that’s politically difficult. Voters don’t understand that this “giveaway” actually costs them money. And the banking industry isn’t going to give it up without a fight, with so much profit at stake.
But that doesn’t change the fact that it’s high time we got rid of this vast hidden bank subsidy.
What do you think? And can you think of other government scams that are supposed to benefit you, but actually benefit big business? Let us know at email@example.com.
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