18 March 2022

The unintended consequences of the State-backed Covid Recovery Schemes

There is an unwritten law that the larger the scale on which a Government tries to help, the more the Law of Unintended Consequences comes into play.

For example – in recent months, we’ve seen the unintended consequences of the Energy Price Cap. The intention, of course, was to keep energy affordable for all. The effect it had was akin to what happens when one puts one’s thumb over a hosepipe. The pressure builds and builds until everyone gets soaked.

A similar failure of good intentions was when the Government tried to encourage more people to use their newly-built roads in the 1960s by slashing the railway infrastructure. Over the ensuing decades, car use boomed. But by the 1990s, the roads were so congested, people were crying out for more trains, but the lines were long gone.

Which brings us to the variety of state-backed lending schemes introduced at the beginning of the Covid Crisis.

We had the Coronavirus Business Interruption Loan Scheme (CBILS) –  where the Government authorised certain lenders to advance up to £5m to SMEs via term loans, overdrafts, invoice finance or asset finance; we had the Bounce Back Loan Scheme (BBLS) – where SMEs could apply for between £2,000 and £50,000, pay no fees or interest for 12 months, and then a maximum of 2.5% p.a. thereafter; the Recovery Loan Scheme (RLS), where businesses of any size could borrow up to £10 million at an average of 6.16% for 3 years; and the Future Fund, in which innovative companies could get government support of £125,000 to £5m, if that funding was matched by private investors. There was also CBILS big brother, the Coronavirus Large Business Interruption Loan Scheme (CLBILS) which facilitated lending up to £200m, but this entirely excluded P2P platforms.

Each was designed to put a much-needed jab into the arm of the economy, at a time of unparalleled instability. And each (except CLBILS), was to combine the mustered might of both traditional lenders and institutional investors (via the P2P industry) to support suffering businesses.

And what, you may ask, could be wrong with that?

Of course, in the plus column, they enabled homes to continue being built, hence great news for house buyers. And it was also great news for borrowers. But at what cost to the nation? And what are the unintended consequences?

Well, imagine you set up… oh, I don’t know… a nice upmarket wine bar. Being a responsible entrepreneur, you adhered to the requisite laws – those both of the land, and of common sense. You sold only quality produce, to protect your consumers, and you set the bar sensibly high, keeping out the young and inexperienced, the misguided and the riff raff, to protect them from themselves.

Then let’s imagine the Government sets up another wine bar next door. It substantially undercuts you – selling products much cheaper than you possibly can; it drastically lowers the bar, makes the doormen radically less strict and suspends the consequences of selling inferior products.

The need for such an outlet is of course questionable. The risks to both clientele and established businesses predictable.

But this is pretty much the situation faced by the property P2P industry and the small private lenders who depend on them to make their money work. Of course, CBILS was not originally destined for property developers, but eventually morphed into a very attractive stimulus for them. So the property-based crowdfunding platforms set up their stall however many years ago supposing that their main competition would be other P2P platforms, or at least other forms of alternative finance. Imagine their surprise when they woke up one morning in 2020 to realise they were now competing against the Government.

Now it has to be said that some P2P platforms benefited from the schemes. But this was Unintended Consequence Number One: an unnaturally-skewed marketplace, tilting the field away from the small investor. Platforms offering CBILS, were only permitted to use funds supplied by institutions, not “retail” (private) investors. This meant that platforms who wished to remain loyal to their small investors were excluded.

Next, Unintended Consequence Number Two was elicited by the Recovery Loan Scheme.

Allowing developers to borrow at an average of 6.16% – with Mr. Sunak kindly paying the valuation fees, legal fees and arrangement fees – meant developers could delay sales exits. In short, they could sit on finished developments with no pressure to sell, thanks to all that cheap money. So it artificially propped up house prices at a time when sales weren’t exactly an issue, because at the same time, the Government was subsidising Stamp Duty.

This was Iteration 1 of the Recovery Loan Scheme. Iteration 2 leads us further down the slippery slope to Unintended Consequence Number Three: the Government guaranteeing 80% of loans (now 70% since the start of this year) encouraged the banks to lend more than they otherwise might – allowing gearing to increase to an extent that erased the need for mezzanine finance. And artificially cutting out a service which was built precisely to plug that specific finance gap, by temporarily closing the gap.

Basically, if a developer could borrow 70% of value at lower cost than if they were borrowing 65%, he might as well just tip in a bit more equity and save the cost of mezzanine finance.

Once again, the need for this stimulus was questionable. It’s not as if mezz finance wasn’t available. It was then and still is now – for those very same deals. So while this was a windfall for both the senior lender and the developer, it unquestionably pushed small investors away from a valuable source of income, and made redundant the funding pipeline that developers had hitherto grown to rely on.

What’s more, where banks typically take a 20% personal guarantee, the Government now provides a 70% guarantee before the 20% kicks in. So if the loan is £10m, the government is underwriting £7m and if there’s a shortfall, the borrower covers a further £2m. And whilst there is no evidence of underwriting standards being relaxed on the back of this, those banks offering these loans are almost certainly not going to be making any provisions.

Of course, compassion demands that we say it has compensated developers for extra building costs – every site has suffered labour shortages, delays and rising costs – but again, this was an unintended outcome of the stimulus.

Bounce Back Loans might have been more attractive to lenders. While minimal due diligence was required, the Government backed them with a 100% guarantee, so the lender wouldn’t lose any money in the event of a default. However, only one P2P platform – Funding Circle – was approved to offer the BBLS, after they struck up a partnership with Starling Bank.

But all this, of course, ignores the elephant in the windpipe of the recovery: the Not-In-Any-Way-Unforeseen, but unfortunately Unintended Consequence Number Four: what happens when a substantial number of these loans default (as we’re now beginning to see)?

Inflation, labour shortages and supply chain issues are widely expected to build up the pressure. We’re also starting to see the first evidence of widespread fraudulent applications. The Treasury Minister Lord Agnew resigned in January over the £4.3 billion of Covid loans written off so far [1].

Of course, the real tragedy of all this was that support for residential development was so unnecessary. There was never any shortage of funding in this sector. Alternative funders and platforms like CapitalStackers have been providing it all through the pandemic, except on those deals where they were displaced by government cash.

There is also evidence that the Levelling Up Home Building Fund – designed, in the Government’s own words, “to support small and medium homebuilders that are struggling to access development finance from the private market” has been taking business from banks on deals that they were fully prepared to fund.

However, there is some good news for the private investor. The last of this artificial support which has unfairly pushed opportunities away from you – the Recovery Loan Scheme – will have ended by June. From that point, the natural order will be restored. Good, sound building schemes will once again be funded by a combination of sensible banks, P2P and the developers themselves.

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