Nov 07 2007
Markets can now worry about other kinds of debt
The attention of rating agencies and credit analysts is moving onto other types of debt beyond sub prime mortgages. In the re-"pricing of risk" - cutting the value of advances already made to reflect the possibility there will be more defaults - there will be more losses for banks to report. The financial sector became adept at packaging municipal bonds, leveraged buy out loans and corporate debt as well as mortgages. They did so to spread the risk around the world’s financial system, and they did so in the belief that a package of difficult debts would be more resilient than the individual debts on the reasonable basis that a portfolio diversifies risk, and on the law of averages more will survive than will fail. They were right about this, but the market underestimated the amount of risk that still resided in these collections of loans. That is now being being sorted out against the backdrop of higher interest rates, which makes defaults much more likely. The Rating Agencies believed these packages had little risk in them. They too are having to revise their views in some cases, adding to the price falls of these loan parcels,and adding to the reluctance of buyers to appear in the market for them at any price. We will hit bottom when vulture funds are established to buy up these packages at knock down prices and trade them out for a profit.
The future is very dependent on what the Fed, the Bank of England, the ECB and the other monetary institutions do from here. They must have been aware in the low interest rate era that financial institutions were lending large sums and packaging it up to place it around the balance sheets of the world. They must now be aware that their move to substantially higher interest rates has exposed the dangers of some of this borrowing. They have to decide how much more damage they wish to do. They are also now in the position that even as interest rates come down there will be no immediate relaxation of the credit crunch, because the banks have lost substantial sums and this will constrain their ability to lend more.
The Fed seems to understand all this, and has been doing its best to pump liquidity into the market. The Bank of England does not seem to grasp this yet, and seems intent on putting more pressure on interest rate sensitive areas like housebuilding and property development. The Governor is engaged in a war of words with the Chancellor, seeking to shift the blame for the Northern Rock crisis onto the Chancellor who we learn was kept fully informed of the looming crisis and given options to deal with it some 4 weeks before the run on the bank began. The Bank of England still thinks its problem is fighting inflation (0.2% below target currently) rather than stabilising the banking and property sectors.
There is an unresolved tension in government policy. The Prime Minister wants more housebuilding, yet the Chancellor and the Bank are putting off that possibiltiy by their credit squeeze, and by their veiw that too many people have already borrowed too much on mortgage to put them off wanting more mortgage debt by more people. Latest figures imply a sharp contraction in demand for homes in the UK. There has also been a reduction in the supply, thanks to the government’s imposition of Home Information packs on sellers. Many are deciding they are not going to pay more than ??500 ($1100) just to see if there are any buyers out there for their property.
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
JR: “The Fed seems to understand all this, and has been doing its best to pump liquidity into the market.”
It is the Federal reserve policy under Greenspan and successor that has caused the problem in the first place. Their policy of squirting money at every problem has itself distorted the market and resulted in the excessive behaviour we are seeing the results of today. Your solution of squirting more money ( “pump liquidity” ) is rather like pouring petrol on a raging fire. It won’t put the fire out but it will keep the fire burning a bit longer.
The behaviour of the corporate sector is an entirely rational response to the economic climate set by the US fed - massive inflation in the US economy. It has resulted in the dot com bubble and most recently the housing bubble. We saw the DCom crash now we will see the credit crunch.
JR: “The Bank of England still thinks its problem is fighting inflation (0.2% below target currently) rather than stabilising the banking and property sectors.”
As I understand it, the bank of England is legally obliged to follow this policy.
Although it is rather amusing that one organ of the state (The BOE) is obliged to counter what the other, the treasuary is doing. It is rather like two people in a life boat, one is hacking at the planks while the other is bailing the water with a teaspoon.
If it wasn’t so tragic.
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What the Labour government needs to learn from all this is that economic growth created by borrowing and spending only lasts as long as cash-flow is not interrupted. A situation has now developed in Britain where people have borrowed beyond what they can pay back and Labour’s spending led growth is going to grind to a halt. Labour have been fortunate in that the strength of the pound has held back inflation because clearly too much money has been chasing too few goods. Of course that does not apply to the housing market where inflation is rampant.
I’m delighted that David Cameron has committed a future Conservative government to supporting the supply side of the economy. Labour’s policy of only supporting demand has created problems which are starting to surface and would have surfaced sooner had it not been for the strength of sterling. When Gordon Brown was chancellor he put the concept of credit ahead of productivity. Now however Brown is hpefully starting to realise that an economy can’t be run on tick forever, as those in the 1920s Weimar republic found out to their cost.
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Bankruptcy is a, perhaps the, vital element of the “wind of creative destruction” that the free market produces. If banking institutions are ptotected from it progress is restrained. The Japanese lesson should be instructive. The, then, fastest growing economy in the world was brought to a shuddering halt not by the property crash but by the decision of its government to provide unlimited money & set interests rates to prevent its big banks, whose mortgages were now backed by negative equity, from going under. The treatment of Northern Rock is a small but definite step in that direction.
I do not think there is a real contraction in demand for homes, there is merely a contraction in the feling that owning a home is, forever, going to guarantee an increase in your assets. The real demad for homes greatly exceeds the supply which is not lomoted by the market but by the planning system.
Reply: yes, the Japanese case is a worrying one. It may have speeded up adjustment if some banks had been allowed to go under there, but that in the short term would have created a worse recession and accelerated the downwards lurch in property values. The case of Northern Rock is different - all the experts say the mortgage book is fine, the problem was the inability to raise money in the normal way in the short term markets. There has not been a sharp downwards move in UK houe prices to expose the mortgage security, nor has there been a big increase in unemployment to raise the default rate.
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JR in reply to earlier comment:-”There has not been a sharp downwards move in UK house prices to expose the mortgage security, nor has there been a big increase in unemployment to raise the default rate.”
Isn’t that the big danger, though. With house prices at their present levels isn’t it inevitable that a correction will come sooner or later? The banks have been very free with their lending in recent years, but they can’t continue indefinitely to extend the maximum salary multiple that they are prepared to lend to borrowers. In my day it was 2 or 2.5 times salary. I understand that a multiple of 8 is not unusual these days.
Before their economy hit the doldrums, the Japanese house price boom resulted in the concept of an inter-generational mortgage that would take more than an entire working lifetime to pay off, but you could pass the remaining debt onto your children. Is that where the UK housing market is going?
The UK housing market is in for bad times, I fear, but what of the wider economy? The common negative factor is enormous, unprecedented debt, both personal and public. I can’t see the wider economy escaping the effects of this debt burden, especially if the personal equity in housing that has supported years of excessive spending vanishes.
Reply: There may be house price falls, but this need n t trigger a general recession. That depends on what the government and the Bank do next. If they take early enough action they can prevent recession.
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All the experts say Northern Rock is solvent, but then experts have a reason to talk it up & the fact that nobody is keen to buy it is worrying. It may be solvent on current house prices but the institutions discounting for an overvaluation of the entire market.
I think we agree about the effects of letting or not letting failing banks fail - the question is whether politicians have the cojones to accept short term recession for longer term growth (when they may be out of office). Practice over Northern Rock suggests not.
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