Author: johnredwood

Today someone of the radio told us that the credit crunch was easing in the UK wholesale markets, and intensifying on the High Street.

That’s what you should expect to happen. Banks and Building Societies are getting the message from the money markets that they cannot carry on lending so much. That’s why they are withdrawing their attractive mortgage offers, putting up rates and demanding larger deposits. They need to rebuild their margins (make more profit and protect themselves from loss) at a time when they cannot borrow cheaply in large amounts on the money markets, and cannot sell the same volume of mortgages on to others in the way they could in 2006. They need to husband cash and make more profit to deal with the write offs on past business and to combat the changed conditions they are experiencing for raising money to lend on.

As they withdraw their High Street offers, or ration them by price and deposit requirements, so their demand for extra funds from the money market declines. As a result, money market rates have started to come down, to get closer to the Bank of England’s rate that has been an academic irrelevance for much of the time since the crisis struck.

Some of the money market reaction is a question of timing. Banks and mortgage companies need to be more careful at a quarter or year end, and can relax a bit mid month. Some is more fundamental, reflecting the big decline in credit being offered to consumers, reducing the banks’ total need for cash.

It is by this mechanism that the credit crisis will move from hitting the financial sector, to hitting the consumers. All those who took pleasure in some well paid City types getting into difficulties and maybe facing cancelled bonuses or something worse, will now see that this is a crisis that will hit others too who were nothing to do with the credit explosion. The first casualties of the UK credit crunch will be first time buyers who will not have access to the same proportion of the selling price of a property on the same favourable terms as their predecessors in 2006/7.

There is a two way pull in the UK housing market at the moment. The price falls of the last few months have been small on average. The epicentre of the decline so far seems to have been some new flats in some city centres where developers had done well with their selling prices not so long ago, and where there is now excess supply. Some say the continuing pressure from new households, and the shortage of new build will keep prices up. They point out that interest rates are still much lower than in the last housing price decline. Others point out that whilst interest rates are lower, house prices are so much higher so mortgage payments are also very high. A one percentage increase in the mortgage on the base of say a 5% rate is a 20% increase in interest cost for the individual or couple concerned. If that is charged on a high house price and mortgage that can be very painful to the mortgage holder.

Whilst it is true that there are more people who want to buy a home here, that only keeps the market up and prices rising if it can be translated into effective demand through such people obtaining mortgages. There are always more people who want a first home or a bigger and better home than there are homes available. Prices sort out the imbalance in the market, limiting most people’s ambitions by the reality that the house they might like most is simply too dear. We are entering a period when more people are going to have more limitation placed on their ambition to own a home or a better home, because there is going to be a painful shortage of mortgage funds.

In these conditions prices on average are likely to come down. That is also part of the painful process of adjusting after a long period of inflationary credit has been let loose in the system. Falling house prices bring other economic problems in their wake. If fewer people move the demand for carpets, curtains and new furnishings will take a knock from that source. If people feel less rich because their main asset is no longer appreciating, then they will spend less on luxuries. As people pay more interest on the mortgage, so they have less income to spend on other items, as the mortgage interest is like a tax – you have to pay it or else. It’s all part of the economic slowdown most economists are now forecasting.

PS: Since writing this post I have seen the Halifax house price index for March. That shows a 2.5% fall on average in March 2008, taking the annual average increase down to just 1.1% despite the strong start to the last twelve months. It also reveals that the West Midlands and Wales are leading the market down, with London overall still up. I can’t see house prices suddenly reversing this downturn in the national average that has shown up so strikingly in the last month in this index.

Just as we have seen a rush by mortgage companies to put their rates up, so they are not left as the cheapest on offer facing a deluge of applicants, so we are now seeing a rush to withdraw mortgage products altogether as mortgage companies struggle with the volume of demand.

Individual companies are right to stress they are withdrawing products and increasing prices because they are inundated in the wake of Northern Rock’s withdrawal from the market, not because they have run out of money. The system as a whole, however, is cutting back on its volumes because it is rightly being more cautious about how much money it can raise from different sources. The Credit Crunch is having a real impact at last – it means less money for banks and Building Societies as a whole to lend, which means fewer mortgages, lower proportions of the house value being advanced and higher interest rates (relative to market rates).
This in turn will mean lower house prices.

The rest is covered by yesterday’s post entitled “Are all mortgages wicked?”

Today a leading mortgage company has announced it is withdrawing for the time being from making any new mortgage advances. This follows hard on the heels of the government’s decision to halve the amount Northern Rock has lent on mortgage over the next couple of years in order to repay the money owing to taxpayers.

In recent days mortgage rates have been rising, even though the Bank of England’s message on interest rates has been to keep them the same. As one or two mortgage companies find they are offering the lowest mortgage rates, so they are inundated with people seeking a good value mortgage. They are forced by the rush into putting up their rates, only to leave another mortgage company exposed to the rush. It is going to be a difficult time for people seeking a mortgage, and a more difficult time for those with a variable rate mortgage, facing higher interest payments as a result.

Today Parliament will be debating mortgages on a Liberal Democrat motion. The LDs have been saying for some time that people in the UK have borrowed too much, and have been urging action to curb private sector borrowings. Presumably they wanted higher interest rates sooner, to choke off some of the mortgage demand, and probably want tougher regulations to make it more difficult for people on low incomes or with few assets to borrow.

I certainly opposed Gordon Brown’s decision to tinker with monetary policy by changing targets for inflation from the RPI to the CPI. It meant the Bank of England had to set lower rates in the run up to the 2005 election than if they had kept the old target, and did mean more credit was extended. If the government had stuck with the RPI, and had kept a better control over its own borrowings, we would be better placed to weather the current financial storm.

I do not, however, share the LD view that things should be made a lot tougher for those on low incomes or with no cash for a deposit to buy a home. Home ownership is rightly much sought after, and is an important part of an English person’s liberty. Once someone owns a home they make decisions about their private space in a way tenants cannot, and they have an asset which usually goes up in price which brings them greater financial independence as the years progress. There can be little worse financially than facing old age with no home that you own – it means you pay the highest rents of your life at the end of your life when you have least income.

So what should the authorities do about the move from boom to bust in the mortgage market? They should not rush to regulate to dictate terms to mortgage companies., Saying now people cannot in future borrow 125% of the value of their property, or saying to those without deposits they have to save for one first would be seeking to bolt the stable door long after the horse has gone. Yesterday’s problem was too much borrowing. Today’s may easily become too little if the government is not careful.

The Bank should cut interest rates, to offset some of the unplanned increase in rates we have seen in recent weeks. It needs to try to get control back over the general level of rates in the markets. The authorities should not introduce new and more mortgage regulation. In a global market it is difficult for such regulation to bite if done nationally, whilst the consequences will be harmful to those seeking UK based loans, making them still scarcer and dearer.

It is probably necessary to cut Northern Rock’s mortgage book because the bank is now nationalised and must not be seen to competing successfully to lend more money. It is certainly necessary to get the taxpayers money back in reasonable time. This will place a continuing strain on the mortgage market, as other lenders find the £50 billion to replace the Northern mortgages destined to be repaid. In these conditions the Bank needs to do all it can to keep the mortgage market reasonably liquid, without putting more taxpayers money at risk without more than adequate collateral and protection. The Bank should also be sympathetic to the idea that the banking sector should not have to write down all their good quality shorter term paper every time some financial institution has to dump some of it at distressed prices to raise cash, for that way leads to a race to the bottom with continuing dangers for some financial institutions.

It is important amidst all the puritan commentary telling us it serves people right, that they have borrowed too much and the financial sector has been greedy and irresponsible, to remember that people still need homes and home ownership is the best way of organising and financing that. The important task is to get rid of the froth in the market without causing a slump, for that would just put more people into misery and prevent the rising generation buying a home as soon as they would like.

The taxpayers’ misery – and the government’s discomfort – have now begun. The nationalisation of Northern Rock will be costly to taxpayers and damaging to the government’s reputation.

Last night the government brushed aside Conservative proposals to handle Northern Rock in a different way and to avoid the taxpayer taking on responsibility for all the jobs, mortgages, loans, properties and bills.

Instead, the government announced a one third cut in the workforce, and a halving in the size of the business, along with confirmation that the bank will lose money in each of the next three years. That prospectus for the nationalised business suited no-one. MPs from the North East, along with the rest of us, did not want to see such large reductions in the workforce. MPs who care about the taxpayer do not wish to see taxpayers having to foot the bill for the job losses and the other losses in the business.

The government refused to tell us what the forecast losses amount to, implying they will be significant. They refused to tell us how the taxpayer would be asked to pay for these losses, implying they have not thought through how the revenue subsidy will be injected in to the business. Their numbers of course did not add up, as the size of the business is going to be reduced by more than the workforce, implying further job losses to come later.

The Chief Secretary contented herself with claiming that the Opposition had no alternative to nationalisation, declining to answer my points about how the Bank of England and the Treasury could have acted as Northern’s bank manager, lending them the minimum necessary to see them through and managing the repayment of the loan in a timely way.

The government seems to be in denial. It thinks nationalisation is the answer, when it will turn out to be a whole new load of problems. Every staff member dismissed, every loan that goes bad, every customer upset now stretches up to a Minister who is in ultimate control of the destiny of the company. They do not seem to have a plan to handle the complex management problems, and are refusing to own up to the magnitude of the cash requirements of their new acquisition.

Last night the Opposition were right to ask them to think again. We were right to offer them a better way of handling a distressed bank. It is a pity for all of us they turned us down and made silly political points instead.

It is good news that the Bank of England is thinking about its role in modern markets, and that the US and UK authorities are to review how to handle banking liquidity and regulation in future.

This agenda should include:

1. Have the Basel regulatory arrangements encouraged too much off balance sheet lending?

2. How can a market in securitised good quality loans be restored? Should the authorities buy in or accept as collateral more of these loans, whilst protecting taxpayers against losses?

3. Has the UK Government burdened British markets with too much off balance sheet borrowing of its own? Can this be curbed?

4. Do the leading Central Banks have enough capital of their own to keep markets liquid enough?

5. Shouldn’t Central Banks try to keep market interest rates in line with their announced main interest rate by open market operations?

There is nothing wrong with the idea of banks bundling up loans and selling them to others in the market. That is healthy and helps the growth of the world economy. The danger arises if the banks themselves continue owning large quantities of corporate bonds or securitised papers in conditions where they find they cannot sell or value these assets at a realistic price. Market seizure for bonds or loan packages forces banks to cut their lending and to write down the value of these assets on their balance sheets in moves which can become a vicious circle.

The Central Banks need to find a way of keeping the high quality bond and securitised paper market in line with their chosen interest rate generally. That should be the main issue facing the US/UK Committee.

Meanwhile, the UK Government needs to ensure rapid and orderly repayment of the Northern Rock loans and needs to consider whether that is sufficient to give the Bank of England the financial firepower it needs. It also needs to cut its own appetite for borrowing, which is now in danger of crowding out other borrowers from the market. The Bank needs some of its old powers – and information – back from the FSA so it can understand banks’ positions more quickly and respond in money markets appropriately.

I am glad to see the Telegraph today giving front page prominence to the rise in mortgage rates this week. See yesterday’s blog on interest rates and the MPC for the background.

This morning the FSA takes the regulatory blame for Northern Rock and admits it made mistakes.
I think it is a case of mistaken identity. It was the Chancellor and the Bank of England that presided over the collapse of Northern Rock, not the FSA.
Remember what happened. In the summer of 2007 money markets dried up in an unprecedented way. Some of us went hoarse telling the Bank of England they needed to make more money available so the money markets could function.
Instead, in September, knowing Northern Rock could not borrow all it needed from the money markets, the Chancellor and the Governor of the Bank made speeches saying banks had lent too much and if they got into trouble it served them right. There would be no bail out.
There was then a run on Northern Rock, as small depositors sought to take their money out. (All this was obvious at the time – see the tab on Northern Rock for my contemporary comments on the Bank’s inaction and the Chancellor’s moral hazard speech).
Fortunately for Northern Rock, after huge damage had been done, the Chancellor and the Bank changed their minds and intervened to protect depositors.

I would not conclude from this that the FSA had got its stress testing wrong – or that the FSA needs more staff. I would conclude that both the Directors of Northern Rock and the FSA did their jobs in the belief that money markets would continue to function, and that the Chancellor would avoid comments that were damaging to regulated banks. These beliefs were not unreasonable. Northern Rock raised money in three main ways – from the money markets, from retail depositors and from securitisation. So do most banks, to differing degrees. As we have seen, other institutions can get into difficulties if money markets seize up, as with Bear Stearns.
What was wrong was that the Bank of England kept the markets so short of funds in August and September, and what was wrong was the speech and interviews of the Chancellor blaming the banks at the very point where a crisis of confidence was about to erupt.

The correct response to this crisis is not to appoint more staff at the FSA and let the FSA take the blame. The correct response is to strengthen the banking arm of the Bank of England, and reconnect the Bank more directly to the full working of the money markets, with a remit to keep the markets reasonably liquid. The Bank has as its main responsibility the setting of interest rates. In recent months the rates it has set have often become academic, as market rates have deviated from them under the pressure of the credit crunch. The Bank needs not only to set rates, but to enforce them.

The questions to be asked today are not about the FSA but about the Chancellor and the Bank.
Does the Chancellor now accept that his no bail out speech was a mistake?
Does the Bank now think it should have made more liquidity available to markets last summer?
What action is the Bank going to take now to ensure that the rates it sets are the rates the market follows?
Will the government restore the powers and duties in banking and money markets to the Bank of England that it took away in 1997?

There has been a lot of comment on the state of the economy, the Credit crunch and the banking problems over the week-end. It is time to re-examine the views of this blog, and the responses from many of you.

I have argued:

1. The US and the UK will avoid recession but will experience a slow down, sharp in some areas and sectors. Some are trying to talk us into recession, by claiming the US is already in one, but the numbers tell us otherwise. It is quite clear that the Fed, the Treasury Secretary and the President will do everything they can to avoid recession in the US.
2. Inflation will remain unpleasant for the first part of 2007, but in a year or so will have reduced. Most of you disagree strongly, believing the current inflation will persist, and if the authorities do too much by way of cutting rates and making money available will trigger a faster one. I see no evidence that inflation is passing from energy and commodities into wages. We instead seem to be entering a period when real wages will be squeezed, limiting the second round inflationary effects.
3. The authorities need to do more to make the markets more liquid to ease the banking problems. So far the Fed has been very active, doing all it can. The Bank of England seems to be reluctantly coming round to the same conclusion. The ECB is half way there, making cash available but not cutting interest rates. Many of you dislike the advice I am giving, but the authorities seem to be moving in the direction I think is right.
4. The banks will gradually be recapitalised by rights issues, new share issues, and money from the cash rich parts of the world – Asia and the commodity producers. This is gradually happening.
5. UK house prices will fall, along with commercial UK property prices and US house prices. Some think UK residential property price falls unlikely because we are building so few new houses whilst new household formation is greater. I still stick to this view, because the mortgage market is tightening substantially. I accept there is no need for Florida style falls as we do not have the same over building problem and did not have the same degree of excess in sub prime mortgages.

Today Anatole Kaletsky has written one of his thoughtful pieces. He states that the banking crisis is a liquidity crisis, not a solvency crisis. A liquidity crisis is when banks need more cash to pay out depositors and other creditors than they have readily available, and find it difficult to sell their other assets quickly enough to raise the cash. A solvency crisis is when banks do not have enough total assets to meet all their liabilities, so they need to raise substantial new capital.

I agree with him that Northern Rock and Bear Stearns both were liquidity crises – depositors and creditors lost confidence in the institutions and demanded more cash than the institutions could immediately lay their hands on without official help.
The one thing we have to remember, however, that is not in his article, is that a liquidity crisis if badly handled by the banks and the authorities can become a solvency crisis. If Institution A is experiencing a run on its cash, it needs to sell assets quickly to raise more money. This, in poor markets, can drive the price of these assets down to unusually low levels. All banks then have to mark down the value of their assets on their balance sheets, as even high quality assets can no longer be sold for good prices in such conditions. This can lead to some institutions no longer having sufficient assets to cover all their liabilities, so they need to raise more capital or they get into trouble.

This is why some of us recommend that the authorities should help the markets by intervening to keep the price of high quality financial assets up to realistic levels. If the Central Banks stand by and watch as well run institutions are forced to sell high quality assets for well below their normal value, they are allowing more serious problems to emerge in the banking system as a whole. It is in everyone’s interest that high quality mortgage debt, high quality bonds and corporate debt should sell at realistic prices, related to the current structure of interest rates. In a liquidity crisis the price of good quality assets can be driven down too far, putting pressure on well run financial institutions.

Today the Regulators start their search for the bear raiders who spread false rumours yesterday.
Meanwhile, the Bank of England should repeat that as the apex of our large and strong banking system, it will make enough liquidity available on a continuing basis so the markets function better and bear raiders have less chance to peddle their unpleasant trade. The authorities must use all their powers to protect decent institutions from false rumour and from artificially frozen markets.
The US authorities have responded postively and quickly. The Bank of England and the ECB are also important players. A strong united front from the Central Banks, facing the bears down and reassuring depositors by showing that they will do whatever it takes to support the many good banks there are in the system is what is now needed.
The UK government needs to act with and through the Bank of England. Ministers took the decision to throw so much resource into saving and nationalising Northern Rock, so they need to show the Bank of England that it by areement work with Treasury resources to keep the rest of the banking system liquid if needed. We do not want the authorities restricted in their actions because of the amount of Northern Rock support already on the books.