The Government says we’re fine. The experts disagree.

April 21st, 2008

No one is really sure whether Brown and Darling really believe, as they keep saying, that Britain is best placed of most western nations to weather the economic storms or if they are just saying it because they have to. Either way they are wrong, very wrong.

There are two vulnerabilities that point to a recession more severe than elsewhere. The first is the importance of financial services to the UK economy, not just in London but in other centres such as Edinburgh. The lack of trust that is manifest in the risk premiums required in the inter-bank market is bound to chill activity. As finance dries up, merger activity is stalling. Investors are paying down debt, not gearing up. Fear has taken over from greed, and jobs are going fast across the City.

In turn, the difficulty of interbank funding means mortgage packages are being withdrawn, particularly by smaller institutions. Far more cautious lending criteria (loan to value ratios and loan to income ratios) are being applied. The big lenders are less affected – there is a flight to safety in scale – but they will not pick up the baton from all the Northern Rocks that were growing so strongly. As a result, the housing market has turned. This will dominate consumer sentiment for years.

The housing market is like any other asset market: when prices rise, people think they will go on rising. When prices fall, they may hold out of the market until the decline is done. No one wants to buy when it may be even cheaper tomorrow, and particularly when prices are so much higher than historical relationships would suggest. The average house price to income ratio is more than 40% above its long-run average, and nearly double the last low.

Moreover, this inflation of asset prices has been built on an extraordinary accumulation of personal debt. The international comparisons are not favourable: in the UK, personal debt was 164% of disposable income at the end of 2006 compared with 138% in the US, and 104% in Germany. Ministers argue that debt levels are more sustainable because interest rates and inflation are low and employment is stable.

These points are less reassuring than they look. First, debt service – taking both interest and capital repayments – compared to income is nearly as high as it was in 1990. So low interest rates have merely allowed more gearing, leaving just as much vulnerability. Second, employment and even more unemployment are lagging indicators and may prove unstable faced with declining demand as consumer confidence slips. Unemployment rocketed from 6.9% of the labour force in 1990 to 10.5% by 1993.

The one important factor that may sustain activity is the decline in the pound, down by 12% overall in a little more than a year, which will boost manufacturing even though it will not prove much help to financial or other services. However, it means the North and Midlands may weather the storm better than London and the south-east, just as they did in 1990-1992. Moreover, the house price cum consumer confidence recession will hit middle-class southern voters hard.

In the past, it has proved sensible for governments to stop digging when the recession begins. They should take the hit on their own finances and balance sheet, because they are one of the few institutions capable of doing so. There is not, though, much point in trying to fine-tune activity with deliberate tax cuts or spending increases. The evidence is that they usually take effect after the event when they supercharge the recovery.

The one set of policy measures that might make sense are those that stop a freefall in the housing market. Instead of repossessions as borrowers fail to pay, which are then sold into a falling market and make it worse, lenders could take a broader view of equity sharing and payment holidays. With the regulators’ connivance, fire sales could be cut sharply. But with consumer confidence and asset price recessions, the best solution is always not to start from a boom. They end in tears.

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The Bank of England Steps In

April 21st, 2008

Perhaps anxious to put some distance between himself and the mistakes of his boss, the Chancellor of the Exchequer has announced his strong support for the Bank of England scheme to stabilise the financial markets.

Under the scheme, banks will be able to swap potentially risky mortgage debts for secure government bonds to help them operate during the credit squeeze.

In a statement to MPs, Mr Darling said the Bank’s intervention was necessary because money markets were not “functioning properly” and were beset by a “lack of confidence” despite billions of pounds in liquidity being pumped into the system.

The measures, he said, would help alleviate the “increasing cost and declining availability of lending by banks and building societies”.

The swap scheme, starting on Monday, will be for a period of one year and may be renewed for a total of three years. It will only apply to mortgage debts on banks’ books at the end of 2007 and the swaps cannot be used to finance new lending. The central bank anticipates that initial take-up of the scheme will total £50bn but there is no cap on lending.

Mr Darling denied the support was a bailout, stressing that the risk of losses remained with the banks which will be required to pay a fee for the swap facility and provide the Bank of England with assets of greater value than the government bonds they will receive.

Banks have welcomed the move and said they were confident it would go some way to free up credit markets.

British banks have become increasingly unwilling to make loans, even to each other, as a result of the credit crisis, which was triggered by massive losses for banks involved in the US sub-prime mortgage market. And many investors, concerned at what happened to sub-prime mortgages in the US, no longer want UK mortgage-based assets.

The disappearance of this market has deprived banks of tens of billions of pounds of finance for mortgage lending.

Although it will not directly support new lending, the greater liquidity should free up bank balance sheets and enable them to lend more to consumers, home buyers and businesses.

The effect the new scheme will have on the current market conditions is still unknown, the scheme has been designed primarily to prevent another Northern Rock, not to try and bring down mortgage rates. It may take some time for confidence to return to the banks and market conditions for ordinary lenders to improve.

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Refinancing problem loans no longer an option

April 17th, 2008

The number of people struggling with their debts looks set to double during 2008 as the clampdown on lending will limit their refinancing options, according to a new report.

It is estimated that about one million people have “problem” unsecured debts, and that these add up to £25bn – an average of £25,000 each, according to debt management solutions firm TDX Group, which issued the findings. Its clients include lenders such as HSBC, HBOS and Alliance & Leicester

About 60% of this money is owed on credit cards, with the rest mainly personal loans.

The report, entitled UK Problem Debt – consumer crisis or efficient market? warns that changing economic conditions, including the property market slowdown and an increase in personal inflation, will result in more people facing financial difficulties

It adds that the recent credit crunch and stricter lending practices will have a major impact on the solutions available for people looking to manage their debts.

The report says, ‘There will be fewer refinancing solutions such as re-mortgaging and homeowner loans available, because banks and building societies have tightened up their lending criteria. This could mean there could be a doubling in the number of people taking out repayment plans such as individual voluntary arrangements (IVAs) and debt management plans.” IVAs are an alternative to bankruptcy that allow borrowers to restructure their debts. Last year, an estimated 58% of people who were unable to keep up with their debts refinanced them or remortgaged to make their repayments more manageable.

Those who find themselves in difficulties are urged to shop around for the best solution for them. The majority of people who take out a debt solution sign up with the first organisation they contact, despite fees from IVA providers varying from £5,000 to £9,000.

Meanwhile, up to 45% of people fail to complete their IVA – these typically run for five years – with 15% dropping out during the first 12 months

The most recent government figures, issued in February, showed that personal insolvencies in England and Wales fell 4% in the final quarter of 2007 to 24,846 – a drop of 16% from the same period in 2006. That left the overall total of people declaring themselves insolvent during 2007 just below the previous year’s record levels

The level of bankruptcies rose 2.4% during the year, although a fall of nearly 5% in the number of IVAs pulled the overall figures down

It is unlikely that the downward trends described here will continue and the main lesson to learn from this report is that people with unmanageable debt should seek help quickly and shop around to ensure that they are getting the best deal possible. Failure to do so could lead to bankruptcy.

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