Friday, 15 February 2008

Seven steps to ruin

It is Saturday; it is sunny outside; at least it is here in London. Let us bring the mood down and consider the calamitous prospects facing the UK economy.

Things are bad, but it is going to get worse. Here are my seven steps to economic ruin. As always, it starts with the great distortion that has twisted the UK economy into a debt-addicted mess - the housing market. It ends with a banking crisis and a government bailout.

Step 1 – UK Households try to pay down the debt

The overextended UK consumer is in the driving seat for this trip. For the last ten years, households borrowed as if the world was about to end and no one was going to ask for the money bank.

The extent of UK personal sector indebtedness is truly frightening. Today, individuals owe around £1.4 billion, which is well north of 100 percent of GDP. About 85 percent of personal debt are mortgages and home equity loans; the rest is owed on credit cards and unsecured loans.

What encouraged this explosion of lending? The housing bubble; people took out loans to pay for overvalued houses, believing that these overpriced assets would continue to appreciate.

Today, the UK personal sector has reached saturation point; it cannot soak up any more debt. Many households are suffering from payments difficulties. Sentiment is about to shift; the spend fest is about stop and people will try to reduce their debt levels.

Step 2 - Consumption declines, economy begins to slow.

There is only two ways that people can reduce their debts; either earn more or spend less. Unfortunately, the first option is not available. UK real wage growth is now negative; the latest average earnings data shows wage growth at 3.8 percent but RPI inflation is running at 4.1 percent. If earnings will not grow, then spending must slow. The aggregate effect of all those little decisions to cut back on spending will be a reduction in aggregate consumption, which makes up about 70 percent of GDP. It will not take much of a fall in consumption to make a serious dent in economic growth.

Step 3 - Unemployment begins to rise

As people reduce their consumption and as the economy slows, firms will begin to fire workers. The unemployment rate will begin to rise. However, there is no policy-driven escape strategy available.

As soon as the dole queues begin to increase, the Bank of England will face irresistible demands for drastic interest rate reduction. However, lower rates will only exacerbate the UK's macroeconomic imbalances. It will push the sterling exchange rate down, and as imports become more expensive, inflation will rise. Lower rates will not help the housing market much either. Banks are already in way too deep, and want to reduce their exposure. Lending standards have already tightened up. The days of easy credit are now over.

The government will not have much room to use fiscal policy as a recession-evading tool. For the last two years, public sector deficits have grown dramatically, in effect, propping up the economic growth. Higher government deficits would push up long-term interest rates as investors become increasingly wary of buying government debt.

Unfortunately, higher unemployment seems inevitable, and here is where the banks really need to start worrying.

Step 4 - Default rates begin to rise, repossessions increase, and housing prices collapse.

It is an obvious point, but unemployed people invariably have difficulties paying their debts.

As the default rate rises, repossessions will increase. Soon, this additional housing inventory will push the house prices down. Forget all that rubbish about pent up demand from real estate agents; there will be plenty of supply when the economy slows.

Recent housing data is already showing a market under enormous stress; house prices have been falling since July 2007; mortgage approvals are down dramatically, and default rates are already creeping up. Notwithstanding this slowdown, the worst is yet to come.

Step 5 - Bank losses increase

Given the enormous levels of mortgage debt out there, it would not take much of a rise in unemployment to push the default rate up to dangerous levels; dangerous that is, for UK banks. While repossessions are a personal tragedy, for the banks, a rising default rate on mortgages is a mortal danger. It was the banks, with their reckless lending, who inflated the housing bubble. They provided the rocket fuel; without the double-digit growth in mortgage lending, there could be no double-digit growth in house prices.

Step 6 - Bank failure followed by panic

Banks fail when people stop paying them back, their assets evaporate, and as the banks go down, depositors find their money trapped in bankrupt institutions. Even the very thought of a failure is likely to prompt a run on a bank. We have already seen how quickly a bank can turn bad. Last summer, Northern Rock crashed in just a few short days. Although Northern Rock did not prompt a run on other banks, UK depositors had their confidence in banks severely tested.

However, banks are more than just lending institutions; they play a vital role in the payments system. A smooth settlement of accounts is the cornerstone of a properly functioning economy. Money trapped in failed banks cannot be used to pay bills, wages or taxes.

Step 7 - Ruin

No economy can allow a systemic banking failure. When banks fail, the government has to step in and rescue the payments system. Ultimately, this is probably where the UK banking system is heading. As banks wilt under the weight of defaulted mortgages, we will see the nationalization of a fair chunk of that housing debt. The Bank of England will extend emergency loans to bankrupt banks, and the government will pick up the tab. If anyone thinks this is far-fetched, just remember Northern Rock. That little failure has already added 6.7 percent to the government debt.

Surely, you exaggerate.

It is a dismal perspective, to be sure, but there are good reasons to worry. Rising government indebtedness, banking failure, tanking house prices, and increasing unemployment; that is one toxic brew, but it could be where we are heading.

For those who think this scenario seems a little far-fetched, sit back and thing about the following point for a moment. Last year, UK banking sector managed to pull off three incredible feats; it engineered one major bank failure, the first in over one hundred years; it kept financing the housing sector when every available indicator suggested overvaluation; and it accumulated losses without the economy actually slowing down. Can you imagine how bad things could get when the economy does finally begin to grind to a halt?

Make no mistake; the UK banking sector is an accident waiting to happen.

13 comments:

Lord Wraggley of Myre said...

Dear Alice
I think Step 6 is a little fanciful. Perhaps a smaller mortgage lender (or two)--Alliance & Leicester, Bradford & Bingley?--but the Guv would not let a major bank get washed out to sea, let alone drown in the waves: it would be too traumatising for the country. If there's trouble at Barclays, the BoE will hush it up and supply the necessary funds on the quiet until the problem blows over. However long that takes. For precedent, look at the US, where the Fed currently has something going called the TAF (Term Auction Facility), which allows banks to borrow as much as they need (at a slightly higher interest rate, sure, but who's counting)--anonymously. That's right. Anonymously. No one knows who's in the dogpile.
Pip? Pip? Pip! Pip!

ukhousingbubble said...

The Bank of England will not let any bank go under. However, I would not rule out a big bank getting into trouble. My main points, however, are that banks are in trouble, and that the government will end up footing the bill. Also, I don't think that the BoE could keep a banking crisis quiet.

BTW, I was shocked to learn just how expensive Northern Rock turned out to be. The government had to give guarantees amounting to 6.7 percent of GDP.

Alice

Lord W o' M said...

Yes, I read that too. Extraordinary. And I am following the "sale" of what is left of NR with much interest. Branson won't pay more than 25p in a £, so I reckon he's out; which leaves the management buy-out. Hmmm. But the Guv will do anything to avoid nationalisation--it reeks of the pre-Thatcher era, and we can't have that, can we!

Anonymous said...

A couple of comments.

household debt = £1,400,000,000,000
household debt excluding mortgages (15% of total ) = £210,000,000,000
household debt average (assume 25 million households) excluding mortgages = £8,400

If my estimate of the number of households isn't too far off, then the average unsecured debt is *way* higher than I realised.

"No economy can allow a systemic banking failure. When banks fail, the government has to step in and rescue the payments system."

I honestly don't see why. This is tantamount to declaring that we have become a communist country. I know it will hurt some people but capitalism is all about success and failure. The only way the banks will ever learn the old fashioned discipline required for responsible lending is by market correction.

I am looking forward to seeing how the history books deal with this in the coming years.

Anonymous said...

4.00pm Rock to be nationalised.

Laplace77 said...

http://www.northernrock.co.uk/

BUSINESS AS USUAL

Temporary Public Ownership: What It Means For You

* The Government has announced that in the best interests of customers and taxpayers, it is taking Northern Rock into temporary public ownership.
* Customers are not affected by this change.
* Your savings with Northern Rock continue to be safe and secure, protected by the Government guarantee arrangements.
* The terms and conditions of your mortgage, savings and other products remain unchanged.
* All branches, call centres and other operations remain open for business as usual.

Lord Wraggley of Myre said...

You could have knocked me down with a feather. And now the only thing that will get me up is a tumbler of Glenmacsponge. This is all so 70s!--I'll have to get my flares and platforms out. Pip! Pip!

Anonymous said...

In reference to the TAF above, note there's a huge debate raging on the financial blogs. The basic fact is that banks must post collateral in order to borrow reserves. If they don't have collateral they don't get reserves, sink below the BIS 8% rule and get closed. The problem with all the asset writedowns is that it is lowering the value of the collateral the banks can take to the Fed.

The Fed (and BoE) cannot simply print money and give it to banks. It's not in their charter and it wouldn't work anyway (because bond interest would go through the roof as investors require an inflation premium).

The government can't bail out any more banks because they know what it would do to the interest rates on their massive deficits, and on private and corporate debt.

BTW, I'd recommend you stick to the Austrian definition of inflation (an increase in the money supply) rather than use the word to describe one of the many effects of inflation (an increase in consumer prices).

Last I read inflation in its real sense was about 12% in the UK and Euro zone. It just hasn't filtered through into the RPI yet.

Nick

ukhousingbubble said...

Nick,

You point to a serious problem.

I would be grateful if you could add some links to the financial blogs you mention.


Alice

Anonymous said...

Alice,

I forgot to add that I like your blog and have checked in every day since I discovered it last month.

Although I have a financial background and work in fund management the details of this (especially for predictions) is fairly new to me. My main sources of information have been:

The reserves history: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt
Analysis: http://globaleconomicanalysis.blogspot.com/2008/02/borrowed-reserves-and-tin-foil-hats.html

These two sites also cover it
http://calculatedrisk.blogspot.com/
http://www.nakedcapitalism.com/

regards

Nick

Lord Wraggley said...

Attn: Anonymous

Rer TAF

From today's FT: “The TAF . . . allows the banks to borrow money against all sort of dodgy collateral,” says Christopher Wood, analyst at CLSA. “The banks are increasingly giving the Fed the garbage collateral nobody else wants to take . . . [this] suggests a perilous condition for America’s banking system.”

Sounds like they are giving the Fed the CDOs that nobody can value. Still want to call it "collateral," or should we discuss a new term?

Anonymous said...

That "collateral" is sitting on the banks balance sheets as assets. When it's covered by a CDS or otherwise avoiding a mark-to-market then it'll be sitting there at close to 100 pennies on the pound. If they have to write it down (or more correctly, WHEN they have to write it down) the collateral will be worth less.

So long as the T stays in TAF these loans mature and are rolled over. But the next time they roll over they are at a lower value.

It's a good point about using dodgy collateral, but I think it's just a temporary fix. They are just holding their breath and waiting for a miracle.

It's interesting how the MSM is only just getting around to reporting this and mostly pooh-poohing the implications. People who bothered reading the Fed's own website spotted the trend in December.

Nick

Anonymous said...

Don’t believe one optimistic word from any public figure about the economy or humanity in general. They are all part of the problem. Its like a game of Monopoly. In America, the richest 1% now hold 1/2 OF ALL UNITED STATES WEALTH. Unlike ‘lesser’ estimates, this includes all stocks, bonds, cash, and material assets held by America’s richest 1%. Even that filthy pig Oprah acknowledged that it was at about 50% in 2006. Naturally, she put her own ‘humanitarian’ spin on it. Calling attention to her own ‘good will’. WHAT A DISGUSTING HYPOCRITE SLOB. THE RICHEST 1% HAVE LITERALLY MADE WORLD PROSPERITY ABSOLUTELY IMPOSSIBLE. Don’t fall for all of their ‘humanitarian’ CRAP. ITS A SHAM. THESE PEOPLE ARE CAUSING THE SAME PROBLEMS THEY PRETEND TO CARE ABOUT. Ask any professor of economics. Money does not grow on trees. The government can’t just print up more on a whim. At any given time, there is a relative limit to the wealth within ANY economy of ANY size. So when too much wealth accumulates at the top, the middle class slip further into debt and the lower class further into poverty. A similar rule applies worldwide. The world’s richest 1% now own over 40% of ALL WORLD WEALTH. This is EVEN AFTER you account for all of this ‘good will’ ‘humanitarian’ BS from celebrities and executives. ITS A SHAM. As they get richer and richer, less wealth is left circulating beneath them. This is the single greatest underlying cause for the current US recession. The middle class can no longer afford to sustain their share of the economy. Their wealth has been gradually transfered to the richest 1%. One way or another, we suffer because of their incredible greed. We are talking about TRILLIONS of dollars. Transfered FROM US TO THEM. Over a period of about 27 years. Thats Reaganomics for you. The wealth does not ‘trickle down’ as we were told it would. It just accumulates at the top. Shrinking the middle class and expanding the lower class. Causing a domino effect of socio-economic problems. But the rich will never stop. They will never settle for a reasonable share of ANYTHING. They will do whatever it takes to get even richer. Leaving even less of the pie for the other 99% of us to share. At the same time, they throw back a few tax deductable crumbs and call themselves ‘humanitarians’. IT CAN’T WORK THIS WAY. This is going to end just like a game of Monopoly. The current US recession will drag on for years and lead into the worst US depression of all time. The richest 1% will live like royalty while the rest of us fight over jobs, food, and gasoline. Crime, poverty, and suicide will skyrocket. So don’t fall for all of this PR CRAP from Hollywood, Pro Sports, and Wall Street PIGS. ITS A SHAM. Remember: They are filthy rich EVEN AFTER their tax deductable contributions. Greedy pigs. Now, we are headed for the worst economic and cultural crisis of all time. SEND A “THANK YOU” NOTE TO YOUR FAVORITE MILLIONAIRE. ITS THEIR FAULT. I’m not discounting other factors like China, sub-prime, or gas prices. But all of those factors combined still pale in comparison to that HUGE transfer of wealth to the rich. Anyway, those other factors are all related and further aggrivated because of GREED. If it weren’t for the OBSCENE distribution of wealth within our country, there never would have been such a market for sub-prime to begin with. Which by the way, was another trick whipped up by greedy bankers and executives. IT MAKES THEM RICHER. The credit industry has been ENDORSED by people like Oprah, Ellen, Dr Phil, and many other celebrities. IT MAKES THEM RICHER. So don’t fall for their ‘humanitarian’ BS. ITS A SHAM. NOTHING BUT TAX DEDUCTABLE PR CRAP. Bottom line: The richest 1% will soon tank the largest economy in the world. It will be like nothing we’ve ever seen before. and thats just the beginning. Greed will eventually tank every major economy in the world. Causing millions to suffer and die. Oprah, Angelina, Brad, Bono, and Bill are not part of the solution. They are part of the problem. EXTREME WEALTH HAS MADE WORLD PROSPERITY ABSOLUTELY IMPOSSIBLE. WITHOUT WORLD PROSPERITY, THERE WILL NEVER BE WORLD PEACE OR ANYTHING EVEN CLOSE. GREED KILLS. IT WILL BE OUR DOWNFALL. Of course, the rich will throw a fit and call me a madman. Of course, their ignorant fans will do the same. You have to expect that. But I speak the truth. If you don’t believe me, then copy this entry and run it by any professor of economics or socio-economics. Then tell a friend. Call the local radio station. Re-post this entry or put it in your own words. Be one of the first to predict the worst economic and cultural crisis of all time and explain its cause. WE ARE IN BIG TROUBLE.