Sunday 1 September 2013

Base-rate, Bonds, Bubbles and Bust Banks


Once again, as Bank of England Governor, Mark Carney, spoke, giving forward guidance, and promising that interest rates would remain frozen for the next three years, interest rates rose, as they did the last time he spoke! As I pointed out a few weeks ago - Carney Freezes Rates For 3 Years, UK Interest Rates Rise – the idea that state bureaucrats can guarantee that interest rates will remain frozen is ludicrous. Interest rates are determined by the market, on the basis of the demand and supply of money-capital, and the rate lenders are prepared to charge, for the supply of money-capital, also depends on what they think inflation is likely to be, i.e. what the real value of the money they will be paid back with will be. The policy of money printing by Carney, Bernanke and other central bankers, pushes up inflation, and so lenders will demand higher returns to compensate. But, as I've set out - Rates Of Profit, Interest and Inflation – global interest rates are in any case now set to rise sharply and for a long period.

In my post, a couple of weeks ago, I referred to the fact that economic reporters on TV simply asserted that interest rates would stay low, because Carney had said so, without making any reference to what market interest rates were actually doing. To the credit of one of those reporters, on Sky News the other day, she did make this point, in an interview with the Chief Economist of Nationwide Building Society. She asked him if higher market rates of interest had caused the Nationwide to increase its fixed rate mortgages. She asked him twice, but he refused to answer, referring only to the fact that rates were at historically low levels. But, of course, that is the point. Rates are at 300 year low levels, and yet according to this source,

“£3 trillion debt in banking system – Office for National Statistics, Budget Report 2011 – HM Treasury

260,000 people on interest only mortgages do not have a strategy to repay their mortgage – The FCA publishes findings of review into interest-only mortgages and reaches agreement with lenders to contact interest-only borrowers, 2 May 2013

The average shortfall stands at a staggering £71,000, according to the FCA – The Guardian, Interest-only mortgages: how to tackle the shortfall, 2 May 2013

300,000 homeowners in Britain are not paying their mortgage at all and Nick Hopkinson call forbearance “a sick joke” – mortgageintroducer.com, Lender forbearance becoming “a sick joke”, 29 May 2013”

So, with market interest rates rising, i.e. the rate at which banks and others have to borrow, the amount they have to charge for mortgages, and other loans, can only go higher. And, because rates are so low, any increase represents a large percentage rise. If interest rates are at 0.5%, for example, and they rise by 0.25%, then although this is a small absolute rise, it represents a 50% increase. Imagine what effect even a 50% increase in households mortgage payments would mean, when as shown above they are already struggling to pay at current levels. But, in fact, mortgage rates are more likely to more than double than just rise by half. Back in 1990, mortgage rates went over night from 6-7%, to 15%. But, 1990 came at a time when the amount of debt and money printing was much lower than it is today. It came at a time when global interest rates were still at the start of that 30 year period when they were falling. Today, we have an unprecedented level of debt, rising inflation, and we are now in a period of rising rather than falling global interest rates.

Moreover, in 1990, mortgage rates were already high, compared with today. The 150% increase then is almost certainly less than the rise there will be from today's 3-4% mortgage rates. This is one reason that the spokesmen of the banks, like the one from the Nationwide, dare not admit that these rates are likely to rise whatever Carney does. The Nationwide spokesman was on the programme, because they had just come out with a claim that house prices had started to rise again. That claim was in contrast to the claim by Rightmove, that, in fact, despite all the Government bribery, and record low interest rates, house prices had fallen by 1.8% in August.

Banks like the Nationwide need to claim that house prices are rising, and that interest rates will stay low to keep them doing so, because they are massively exposed to all of this property debt, and to the fact that the properties on their books are massively overvalued. Once the Emperor is seen as having no clothes, property prices will collapse. The banks will no longer be able to continue with pretend and extend, which will accelerate the selling, causing a firesale of properties, and further collapse of prices. But, when property prices collapse, that also means that the value of property on the banks' balance sheets will be decimated. In order to maintain capital adequacy ratios, the banks would then have to call in vast amounts of loans, or else seek additional capital by issuing new capital, and bonds. But, the banks have already been told they are under capitalised.

A glimpse of that problem was provided with the collapse of Northern Rock in 2007, but it can again be seen today with banks like the Nationwide and the Co-op. The Co-op has hardly been a reckless lender in the past, yet the Co-op also merged with the Britannia Building Society. Like Northern Rock, and other property based lenders, Britannia, seems to have over committed itself as part of the property bubble of the last three decades. As people have been pushed more and more into debt, there has been less and less money available as saving for building societies, so the building societies and banks have had to raise the money they need in the market. That is fine while interest rates are falling, but when they start to rise, it leaves the banks terribly exposed. That indeed is what happened with the collapse of Northern Rock.

Now the - Co-op Bank looks set to go bust - in the same way, and there is talk about - Nationwide being not far behind. If the pretence maintained so far of property prices collapses, then these banks capital adequacy will be shown to be even worse than it seems even now. But, every other bank in Britain will be in the same position. That is why Osborne is doing all in his power to save the banks by trying to keep the property bubble inflated.

It will not work. For any property market to be stable, it requires a steady intake of first-time buyers. Osborne is trying to ensure that with his “Help To Buy” scam. But, even with that, the basic fundamentals of the economy mean that there will be not enough first-time buyers, and without first-time buyers, people at the lower levels of the ladder cannot sell their houses and move up. Indeed, the inability to sell such houses, is one reason that many sellers have given up, and decided to rent out their houses instead. But, because house prices have bubbled up so much, the ability of people lower down the ladder to trade up has also been reduced, because the house they want to trade up to has moved further and further out of their reach as prices rose.

According to some analyses, there are 12.5 million people in Britain who are either unemployed, under-employed, on zero hours contracts etc. Even with Osborne's bribery, its hard to see how these people are going to be able to raise deposits for over priced houses, or how, even if they could, they would be able to meet their monthly repayments, even before mortgage rates rise. Around 30% of households run out of money after three weeks, and have to go into debt for the last week. That has been fuelling the increased level of debt, and the growth of the Pay Day Loan sharks. It is difficult to see how people in such circumstances are going to be able to become first-time buyers. Indeed, its difficult to see how they can continue paying pay day loan rates of interest for long, and how, therefore, they will be able to pay their monthly mortgage bill. As rates rise, that is even less likely.

I heard one financial analyst on CNBC last week, however, argue that Britain is not like the US, where fixed rate mortgages for 30 years are common, and where the rate is largely determined by the yield on the US 30 year Bond. His argument was that in Britain, this link with bonds is not so close, and mortgage rates are often set as so many points above Bank of England base rate. Its true that banks and building societies offer such mortgages, but that has been on the basis of largely stable and falling market rates of interest. Its easy to see why, as interest rates rise, this can't continue.

Suppose, banks can borrow from the Bank of England at 0.5%. They add 2% for their costs and profit, and offer mortgages at 2.5%. Fine, so long as property prices are rising and you think you will get your loan back, and so long as market rates of interest are falling. But, suppose there is an increased risk that property prices might fall, that the people you have lent to may not pay back the loan, and so you make a capital loss. Already, it looks less tempting, and you might want to increase that 2% margin, to cover the increased risk. Moreover, suppose you suspect that all of the money printing is set to increase inflation, so the money you get paid back with will be worth less than the money you lent out. Again you might want to add a bit more to that 2% to cover such an eventuality.

But, you may still be happy to make such loans, provided the return you could get elsewhere is less attractive. That has been the case until recently. The yield on the UK 10 Year Gilt fell to just 1.5%, on the US Treasury similar, and on German Bunds was even negative for a time. But, the rise in global interest rates has changed that. US Treasuries are approaching and likely to go past 3% in the next weeks. UK Gilts have gone past US rates, rising to over 2.8% last week. The advantage of buying these Bonds is that its pretty certain that the UK and US Governments, unlike a massively indebted UK household, will actually pay you your interest, and you will be able to get your capital sum back. That means that there is an obvious carry trade open to the banks to borrow cheap from the central bank, and then simply lend this money to the government by buying its bonds.

That, in fact, is what the ECB did through its LTRO programme, which provided low interest rate loans to European Banks, which they used to buy the bonds of the peripheral economies to bolster the price of those bonds, and thereby lower their yield, and subsequent borrowing costs. So, there is no guarantee under current conditions that the money printing will find its way into mortgage lending or lending to businesses. Yet, the reality is that bonds are in as much of a bubble as property prices, and for the same reasons.

Its difficult to see how governments and central banks get out of this Catch 22 situation, and they don't seem to have any ideas themselves, which is why they are reduced to simply continuing to hope that something turns up, and that they can continue to convince populations that the Emperor's new clothes are the best ever. It is why they are reliant on fraudulent house price indices produced by the very banks that will go bust when the bubble bursts, and why they are reliant on the media continuing to send out the message that prices are rising, and interest rates will remain low.

The unreality is palpable, and yet when the bubble bursts, there will be endless TV programmes, and newspaper articles asking why no one saw it coming. Anne Pettifor has called it Alice In Wongaland and its one of the best descriptions I've heard.

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