Why the British Economy Will Plunge Into Depression - The Intelligence Daily

Summary:
Michael C. Feltham describes the origins of the credit crunch and looks at the prospect for the British economy. Root causes are the low interest rates in the late 90s followed by irresponsible lending, and consumer spending on credit. Rates will eventually need to rise to stem inflation, which will to a rise in unemployment. With no meaningful industrial base and an economy previously predicated on house price and the import, distribution, sale and fitting of foreign goods, there is no where to go and no salvation in sight. (Published: 04/07/08)
Notes:

• credit crunch did not appear out of the blue
• was inevitable, caused by by slack regulation, fiscal desperation and greed
• causal factors:
• Bank of England synthetically depressing core interest rates to a 50 year historic low;
• Insane Parameters adopted by Mortgage Lenders: including up to 120% Loan To Value; 28 year terms; Income Multiples up to 8.5; Lack of Test of affordability;
• Abuse of Mortgage Backed Securities (Securitisation, i.e. Derivative Products);
• Lack of Effective Capital Bases of Mortgage Lenders;
• Bank of England’s lack of control over Money Supply;
• An economy predicated on house price escalation and
• The import, distribution and sale of foreign goods mainly on credit.
  
• 1997, Labour government
• BoE made independent
• Eddie George, then-governor
• feared recession
• lowered interest rates to 3.5%
• historic 50 year low
• aware that it could trip a massive house price spiral and cause consumer credit binge
• considered "a risk worth taking" (as testified before Commons Select Committee, March 2007)
• both things happened
• low interest rates of late 90s
• mortgage lending became considered safe and very lucrative opportunity
• cash was secured by a tangible asset
• rates were at an all time low
• employment was booming
• things couldn't go wrong!
• lenders competed with each other
• effective insanity hit risk managers
• lending probity became thing of the past
• LTVs (loan to value) escalated from 85% to 120% in some cases
• Tenor (life of loan) expanded from 17y to 20, 25 and eventually up to 30y
• income multiples moved from 3.5 to up to 8.5
• dazzling range of mortgage products
• low start; cheap interest rates below market for first three years; trackers; options; fixed; interest only
• each lender determined to dominate this market pitched in with an even better offer
• as a result, value of property went up and ever up
• MEWing (mortgage equity withdrawal) became common and was encouraged
• contributed to buying binge boom
• most of the stuff bought was imported
• transport logistics, road haulage, warehousing, distribution, retailing boomed
• British economy boomed
• Consumer Credit boomed too, on top of mortgage debt
• much of it unsecured and at subprime rates
• spread between deposit and lending rates up to 40% APR
• usury, when base was hovering at 3.5%
• employment boomed
• to finance this never-ending eureka, banks had to find a new way to lend and lend without rapidly expanding their capital base
• new products: securitisation
  
• portfolios of loans "packacked" and sold on
• mortgage backed securities (MBAs)
  
• lender receives cash back, less service costs
• can re-lend the same money to another set of borrowers
• allowed banks and other lenders to sell of mortgage obligations and expand rapidly on a slender capital base
• MBAs were sold "without recourse"
• i.e. if loan went South, original lenders was free and clear
• to fund period between granting the loan and until they had yet another package of tempting debts all neatly wrapped up, banks turned to the Interbank Market
  
• Interbank Market brokers short and long positions between banks
• mortgage lenders were usually able to tap into this source
• most interbank deals are on name only
• the giver of funds - another bank or financial institution - takes no security and is assured by the obligor's credibility and creditability
• 2007: Interbank slammed tills shut on Northern Rock
  
• on back on market misgivings on subprime lending
• as US mortgage was increasingly hit with a deluge of defaults, many leading banks were sitting on large portfolios of almost worthless MBS products
• rapidly drained the capital markets of ready risk funds
• despite vast injections from Fed and BoE, tills remain firmly locked
• due to global nature of the international capital markets, much subprime MBSs had been sold to Asia and Europe
• these sources of capital remainded closed alsoe
• British banks, e.g. Barclays, taking in large funds from overseas SWFs, or desperately floating huge rights issues to boost their capital bases
• where does the British economy go from here
• indication: Interbank Market
• LIBOR is financial thermometer:
  
• shows what rate lenders demand in all periods from overnight and call through to 10 years when the market is bubbling
• normally tends to follow BoE's lead on rates
• LIBOR refuses to track BoE's base rate
• mainly because lenders realize that rate is too low
• mortgage lenders are now tracking LIBOR
• despite attempts by governments to stimulate the housing market with low rates and injecting massive tranches of cash into the system
• problem with trying to control Britain's economy with one weapon, interest rates
• blunt instrument, like an axe, cuts both ways:
• raise rates to dampen demand and stem inflation
• housing market tanks
• lower rates to ease housing market
• inflation roars away
• Sterling devalues
• BoE ought to have limited excessive lending instead with controls
• e.g. introduce the "Corset"
• lending institutions required to lodge matching Special Deposits with the BoE as a percentage of lending, at punitive rates well beneath market
• rates will eventually need to rise to stem inflation
• will trip the last lack of affordability factor on the average Britisch family's budget
• rapidly escalating food, fuel and heating costs, raised taxes
• tipping point will be a small hike in mortgage rates, 1.5-2%
• support activities will crash
  
• unemployment will rise
• weakened Sterling causes rocketing of Britain's import bill for essentials, e.g. crude oil, gas and food
• current account shoves yet further into deficit, which has to be funded
• with no meaningful industrial base and an economy previously predicated on house price and the import, distribution, sale and fitting of foreign goods, there is no where to go and no salvation in sight
• "music has just stopped and there are no spare chairs"