Friday, October 17, 2008

If lending at last year's level was the problem, why is it now a condition of government support?

The announcement that government support to the banks is to be dependent on their lending to other banks, and to business and retail and mortgage customers at the level it was in 2007 struck me as an odd requirement when it was first announced. Whilst lending to businesses needs to be maintained (much lending is simply short term to allow for cash flow) the need to lend at last year's level on mortgages and personal lending to individuals suggests that the government actually wants a return to the problems that led to the financial meltdown in the first place.

Lending was previously unsustainable. Loans were made using assets as security that were massively overvalued. And much of the over valuation was itself caused by the easy supply of credit. 100% (or more) mortgages at five times personal income simply drove house prices higher and higher. Their true value however did not increase. And then there was all the unsecured lending at high interest rates for consumption (effectively a few hundred billion pounds of credit card debt for consumption). And then there was the secured lending on the inflated value of homes, in which people were cashing in on the increased value of their homes to pay for consumption that they would not otherwise have engaged in.

The common theme throughout this is that the vast majority of non-mortgage lending to individuals was based on rising house values and an assumption that any debt incurred would at least be covered by the rise in the value of the homes people owned. And if it wasn't based on that, much of it was based on an assumption that at some undefined point in the future, it could be repaid on the back of a prosperity level that was assumed could service past debts. In other words, buy now and hope you can pay later.

I past decades, such a situation would have led to runaway consumer inflation. We escaped that this time, but at the expense of other areas of the economy. All the excess captial converted to consumption was soaked up in a tsunami of cheap imported goods and cheap oil. Without access to all those cheap goods from abroad, our surplus income would have been eaten up either by inflation (which is what happened in much of the post war decades) or by putting the money into savings (the less likely outcome). We ended up with a huge deficit on our international trade. The reliance on cheap oil meant we were highly inefficient in the way we used it and were hit badly when demand rose sharply from countries such as China and India.

The rise in the cost of basics immediately made the servicing of debt a big problem. Forecasts of future growth had to be rewritten downwards. This was the outcome of 2007. The first to feel the heat was Northern Rock. It had provided too many mortgages at a level higher than the property was worth. The bank had assumed that putting people into a negative equity position on the first day of their holding a mortgage would only be a short term problem. The inflating property value would soon wipe our the negative equity. In 2007 that was no longer happening. The system was simply running out of money to lend, property prices could not continue to increase beyond the ability of the financial system to lend the money to pay for them, and confidence in the system was needed to maintain and increase prices - confidence which had reached its limit.

So it is easy for the government to say that banks are required to return to 2007 levels of lending, but as far as mortgage and personal lending is concerned, this is just not going to happen. Nor would it be sensible for it to do so. Lending for consumption simply increases the trade imbalance or causes inflation. Lending to buy a capital asset, provided the borrower has the future capacity to repay the loan, is perfectly reasonable provided the asset bought is not over valued.

Where the asset bought has a real value less that the amount paid for it, and more importantly, the purchaser does not have the future capacity to pay off the debt and the interest, you are in a sub-prime situation. House prices are now dropping fast so lending against them now almost certainly means negative equity in the very near future. Buyers are waiting til the market bottoms out. The banks may now have the money to offer as loans but the buyers aren't there.

So what the government was claiming was pure spin. We cannot return to sub prime lending as this is what has started the collapse in the financial services in America. Ministers knew there will be no return to the lending levels of last year. The only return is to the spin level.

The big problem now is not the level of lending to individuals but the lending to businesses instead. With a recession almost certainly now with us, the lenders will not have the confidence that business borrowers will be able to repay loans. Interbank lending is not the problem. Bank to business lending is. Perhaps the government should have looked at guaranteeing some of that lending instead of guaranteeing lending between financial institutions. It could only be for a short while and should require a risk by any business person taking such a loan. And it should not become a permanent feature of the economy. These are crisis times and sometimes crisis solutions are required that would not be contemplated in ordinary times.

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