Pub. Date
02 May, 2008

<strong>Introduction</strong><br />

The last few weeks have seen an intensification of the banking crisis in the United States, with the near failure of Bear Sterns, while in the United Kingdom the gap between the Bank Rate and money<br />

market rates has re-opened and is described as indicative of a reluctance of banks to end to each other. In this commentary we seek to explain the fundamental factors behind recent developments in UK lending markets. The crisis comes after a bubble in the financial services industry. Its share of<br />

total value added in the UK economy has almost doubled, from just over 5 per cent to just under 10 per cent since 1991. Looking ahead, it is likely that the share will fall back again. The increased competitiveness of the UK economy resulting from the recent fall of the exchange rate makes it possible for more the more conventional traded goods sector to expand to fill the gap.<br><br><br />

<br />

<strong>The Crisis in Perspective</strong><br />

Financial crises are recurrent features of market economies although they became less frequent after the Second World War than in the pre-war years. In the mid-1980s in the United States of America $160bn was lost in the Savings and Loans crisis, amounting to 3.8% of US 1985 GDP. If losses in the current crisis reach the $1000bn forecast by the IMF, this amounts to 7.4% of US GDP although up to half will fall on foreigners. The magnitude of rights issues under discussion in Britain suggests<br />

that perhaps 2-3% of UK GDP has been lost.<br><br><br />

<br />

<strong>Liquidity Problems or Risk Reassessment?</strong><br />

It is widely believed that lenders are affected by a 'shortage' of liquidity in wholesale markets. But it is more likely that there is a 'shortage' of finance for high loan to value mortgages not because wholesale markets have 'dried up' but because lenders have now understood that they are risky. The nature of the risk reassessment can be seen from the changing pattern of mortgage rates. Rates on discounted mortgages have drifted up since the Autumn and the rise is particularly marked in mortgages for 95% of house values. A na•ve interpretation of this would be that in the last few months the risks associated with high loan to value<br />

mortgages have changed. But a better explanation is that lenders modelled risk badly. While house prices were rising they did not regard there as being a significant risk that prices might turn down because they assessed risk on the basis of relatively<br />

short-term data. In other words they were too ready to believe that the economic environment had changed. Stagnating house prices have reminded lenders of the reality that high loan ratios are risky. Indeed in the last housing slump in the early 1990s house prices fell on average by twelve per cent. But inflation was considerably higher and, with today\'s low inflation the decline would have been around twenty per cent and perhaps up to thirty per cent in London. So even 75 per cent mortgages have to be seen as risky. The Bank of England liquidity scheme is not going to reduce the<br />

risk associated with mortgages and people who expect it to have a substantial impact on mortgage rates are likely to be disappointed. Nevertheless, the take-up of the scheme, suggested to be at least £50bn, is large compared with the £23bn increase<br />

in mortgages issued to the household sector by monetary sector institutions in the second half of last year. The scheme goes beyond simply financing the net increase in borrowing, and is likely to help those institutions who have habitually financed a considerable proportion of their mortgages in wholesale markets. <br><br><br />

<br />

<strong>Capital Losses and Capital Shortages</strong><br />

Following the losses that many large banks have made it is suggested that they are constrained by shortages of capital. In principle losses are byegones and do not affect the profitability of the business which might be generated by a marginal<br />

infusion of new capital. If this were in fact the case, the capital losses would be no more important in their impact than stock market declines of similar magnitude. The difficulty is that new investors cannot insulate additional capital from the effects of as-yet undiscovered losses. Nevertheless banks are now starting to announce rights issues. The total value of shares and other equity outstanding of all incorporated businesses is £771bn (end 2007). Even if the total value of rights issues by banks<br />

amounts to say £35bn, it is hard to see that this would disrupt financial market substantially. But once banks have put themselves on a better financial footing, there is a question what else needs to change.<br><br><br />

<br />

<strong>Bankruptcy Law Reform</strong><br />

Inevitably there is now a feeling that the current regulatory structure has not worked because banks have taken too many risks. Most of the discussion focuses on regulations imposed on banks, but there is a real question whether there should also be some sort of international standard on bankruptcy law. UK bankruptcy law was reformed in 2002 to reduce the penalties associated with 'honest failure'. In the United States despite a tightening in 2005, laws are laxer than elsewhere. Most mortgages are non-recourse which gives mortagors a strong incentive to default once they find themselves with negative equity. The international financial system would be more stable if borrowers found it harder to walk away from debts.<br><br><br />

<br />

<strong>The Economic Outlook</strong><br />

It is clear that the credit position has worsened substantially since our last forecast in January 2008. The impact of tight restriction on credit mean that we are now expecting growth of only 1.8 per cent in 2008 and 1.8 per cent in 2009. The implications of this for the public finances are impressive. We now expect the current government budget to remain in deficit until 2011 and the public sector net debt as a proportion of GDP to exceed 40 per cent then.