Economic View: With mortgages clogging up the system, a purgative from the Bank is just what the doctor ordered

As the Government launches its rescue plan for the housing market, the latest news on jobs and exports lifts a little more of the downturn gloom
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The woes of British banking come to a head this week with two seminal events. One will be the details of Royal Bank of Scotland's fundraising; the other the rescue operation of the mortgage market by the Bank of England and the Treasury. The former is extensively discussed in these pages, so let me just add one comment. What is fascinating is that the markets can cope with bad news but they hate a lack of frankness. So now that RBS has, so to speak, come clean, the shares can be sensibly valued and may be set to recover. Markets are more adult that many people think.

The even bigger story will be the mortgage rescue. We had better wait for the detail before leaping to judgement because this is one of those things where the detail matters enormously, but the broad outline of the deal is easy to grasp.

The banks have on their books, or on the books of associated specialist lenders, a vast wodge of mortgages that are just sitting there and cannot be traded. Why do they need to be traded? Well, most of us think that if we get a mortgage, the bank lends us the money and that is that. Not so any more: mortgages are bundled together into securities that can be bought and sold rather like stocks and shares. Banks do that because they do not have enough deposits to meet the demand for mortgages, so if they can sell on a mortgage to someone else, they can do more business. But now the market has frozen, for while the mortgages are probably good investments – let's come to that in a moment – no one wants to buy them.

The result is that the banks are in, if you will forgive the phrase, a state of constipation. They cannot do more mortgages because they cannot get rid of the stuff that they have already got. Result: a mortgage famine, deeper housing price falls, more instances of negative equity, a more marked slowdown in the economy and so on.

Step in Her Majesty's Government. The plan is for the Bank of England to exchange these mortgage securities, which cannot be traded, for government debt that can. The numbers are too huge for the Bank to be able to do this on its own, for we are talking £40bn minimum, maybe quite a bit more, so the Treasury has to sign off the deal.

It is not reasonable for the taxpayer to carry the liability for the banks' bad lending, if indeed some of these loans do prove to be duds. So the deal has to be engineered in such a way that the credit risk stays with the banks while the Government supplies the liquidity. We will have to see just how that will be done but it is absolutely crucial. In the case of Northern Rock the taxpayer is liable. No one wants that principle extended, not even the banks, because it would bring into question their own creditworthiness.

So is there a significant credit risk in UK mortgages, a sub-prime meltdown? Actually the risk is probably quite low, for our market is different to the US in a number of ways. One is that the terms on which loans were made have been stricter – maybe not stricter enough, but not so loopy. Another is that we have not had the explosion of new estates, homes that have never been occupied and which, in the extremes of temperature in much of the US, deteriorate fast and may have to be pulled down. Still another is that in the US it is possible for a mortgage-holder to hand back the keys of the house and walk away. Here the person is still liable for the balance of the loan even if the lender forecloses. The money might be hard to collect but there is more of a deterrent here than there.

Of course, there will be a problem if house prices decline sharply but as Ruth Lea, economist at Arbuthnot Banking Group, writes: "There is a good chance that an early 1990s-style crash will be avoided. If need be, the Bank can continue to loosen monetary policy this time, inflationary pressures permitting. In the early 1990s, when the UK was locked inside the exchange rate mechanism, interest rates could not be cut appropriately. Only when the pound was ejected from the ERM in September 1992 could rates be reduced as the economy required."

And we can indeed expect lower rates. The two graphs above show the need for them, at least as far as the housing market is concerned. As you can see on the left, two-year mortgage rates are at their highest level for eight years, with the recent decline in the Bank of England base rate having no obvious impact at all. You can see part of the reason why on the right: although the Bank has cut its rates, money market rates have failed to respond fully. It is as though we have base rates of about 5.75 per cent, not 5 per cent.

The two problems are linked but you could say that the former problem is largely one of supply/demand: a lot of demand, much of it for remortgaging, and not much supply because of the banks' balance-sheet problems that the big rescue scheme is designed to help. And the latter problem is one of lack of trust within banking, with banks not prepared to lend to each other except at very high rates. Supplying funds to the money markets through conventional methods ought to help here but there seems to me to be an argument for cutting interest rates too. The Bank can always put them up again later if it has to.

All this might seem a bit gloomy but I can think of three cheering elements. One is that at last something is being done to un-gum the mortgage market. The second is that banks (RBS now; others I expect soon) are putting their own houses in order. And third, the economy as a whole continues to grow reasonably well. Let's finish on that last point.

Last week there were some stunning employment figures. In the three months to end February the economy added 152,000 jobs. So employers still think it worthwhile to take on labour; they only do that if they can see continuing demand for the products and services.

A further source of comfort is exports. Peter Spencer, chief economic adviser at the Item Club, the independent economic forecaster, notes: "The fall in the pound against the euro has been much greater than the fall against the dollar, helping to maximise the competitiveness gains in the important European market while reducing the increase in import costs. We expect manufacturing output to rise by 1.3 per cent in 2008 and 2.5 per cent in 2009 – the first time it has risen faster than GDP growth since 1994."

What is happening is the start of an adjustment in the economy, taking resources out of home consumption and shifting them to exports. It will mean that we will feel poorer in the sense that we have to cut the rate of growth of consumption but it does not necessarily mean that there will be a large rise in unemployment. So yes, there will be a downturn, but it will be one where the pain is relatively widely spread. We will make the adjustment by squeezing real incomes, not by increasing unemployment. That may be bad for the Government, for the wider the pain, the more people there will be who feel aggrieved, but it is better for the economy and indeed for the housing market. Both will need all the help they can get.


The food crisis follows the oil crisis and arguably is yet more grave. New research by the economics team at HSBC has revealed some startling figures and disturbing conclusions. Start with some stats.

Did you know that Britain is unusual in that the cost of food is a very small part of our household spending? It accounts for just over 10 per cent of the consumer price index basket, the second lowest after Germany. In Japan, by contrast, food accounts for 22 per cent of the consumer index – but then their food producers are even more protected than European ones. In developing countries, unsurprisingly, food accounts for a huge proportion of family budgets. The numbers for India are 60 per cent, for China 33 per cent. So a rise in food prices hits the world's poor harder than it does the rich. As HSBC notes, no other issue can create social tensions as quickly as rapidly rising food prices.

Rice prices are now at levels not seen since the 1970s, and wheat prices are the highest they have been since the Second World War. Why? It is partly the result of supply problems, including the drought in Australia, difficulties in Russia and Ukraine, and reports of a potentially poor US harvest. There is also the longer-term issue that less land is being devoted to food production, particularly in China, and yields per acre have risen slowly. But the main shift has been on the demand side, where two factors have been at work.

One is that as people get richer, they choose a diet with more meat and poultry and fewer root crops. Since a lot of cereals go into animal feed, this puts pressure on overall food supplies. The other factor is biofuels. Because the global supply/demand balance is so tight, switching even small amounts of land from food to fuel pushes up the price.

The policy response has not helped. Countries can have an immediate impact on local prices by banning exports. But that has no effect on the global supply/demand equation; indeed, it may make it worse by cutting incentives for farmers to produce more.

So what is to be done? The starting rule for governments should surely be "first, do no harm". It is too huge a subject to go into here but simple economics would suggest that removing distortions and promoting freer trade in agricultural produce would bring huge benefits. Ending subsidies for turning food into fuel would be a good place to start.