A Better Way to Deal with Mortgage Fallout
January 31, 2008
By David Miles | London
It is clear that the near-term UK economic outlook has worsened. To a significant extent this reflects the continuing fallout from the sharp turnaround in conditions in debt markets that began last August – the ‘credit crunch’. The implications of this – in terms of duration and severity – remain very unclear. That creates a set of difficult policy challenges for the government, analysed in some detail in yesterday’s Green Budget, a collaboration between the Institute for Fiscal Studies and Morgan Stanley.
One of the risks is that funding for mortgage lenders in the UK could remain very difficult for many months. There have been very few issues of mortgage-backed securities or UK covered bonds since last August. One often hears it said that these wholesale markets are effectively closed – which really means that the price (or yield) which would now be acceptable to potential buyers of debt backed by mortgages has risen so much relative to the likely return on mortgage assets that issuance is not commercially viable. There are broadly two ways to view this: either it is a return to more reasonable pricing of debt – in which case the yield on mortgages needs to rise to reflect the (now more sustainable) cost of funds; or the price (yield) at which lenders could now issue mortgage-backed securities has drifted away from what is reasonable, given an informed assessment of the risk with the underlying assets. There may be something to the second view. Fear of risks with UK mortgage-backed securities may to some extent be fuelled by an inappropriate read-across from securities backed by US sub-prime mortgages. If that is the case, there is a form of market failure, and one that could have substantial (negative) impacts on the economy. There are probably now around £200 billion of mortgage-backed securities issued by UK lenders outstanding. If we add in covered bonds we get to around £250 billion of funding. That debt rolls over fairly frequently, so that just to keep the stock constant might require £50-80 billion of issuance a year. If issuance this year were instead close to zero, and lenders looked to retail deposits to fill the gap, it would require a net rise in deposits that could be close to 10% of household income. If that were to be feasible, it is plausible that rates offered on savings will need to be high and that the cost of loans would also have to move higher. There is the potential for these effects to confirm some of the most pessimistic beliefs about the health of the mortgage market. In other words, the situation could become self-fulfilling. It is far from clear that this pessimistic scenario is likely to happen. But the government needs to think about what it could do if things played out this way. One option is to do nothing and wait, and hope, for the wholesale market to unfreeze. More proactive action could involve some form of public sector lending. This could be undertaken by the Bank of England. This would be a major extension of the action undertaken in a coordinated way with other central banks in December. But having the Bank of England undertake massive lending of this sort puts the central bank in a difficult position, because it looks more like a support operation for the banking sector than an attempt to preserve order in the money markets. And the scale of lending would potentially need to be very large – far greater than the facility announced on December 12. And if a massive extension in Bank of England lending were clearly done on behalf of the government, it could be seen to threaten Bank of England independence – which has great value in the sphere of setting interest rates. Having another agency, and not the Bank of England, undertake lending may be the better way to deal with an emergency. How might this work? An agency could either buy, or lend against the collateral of, mortgage-backed securities. Lending for a given period (perhaps initially 12 months) against the collateral of mortgage-backed securities – a repo arrangement – has the advantage that the agency could apply haircuts, i.e., set a safety margin between the amount lent and the market value of the collateral. The repo route has many advantages: it reflects the temporary nature of the assistance; it means the agency does not need to take a view on the right price to pay to own securities; and it means the agency can have conservative lending criteria without forcing institutions to do outright selling at ‘fire-sale’ prices. It is far from clear whether such a large-scale repo facility is really warranted. And it needs much more careful analysis of current pricing of mortgage-backed securities to decide whether it reflects a well functioning market (albeit with low transactions) or something closer to panic. But is has to be worth considering these issues right now.
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Corporate Europe Blind?
January 31, 2008
By Carlos Caceres and Eric Chaney | London
January business surveys (Ifo, Insee, Isae, etc.) conveyed a clear message: euro area ‘real’ economies are resilient and not (yet) hit by the financial turmoil. This does not imply that the region is recession-prone, but simply that, for the time being, the ‘recoupling’ thesis (namely that a US downturn would drag the rest of the world into recession) is not endorsed by company managers, who trust their still hefty order books. Yet, there are two important caveats. First, January surveys were completed before the stock market correction. Second, companies seem to turn over-confident about the future, as if demand was Teflon-like and insensitive to financial market conditions. For these reasons, we tend to believe that the surprising optimism expressed by business surveys might prove short-lived. Current production easing progressively
Current production fell 0.2 standard deviations (sd) this month, and is now 0.5 sd above its long-term average. In fact, output fell in all the reporting countries but Germany, which caused the surprise Ifo index rise. Production seems to have peaked about a year ago at 1.4 sd and has slipped since then. Extrapolating the current trend, we fear that production might not be able to match companies’ upbeat production plans. Demand stable, but mind early signs of slowdown
Demand has been recording a very robust performance in the recent past, hovering above 1 sd for almost two years. It was practically unchanged in January, at 1.1. Despite this relative stability, we note a slight downward trend in demand, which started in April 2007, when it peaked at 1.6 sd. This pattern is even clearer in Germany. This matters because German companies have led the way in the euro area since 2006. Since Germany is more sensitive than other continental economies to global demand gyrations, this might be an early sign of a slowdown in global trade, as the freefall of the Baltic Dry Index (an exchange-based measure of freight rates) seems to reveal. Output plans: Companies seem excessively confident
Production plans for the next three months, a key indicator in our models because it synthesises all the information company managers have access to, recorded a significant jump, from 0.6 to 0.8. The intention to boost production in the coming months suggests that company managers themselves are surprised by the resilience of demand. It also shows that they are not impressed by the gloomy news flow coming from the other side of the Atlantic. Again, we fear that this optimism might prove excessive and that manufacturers might be caught off-guard by weaker demand in the months ahead. Our Compass models are still signaling trend growth
The fall in current production pushed our Surprise Gap down from 0.1 to -0.1, still at a safe distance from the deceleration line (-0.26). For the third month in a row, our Compass camped within the ‘Grey Zone’, after it briefly signaled a ‘risk of recession’ in October. Looking forward, the Surprise Gap could turn more negative if, as we think, production plans prove too optimistic. Our Manufacturing Production indicator is now predicting a robust growth rate in the current quarter, above 0.8%Q, compared to 0.4%Q last month. We take this upbeat prediction with a large pinch of salt, since it is at this stage mostly based on production plans. Finally, the same indicator is pointing towards slower growth in 2Q08 (0.2%Q), a milder correction than implied by last month’s surveys. Our GDP Indicator is more optimistic than our forecasts
The sentiment gap between the lately tumultuous financial sector and the relatively optimistic non-financial corporate sector is confirmed. Our Early GDP Indicator, which depends on the trends in production and demand and past construction orders, is now predicting growth at 0.5%Q (2.2% annualised) in 1Q08, up from 0.4%Q in December. It continues to predict a soft deceleration in the next quarter, with GDP growth at 0.3%Q (1.4% annualised). In this regard, this survey-based model is more optimistic than our GDP growth forecast, which anticipates a ‘soft patch’ with growth tumbling to 1.0% (annualised) in 2Q and 3Q. Overall, we believe that, although business surveys are supporting the ‘orderly slowdown’ path that we have been advocating since last summer (see Towards an Orderly Slowdown, July 27, 2007), downside risks are increasing, especially if companies do not anticipate correctly the consequences of the financial turmoil. The macroeconomic headwinds are strengthening
The good news from the financial markets is the normalisation of money markets, with the 3M Libor spread vis-à-vis the ECB’s refinancing rate now below 30bp. Yet, the de facto tightening implied by the 70bp average spread recorded since early August 2008 will continue to have an impact on companies. In addition, the large-scale losses registered by some commercial banks, compounded with the stock market correction, are likely to shift the credit supply curve further into restrictive lending, thus hitting corporate and household investments. On balance, we think that risks are skewed to the downside, and that corporate Europe might have a painful wake-up call in the next few months. Monetary policy to remain on hold for a while
Seen through the ECB’s council members’ glasses, the news is clearly supportive of the hawkish camp and vindicates the views expressed by President Trichet during his annual meeting with national parliaments. With the economy seemingly running at trend speed and inflation one full point above the ECB’s ceiling, the Council’s tightening bias might prove more resilient than markets are willing to admit. Deterioration in business conditions would probably shift the balance within the Council, but this has still to come.
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