FYI | Sep 04 2008
By Greg Peel
Just as most central banks in the world had done between the period 2004-07, the Bank of England ticked up its cash rate following the early-century recession as the economy boomed and inflation threatened. In what can now be considered unfortunate in retrospect, the BoE’s last up-tick was in July last year when the cash rate was raised to 5.75%. At that point, by comparison, the US cash rate was 5.25% and Australia’s 6.25%. Then the credit crunch hit.
When the credit crunch first hit, the general belief was it was a US problem only, so when the US Federal Reserve started cutting its cash rate aggressively there was little response elsewhere. Later in 2007 it soon became apparent that the UK financial system was also in trouble, no more evident than in the collapse of Northern Rock. In December the BoE made its first cut to 5.50%, followed by another in February and another in April to reach 5.00%.
At the same time, the Reserve Bank of Australia stepped up its tightening policy, ultimately taking the cash rate to 7.25% in March. The impetus was Australia’s strong, Chinese-supported economy, mostly immune to a US recession, its robust banking system, mostly immune to the credit crunch, and most importantly surging inflation, brought about to a great extent by the slashed US cash rate. And there was also a matter of Australia’s cement-floored housing market.
With the benefit of hindsight, we can now question the necessity of the RBA’s last interest rate hikes. A slowing US economy was about to bring about a slowing Chinese economy, meaning a subsequent fall in commodity prices, reduced inflationary pressure, and a sharp slowing in the Australian economy that may now be out of control. The Australian banking industry has also proved far from immune to the credit crunch. House prices have begun to falter. Hindsight is a wonderful thing.
The situation in the UK, however, has become much more dire. Indeed, the world-changing event which began with over-enthusiastic home lending in Hicksville USA has now rendered the world’s fifth largest economy arguably its biggest basket case. The US economy is yet to contract, the Japanese economy has now ticked down, the German economy is struggling, the Chinese economy may slow from bubble to simply strong, but in the UK it has now been accepted as inevitable that the third quarter will bring technical recession.
The UK’s is also the first housing market outside of the US to suffer a significant fall in value. The future is not bright.
The UK’s biggest industry is oil and gas, providing it with some relief from oil price pressure (although Britain’s petrol prices are amongst the highest in the world). That industry is now looking at much lesser spoils. The industries of agriculture and manufacturing are far from what they once were in the UK and the once great coal industry is dead. High on the list of UK industries is financial services. Whether New York likes it or not, London is still the the world’s largest financial centre.
Yet while we have been following, month in, month out, the collapse of US investment banks, regional banks, hedge funds and government-sponsored lenders, the news from the UK has been comparatively scarce.
Aside from slashing the cash rate, the Fed has been dubbed in some circles as “heroic” due to its supporting move to throw open its debt-swap windows to the dark side of town, allowing investment banks to pawn their distressed mortgage debt in return for some solid US Treasury funding, thus keeping their operations running. While BoE governor Mervyn King was at first determined not to support the free market at all – he who lives by the sword etc – Northern Rock brought about a swift change of policy.
And the credit crunch in general brought about a similar move to that of the Fed’s. In April the BoE accompanied its last rate cut with a Specialty Liquidity Scheme that basically allowed UK institutions to make the same debt swaps as their US counterparts. At that point King suggested the Scheme might be accessed to the tune of some 50 billion pounds. More bearish analysts, however, projected that the figure would be closer to 100 billion by the Scheme’s closing date in October.
According to UBS, the actual figure by August may well have reached the 200 billion pound mark.
The last major syndication of UK mortgage securities occurred in June last year, The London Telegraph reports. UK lenders were reliant upon securitisation for funding, and as the credit crunch has only worsened and the UK housing market slumped, UK institutions have since had no choice but to rollover their funding needs by swapping unwanted mortgage securities for Treasuries with the BoE. But while the Scheme may have been intended to provide cover for past obligations falling due, UBS notes that it is also being used to cover future funding.
In the June quarter, UK lenders issued a record 45 billion pounds worth of new mortgage-backed bonds. But there hasn’t been a mortgage-backed deal since June. No one will buy them. They are being swapped with the BoE. UK lenders are creating mortgage securities for the express purpose of utilising the BoE’s swap arrangement.
The UK Treasury estimates UK banks currently need an average 40 billion pounds a year just to meet existing obligations, let alone to actually create any new business. The Halifax Bank of Scotland alone reportedly has 156bn of wholesale funding that comes up for renewal before June next year. Forget October, the UK Treasury estimates the shortage of mortgage finance will persist into 2010.
According to the Telegraph, UBS’ peers have suggested the analyst’s 200bn pound estimation is unlikely but plausible. If correct, it shows that the UK banking system is carrying on regardless, simply recreating the now defunct securitisation market with swapped central bank funds. The “lender of the last resort” has become the lender in all resorts. The UK banking system is being back-door nationalised.
And everyone was worried about only Fannie and Freddie.
One economist is quoted as suggesting: “If it is right, then the British banking system is relying much more heavily on state support than either Europe or the US, which suggests the banking system here is in greater trouble”.
The world has been waiting for another “shoe to drop” before the credit crunch can be called over. Economists across the globe have turned their heads to England and pondered the relative silence from clearly the most stressed economy. Perhaps we now understand.
(The BoE makes a rate decision tonight.)
