What now for the Brics?

Of all the recent economic statistics to come out, the numbers that concern me most are those coming out of a recent report from HSBC which suggests that growth is slowing in the four big Bric countries - Brazil, Russia, India and China. These have been some of the fastest growing economies of the past ten years, and have been largely responsible for keeping the global economy moving forward. Yet now they are facing a sustained slowdown which has largely been blamed on the euro crisis and deterioration in the US economy.

Let’s look at these two issues. Well sadly I predict that the euro crisis is set to run for some time. Even Sir Mervyn King seems despondent accusing EU leaders of failing to tackle the fundamental causes of the crisis and adopting a policy of ‘kicking a can down the road’. He suggests that ‘there is a great black cloud of uncertainty hanging over businesses’ and until they know how things are going to pan out, ‘they are holding back from investment and spending’. His comments seem to make sense albeit will do very little to instil confidence in the UK.

I think economic data from the US is a little more encouraging, after all statistics suggest that the US trade deficit narrowed in May with exports to Europe rising. Yet analysts have warned this may not last suggesting it is ‘unlikely to be sustained in the coming months’. I am however encouraged that the Federal Reserve will act to provide further stimulus if things get worse although I can’t see a rapid return to growth in the US.

So going back to the Brics. Of all the emerging economies, China in particular has responded rapidly to a slowdown with its government easing the curbs it imposed back in 2010 which at the time were brought in to cool an overheating economy and curb inflation. Beijing has cut interest rates twice since the start of June and announced various additional stimulus measures. These measures initially appeared to do some good but with external influences affecting demand for China’s commodities, forecasters have now put back prospects of a rebound until at the earliest later this year.  

I fear we will have to wait some time until the world’s second largest economy, along with other Brazil, Russia and India, once again drive global markets.

LIBOR and Barclays - the real world

If you look at the British Bankers Association website you will see that each contributing bank to the LIBOR rate setting has to answer the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

So BBA LIBOR is not necessarily based on actual transactions. This is an important point.

It seems to me that the latest scandal to hit the markets is little understood by most of the vociferous market spokesmen and commentators.

I am not condoning wrongdoing that Barclays have owned up to but we do need to get this in perspective. First of all LIBOR is not some mathematically computed number which is always accurate to within fractions of a basis point. It is a number derived by dealers in prime banks talking to each other having observed the yield curve and the latest supply and demand for money in the markets and for them at that moment. It is a matter of opinion.  

Even if Barclays were a sole outlier in the LIBOR rate setting, the effect would have been eradicated. Every BBA LIBOR rate is calculated using a trimmed arithmetic mean of all rates submitted to them. Once all rates are received the rates are then ranked in descending order and the highest and lowest 25% of submissions are excluded - this is the trimming process. 

Looking at the second of the two breaches by Barclays; that they rigged the LIBOR rates between September 2007 and May 2009 by making LIBOR submissions which took into account concerns over the negative media perception of Barclays’ LIBOR submissions.

In other words they were looking to mask any Barclays’ specific problems.

Well I well remember this time vividly and as someone who has operated in the sterling money markets since the 1970’s I can assure you that what was happening at that time was far from normal. We were seeing major banks worldwide finding difficulty with raising money in the markets to cover their liquidity positions. The first major warning sign of the credit crisis that I observed was a movement in 6 month LIBOR in excess of 65 basis points above Bank Rate and with no yield curve cause. In other words it wasn’t that banks thought that rates would rise, it was simply that banks were struggling to fund themselves and would pay “whatever it cost” to cover funding positions. Very scary! There were rumours abounding about ‘major banks being in difficulties’. In this market it must have been tricky for any bank to fix a normal LIBOR setting for the BBA. To signal that your bank had a worse position that others and therefore had a problem must have been a real cause for concern.

I could quite understand in fact why it may have been prudent to agree with the Bank of England that a ‘normalised’ LIBOR rate should have been quoted and to take out the peaks and troughs of a far from normal market. But this does not appear to have been the case based on Bob Diamond’s evidence yesterday. Let’s see what Paul Tucker has to say. I’m not trying to make excuses for others and certainly have no axe to grind with Barclays but in relation to the LIBOR fixings in extreme markets maybe we need to reflect on just what was happening in a very hostile real world.

Just as an afterthought however, Bob Diamond’s letter to Andrew Tyrie ahead of the meeting said “The interventions in question were typically on the short term one and three month rates relevant to the wholesale markets and not the longer term rates used to set, for example, retail mortgages.” What planet has Bob Diamond been on? Mortgage rates are set relevant to short dated LIBOR rates such as 1 month and 3 month and not 6 or 12 months.

Sorry but this just doesn’t add up! Get a grip Mr Diamond.

How Central Banks should work

I was heartened to hear Deputy Governor of the Bank of England, Paul Tucker’s words last week hinting that there needs to be a shift in approach as to how the British authorities deal with the lack of affordable credit being made available to British companies and households. Mr Tucker went so far as to say that recent regulation could be proving counter-productive and that banks should be ready to draw on their liquidity buffers rather than hoarding cash.

And then we had the George Osborne/Sir Mervyn King announcements of making funding and liquidity available to the banking sector last Thursday night.

This is a very significant change in policy for the Bank of England and should be noted.

It has been interesting to see how Central Banks have focussed their efforts in a continuing and volatile market situation: in the US the Federal Reserve Bank has extended its ‘Operation Twist’ – a scheme to lower long-term interest rates, which had initially been due to end this month.

It also confirmed its intention to keep short-term borrowing costs at ‘exceptionally low levels’ amid concerns over the US jobs market but they have stopped short of unleashing a third wave of money-printing, or QE3. They have also been active in purchasing debt instruments to ensure a strong supply of credit to the markets.

But the Bank of England has been more conservative and until now at least have eschewed the traditional role of the Central Bank which is to be a lender of last resort, particularly in times of financial distress. The widely accepted critical role of a Central Bank was defined by Walter Bagehot - a 19th century English intellectual who summarised the lender of last resort function with the dictum “lend freely at a high rate, on good collateral.” This has been an anathema to the Bank of England until now where the view has been that it is not to the role of the Bank of England to support the banks – that way leads to moral hazard and encourages loose lending and liquidity practices with the knowledge that the Bank of England will be there to pick up the pieces if it goes wrong.

But all that now appears to have changed.

With the broad supply of money contracting (cash and money in bank accounts), the money multiplier is no longer functioning. Add to that the tendency for banks to hoard cash and rebuild capital reserves and it’s no wonder that the economy has been grinding to a halt amid fears of another credit crunch. Add to this the Eurozone worries and it has been enough to create a major policy change for the Bank of England.

Thus far the Bank of England has been reluctant to take a revised course of action directly to ease banks’ funding costs, preferring to use their quantitative easing (QE) programme to improve liquidity. However it is apparent that banks have not using the facility as intended, choosing to stockpile the money in safe assets and deposits with the Bank of England rather than inject the money into the economy as intended.

It was time for a radical rethink and I’m pleased for the change in stance. Now is not the time for an excess of caution. The markets may be the best capitalised and have superb liquidity positions but if we are not careful the markets and economy will stagnate.

Now is the time for the Bank of England to act like a traditional Central Bank and be prepared to lend against good collateral. I’m delighted that it is doing so now even though it’s taken an awfully long time to get here.

The World as One

Over the last few days Barack Obama has joined the fray on the great eurozone debate and agreed with David Cameron that an ‘immediate plan’ was needed to stabilise the single currency and restore market confidence. He has spoken to Angela Merkel and Italian Prime Minister Mario Monti on the need to strengthen the eurozone. Some may say what business is it of his. I say good for him.

This is despite the regular ‘Beige Book’ survey of the US economy showing a rise in growth over the past two months. For those who wonder what the Beige Book is, it’s a survey that canvasses opinion from business across the US for the Federal Reserve eight times a year and is hugely important to the central bank in helping them set their monetary policy.

Some could argue that the US has limited exposure from fallout of the eurozone crisis. In fact David Cameron has reported that the British economy is six times more exposed to the eurozone than the US economy. True but then again the US isn’t completely untouched by what happens in Europe as there is a huge risk of contagion to key oversees American markets and a euro break up could have a devastating effect on the US exposure to trade with emerging markets, in particular China. So they are right to be concerned. Warren Buffet, billionaire investor and respected commentator has acknowledged that the chance of the US slipping back into recession are ‘very low’ unless the eurozone crisis escalates further with ‘events in Europe developing in some way that spills over here big time’.

So world leaders have a right to have their say. We must be prepared to accept that the global economy has changed significantly and they all have a part to play in helping to stabilise world markets. Individual states cannot afford to operate as a silo unit. 

Nor would we want them to…

Battening down the hatches - what a Greek exit would mean for the UK mortgage market

At the beginning of the year, I wrote a blog predicting a Greek departure from the euro. I suggested that this was the inevitable scenario given that Greece has debt at 144 per cent of GDP and its economy was and is in a downward spiral of contraction and austerity. Well, now most analysts have come out of the woodwork and seem to agree with my view.

In my posting, I also suggested that although Greece would take a massive hit, optimistically its departure could be manageable if the markets were convinced that no other countries would follow, particularly vulnerable countries such as Spain and Italy. I said that it would need international officials to put a firewall around Greece to avoid the markets getting spooked. Of course all this holds true today although thus far I’m not sure if European officials are doing enough to reassure the markets as witnessed last week. Confusion reigns supreme with Angela Merkel and President Hollande saying that they want to keep Greece in the euro but Christine Lagarde, head of the International Monetary Fund raising the possibility of orchestrating an ‘orderly exit’ for Greece from the eurozone.

So there you have it, although I still predict a Greek exit sooner rather than later, I guess much hangs on how the Greek elections in June turn out.

So what would a return to the drachma mean and how would the UK, in particular the housing market, be affected? It all comes back to my earlier point and how the exit is handled. Worst case scenario it will be complete chaos. In the words of Charles Dallara, the International Institute of Finance chief,  the damage to the rest of Europe from a Greek exit would be ‘somewhere between catastrophic and Armageddon’. Therefore potentially a complete temporary collapse of the banking system although from a UK perspective, Mervyn King, Governor of the Bank of England has suggested that contingency plans are in place were this to happen after warning that the eurozone was showing signs of ‘tearing itself apart’.

Even in the best case scenario, the UK would inevitably be affected by this scenario. Already there are signs that investors are spooked as customers withdrew their monies from Santander UK in the wake of the downgrading of the bank’s credit rating. And we should expect more of this jittery behaviour.

On a national level, certainly economic growth would collapse as our export market would nose dive bearing in mind half our market is in the eurozone. Plus our goods would be that much more expensive to buy as our currency increases in value being perceived as a (relatively) safe haven.

As for the mortgage market, I foresee banks resorting to behaviour last seen at the outset of the Credit Crisis, storing up capital and abandoning aspirations of market share. This is evident already to some extent and with more stringent regulation on the horizon, in the form of Basle III which will have a wide ranging impact on bank’s capital holdings, this behaviour is set to continue.  With total disruption to banking capital markets, it will prove harder for banks to raise new debt and significantly more expensive. So the cost of funding would inevitably rocket and homeowners would be hit by increases in mortgage rates. Banks would be keen to pass on costs to the consumer so upward pricing of mortgages would persist. On top of this mortgage availability would dry up and the possibility of obtaining credit would dwindle. This will inevitably have a knock-on effect to house prices which will fall significantly as consumer confidence is dented further. The exception to this would be the London market where luxury houses in particular will rise exponentially. Already Savills reports that homes costing more than £1.5m jumped by 39% in April as investors from Greece and Spain in particular seek a safe haven for their monies.

All in all, not a rosy picture then. But going full circle, back to my blog again, it all comes down to how orderly our plans are to resolve the situation. Because resolve it we must before we, and our EU partners, can move forward. 

The Chinese Way

What a contrast. Let’s stop for a moment and look at how the UK is dealing with an economic downturn as opposed to China and we will see that we are literally worlds apart.

Just to recap. The UK has gone into a technical recession with GDP shrinking by 0.2% in the first quarter of 2012. Deleveraging is the order of the day. Banks are looking to shore up their capital in light of new regulation which is starting to kick in. Plus they have MMR shadowing them and the impending restrictions on capital requirements resulting from Basle III requiring banks to increase levels of highest quality capital to 7% by 2019.

And Mervyn King is putting in his two pennies worth stating that banks haven’t gone nearly far enough and need to improve their ratios considerably from 20:1. So the resulting impact is that banks are choosing to lend less, both to businesses and consumers. Lloyds Banking Group announced recently that it is planning to cut its share of the UK mortgage market from 28% to 25% and no doubt other lenders will follow. Inevitably credit will dry up or only be available to the less risky elements of society and will be risk priced accordingly.

Sadly of course this will have a knock on impact to the economy with mortgage lending faltering and a subsequent knock on effect to house prices. Thus potentially dampening the economy still further. But let’s wait and see.

And what of China? Well China’s manufacturing activity seems to have turned a corner expanding for the fifth month in a row, easing concerns about a sharp slowdown. The worries about a global slowdown and its impact on China’s economy had seen the country take steps to ease monetary policy in order to boost growth. China’s central bank has cut the amount of money banks need to hold in reserves twice in the past few months to try and stimulate lending in the country. The move saw Chinese banks extend new loans in March, much more than forecast. Analysts said the increased availability of credit had started to have a positive impact on the economy. And subsequently, China’s economy is likely to grow at an annual rate of 8.5% in the second quarter, up from 8.1% in the first three months of the year. So good news for the Chinese.

Of course we have to put in some caveats. The UK economy is vastly different to that of China with different concerns and pressure points. The government, Bank of England and FSA are hugely worried that unless we take these measures we are vastly exposed to a potential second banking crisis. I take on board these points. Still, maybe, just maybe, there are some lessons to be learnt from the Chinese approach?   

And the watchword for today is….

In addition to the various debates around the implementation of MMR, the dissipation of interest only loans and the merits of NewBuy schemes, there lurks a sinister spectre which in itself could have more impact on the mortgage world than anything else at present.

It’s been there for a while. In fact the original version (Basle I) may have very well driven the start of the credit crunch. This spectre is none other than Basle III and its implementation.

What does this mean? Well, a whole range of things and I would be happy to take anyone through them in more detail. In fact I’m in the process of drafting an essay around the whole subject matter which I hope to publish shortly. However for the sake of this blog I’ll keep it brief. In a nutshell, banks will be required to hold considerably more capital and liquidity than they have previously.

Some are already addressing this through de-leveraging. Those of you who have read my previous articles and blogs will have seen me mention this before. Perhaps I was getting ahead of myself but it is certainly something that banks are picking up with a huge amount of fervour today in their bid to aggressively dump assets and cut back on lending.

On Wednesday the IMF forecast that a drastic contraction of European balance sheets during the next 18 months could jeopardise financial stability and economic growth in Europe and beyond. In its Global Financial Stability Report, the IMF warned that European banks looked set to shrink their balance sheets by $2.6 trillion (€2 trillion) over that period. It is suggested that a quarter of deleveraging will come from reductions in lending, alongside sales of securities and assets as banks try to shore up their finances.

The most worrying aspects of this activity are, of course, how it will affect the economy. There is a danger that this could go into an uncontrollable tailspin, threatening to drive Europe into a new vicious cycle in which business and households are deprived of credit. This will, in turn, depress the economy leading to more strains within the banking system. The International Monetary Fund has already said that credit supply in the euro area could shrink by 1.7% as European banks dump almost 7% of their assets by the end of 2013.

So restricting credit lines could have a significant impact on the economy – in particular house prices where borrowers, primarily first time buyers even with NewBuy, have limited access to monies.

But almost bizarrely on top of this, you have the euro area and the City of London calling on banks to maintain the flow of lending to the economy on top of raising capital ratios.

So what’s a bank to do?

Well it certainly has to comply with Basle III and that means taking action. Deleveraging is certainly the watchword but how to do it profitably and without alienating your customer base is a fine art – one that some practise well, for example Bob Young at Capital Home Loans, but others may need a little help with.

At yesterday’s HSBC Great Housing Market Debate 2012 the mood was fairly sanguine about the prospects for recovery and house price rises. I’m not so optimistic given the global liquidity issues. I think we are getting ahead of ourselves a little. One thing’s for sure though, be prepared to see that term deleveraging around for some time to come.