The Ticking Time Bomb

With all the chaos in the eurozone recently, coupled with concerns in the US about stagnated growth and stubbornly high unemployment, it is little surprise that there are knock on effects in the UK economy. These external influences coupled with a resolution for the Government to stick to ‘Plan A’ mean that various business groups are now clamouring to scale back their forecasts for GDP growth for this year and for 2012 - and who can blame them. We are certainly living in an uncertain world at present.

Unemployment certainly remains a worry. Recent figures from the Office of National Statistics revealed that unemployment has already risen to its highest level for 17 years, rising to 8.3% or 2.62m. Specifically youth and long term unemployment remain a particular concern with these figures rising dramatically. The number of 16-24 year olds out of work has reached 1.02 million (21.9%).

You may recall, from the blog I wrote in May, about my concerns for a rise in unemployment in the future. I suggested that unemployment is a lagging indicator of the economy and had yet to reflect the impact of the austerity measures - the slowdown in consumer spending and the pending cuts in the private sector. I further speculated that the private sector would be unable to fully compensate job losses in the public sector. Economists seem to agree with me. John Philpott, chief economist at the CIPD said the latest figures ‘confirms that the private sector just isn’t creating enough jobs at present to offset public sector job cuts’. Well I think this will remain true but worryingly with GDP so weak I can’t see how we can expect to see anything but depressing statistics on the job market for the next year or so at least. And with higher unemployment of course there are lower tax returns and consequently less income and this is certainly going to impact on the Chancellor’s deficit plans.

In its latest quarterly economic forecast, the CBI predicted that unemployment will continue rising next year, peaking at 2.75m in Q4 2012. Accountancy group BDO has predicted a worsening situation in the labour market with its Employment Index falling to 93.4 in October from 95.9 in September. This is the first time this year that the index has fallen below the crucial 95.0 mark, showing that hiring intentions across the board are likely to remain weak.

So what’s to be done? Well I think now is the time to be proactive. I’m in agreement with CBI and some of the ‘Plan A plus’ proposals which look at many measures but includes proposals  to target tackling youth unemployment  and investing in education and skills. We also need to think of some plans to tackle long term unemployment and give people the confidence, skills and resources to get out of this vicious cycle.

This is a good start. I don’t think we can afford to sit around with a wait and see attitude.

The Return of Equity Release

Equity Release: universally considered as the bad guy on the block in lending terms. Much maligned by critics, why has it had so much bad press over the years?

Well there are many myths attached to it, probably the most universal being the consumer risks losing his home. (According to research by Safe Home Income Plans (SHIP) some seven out of ten consumers believe that opting for equity release means you have to move out of your home.) However the simple fact is that as long as that property remains the main residence, the customer can remain in it for the duration of his life. 

More concerns follow: you won’t be able to leave an inheritance; your children will be saddled with debt; you won’t be allowed to move home and equity release is ‘unsafe’ and ‘unregulated’ etc. Yet all of these fears are pretty much unfounded if the right product and provider are chosen. Early products didn’t have the safeguards and protections that they do now. This type of lending is seen as specialist and carries risks not found in conventional mortgage lending; hence it has had its own regulatory regime for some years now.

My view is that equity release has to be a force for good if handled with care and compassion. We can’t get away from the fact that the UK population is ageing and going forward there is insufficient pension provision out there. Moreover many borrowers don’t have the capital put aside to pay off the interest only element of their conventional mortgage so there is a genuine need for this product. I can only see that demand for equity release products will grow in the next few years. Its time has finally come in my view. What is important is that the right products are in place to cope with the demand so this much maligned sector gets some positive PR at last.

As Andrea Rozario, director general of SHIP said: ‘The wealth locked up in a property…will continue to be the greatest asset most people have as they approach retirement’. So they should make the most of it.

The way out of this financial crisis: the art of deleveraging

So last week we thought the Eurozone debt deal had been done. And on the face of it, it looked like good news, or at least the stock markets seemed to think so as shares rose across the globe. Of course the devil is in the detail and I would like to see just where the extra monies to support the stability fund were coming from. And will €1trillion be enough? Also the European Banking authority has said that the European banks must raise £91bn of new capital to protect themselves against losses resulting from any future defaults by June 2012 which seems rather a tall order. There certainly is a need to push the measures through rapidly to ensure confidence is retained in the markets.

But that was last week and as we now know, things have moved on swiftly, and not for the better, with the announcement of the Greek referendum which has thrown all Eurozone bail-out plans into chaos. Leaving aside the Greek issues and whether they will or will not be able to sort out the new challenge, it is worth looking at the underlying effects on the banks and the economies of rebuilding capital. This is not just a Eurozone phenomena, it is global.

I have to say I concur with the comments Mervyn King made to the Treasury Select Committee last week. He alluded to the fact that whatever decisions were made in Brussels, this would not be a long term solution but would only ‘buy a year or possibly two years breathing space’ and the ‘underlying problems hadn’t changed at all and they won’t change’. So is this just papering over the cracks then?

As I have mentioned before, the markets have never really been entirely fixed from the original credit crisis four years ago. The world prior to August 2007 was a very different place where it was commonplace for governments, banks, companies and even consumers to over borrow which in turn stimulated economies too much. This was made possible by a too optimistic view of continuing rising economies and asset values and was encouraged by relaxations to the capital and liquidity requirements of banks. This meant that not only were they able to lend so much more for any given €1 of capital but they also needed far less by way of a return on that loan to meet their threshold return on capital. Everything was set up to “over-stimulate” the global economies and that’s exactly what happened. This led to unsustainable asset price inflation which subsequently became an impossible situation when things went wrong. And with the beauty of hindsight we can see that this was always likely to happen.

Today banks are building up capital and liquidity to more realistic levels. Mervyn King mentioned that when the QE programme started, banks had a leverage ratio of 40 to 1 and now it is 20 to 1 so they are going in the right direction. However banks have some way to go; Mr King has expressed that he would like the leverage ratio to go lower. And that’s not just within banks but corporates and government too.

There are three main ways a bank can achieve this deleveraging: issue more equity capital, retain more profits as part of Tier I capital reserves or shrink loan books through deleveraging programmes. Europe’s biggest banks have ruled out tapping the equity markets to find this money. If they are not to call on more government bail-outs then they will have to trim their balance sheets. This will be evidenced by a combination of lending less (bad news for the economy as it will slow things up even more) and actively reducing assets from their balance sheets.

Active deleverage programmes are going to become more familiar to us all and we will see increasing incidences of banks actively “re-broking” their mortgage books out and encouraging borrowers to move their accounts away. We will also see an increase in mortgage and other asset sales if I am correct.

Some banks are managing their deleveraging programmes themselves but to manage this effectively calls for a wide range of key skills including cross-selling techniques, JVs with other lenders and of course corporate finance experience. This is not something that every lender will feel it has the ability to deliver so we can expect a growth in specialist asset management businesses like Home Funding which can manage this on an outsource basis in order to meet the banks’ overall strategic objectives and financial needs. It does seem to be a very pragmatic solution and we are going to see more and more of this type of activity going forward. However there is an art to this and the key is to get the balance right.

It would seem that wholesale deleveraging could help put the markets back on an even keel and I for one welcome it.

We're All Doomed - Part 2

Hate to say I told you so… but sadly in this case, I told you so! Things are getting increasing gloomy in the economy – you only have to look at the latest ‘terrible’ unemployment figures (I did say previously that the private sector wouldn’t be able to soak up the public sector fall out – people were fooled with the lag effect from the Government first announcing austerity measures and the reality of when it kicks in), depressing manufacturing data and stagnant house prices to see that we’re not getting out of this mess any time soon. Additionally, the Euro zone crisis is hanging over us like a dark spectre.

So what are the powers that be doing about it? Well whilst acknowledging that the unemployment statistics were ‘disappointing’ David Cameron has firmly rejected criticism and said that he would stick to his plans to reduce the deficit of nearly 10%.  

So what now Mr Mainwaring? Leading economists have called for George Osborne to announce a job-creation package in his Autumn Statement next month as they are concerned that the latest £75 billion quantitative easing scheme is unlikely to transform the county’s economic prospects.  

The Chancellor will be of course reluctant to do this as the plan has delivered ‘record low interest rates’ and in altering his course may upset the ratings agencies who may then look again at Britain’s credit rating. Mr Osborne also has the added concern that public sector borrowing has increased sharply, higher than economists had expected and is therefore likely to miss his targets for cutting Britain’s deficit. But maybe that’s a gamble we should take at this stage.

It really is a fine balance. In my view I think the Government should be a little more flexible and show that it is willing to listen, be less rigid in its approach and consider other options. We need to bring back some consumer confidence fast.

Making sense of the markets

What’s happening out there I hear you cry? Well debt markets are still in a bad place. In effect they have never really been entirely fixed from the original credit crisis 4 years ago brought on by optimistic overleveraging by banks which have stimulated economies far too much and led to unsustainable asset price inflation. There was a sense that things had recovered but since July they have slipped back again. In truth, it isn’t because they have got worse, its more to do with the earlier optimism slipping away and realisation that things are still fundamentally in a bit of a pickle. They have been since August 2007 when this all kicked off.

Today we are seeing banks building up capital and liquidity to more prudent levels. Good news then. Well yes however what this does is to remove, by a geared factor, the amount of credit available in markets. No wonder economies are slowing and stopping. We have seen many analysts lower their growth forecasts for the UK but my expectation is for the UK growth to go negative.

Unfortunately while this is going on a negative feedback loop is initiated whereby slowing economies engender higher levels of defaults which eat into banks Tier I capital ratios which causes them to reserve more and so more capital is taken out the system on a geared basis and so on and so on….

I mention this as the background to the markets as I see them. Add to all of this defaults and other shocks in Eurozone and elsewhere, plus ongoing problems in the US and it all gets a lot more troubling. Markets don’t like shocks (unless you are a trader – short selling and so on – volatility is where a lot of money can be made).  So we have a nervous global financial market looking for some clarity and strong signals from leaders as to impacts on economies, markets and banks as a result of default/no default. And they aren’t tending to get it, notwithstanding the recent approval from Germany to expand the powers for the EU’s main bailout fund. We have the usual market reaction to this – large swings in market prices on the back of comparatively small amounts of news.

So impact on UK? Definitely. We are less exposed to Greece than some countries but are not immune. We have larger exposures to countries like Ireland (which seems to be doing a good job in recovering at the moment). What is the extent of the impact – impossible to say right now. The entire market has seen Greek default as a near certainty with 2 models: unplanned default or planned default.

My view is that default itself seems to be a dead cert. It looks like the Europeans are working on plan B and buying enough time with the latest bail out to move to Plan B – the planned default with banks bolstering their capital in anticipation. As I mentioned though, losses or increases in capital to meet potential losses have a multiple effect in the amount of credit and liquidity they remove from the markets. This is already happening and I suspect will get worse before it gets better.

Let Battle Commence

So the lines are drawn. In one corner sits Confederation of British Industry director general John Cridland saying that the Government would be ‘barking mad’ to push forward with plans to ring fence UK banks given current grim economic conditions. And in the other corner sits the Chancellor George Osborne and Vince Cable taking Mr Cridland to task signalling their backing for the ring fencing plan.

It will be interesting to see what comes out of the final report to be presented by the Independent Commission on Banking (ICB) on September 12. Its provisional prescription for higher capital requirements, bail in provisions and a measure of separation between retail and investment banking has certainly shaken up the banking industry.

I can see both sides of the argument and whilst I agree that the timing isn’t ideal, my view is that short term pain is needed for long term gain and these suggestions are pragmatic and necessary.

Of course there will be huge amount of costs and disruption in setting up a new system with potentially higher funding costs which could ultimately get passed on to the consumer. It’s natural for banks to recoil against any change to the way they operate. So what will it mean for the mortgage industry in terms of supply of credit and cost of funds?

Difficult to answer and as usual there are two sides to this. By separating the investment bank activity from the ‘normal’ banking you take away the cross benefit to the retail bank from investment banking activities. How so? Investment banking allows banks to run a significantly leveraged model through trading and derivative activities which require significantly less capital than lending to you or me. The profits to be made are huge and across an integrated bank these allow the bank to maintain efficient balance sheet ratios and subsidise costs of lending activities.

So without these ‘subsidies’ the costs are likely to go up for the consumer at least in the short term. But you have to look to the future.  By taking away these other profitable albeit racier activities you remove a good degree of risk to banks.

The solution is to be realistic and pace its implementation. If we take the opportunity now to make these changes, over the longer term we will be left with a more robust financial system and ultimately it will be in the taxpayer’s interest.

Life's a Riot

So we have more gloomy economic data to contend with on top of the riots and turmoil in the markets? Manufacturing data fell by 0.4% in June and Britain’s deficit in goods trade with the rest of the world widened from £8.5bn to £8.9bn in June. Not looking good and I guess it’s hardly surprising that we are starting to hear more of the words ‘double dip’ from many analysts. Oh to be in England…! Then again the rest of Europe and the US don’t look so hot either at the moment either.

With this backdrop it is hardly surprising that Mervyn King and his friends at the Bank of England have revised UK growth forecast for the year from an always optimistic 1.8% to a not so healthy 1.4%. I predicted this would happen in June and  sadly I think he may have to revise this forecast down again in the next couple of months; things don’t look to be getting better anytime soon and not only do we have to look at economic data at home but what’s happening overseas also. Surely it’s only time before the Office of Budget and Responsibility will follow suit very soon forecast down from its buoyant forecast of 1.7% for the year. 

For me, I think 1.1% for the year is more likely a figure. And that’s me being optimistic!