Uncharted Territory

November 26, 2008

The Purpose of Profits (Part 1)

Filed under: Credit crisis, Economics, Housing market, Markets — Tim Joslin @ 7:56 pm

An editorial in today’s Guardian is so incoherent that I find myself reluctantly putting down the analysis-free report to the Chancellor by the Rights Issue Review Group.  I’ll write about that later.

The editorial starts reasonably well:

“This financial crisis began with housing, and any hope of its ending must lie with housing. That does not just mean house prices finding some kind of bottom, but also would-be homeowners being able to get fairly priced mortgages, and securing a more stable supply of new homes.”  [my emphasis]

At this point the leader-writer obviously went out, got drunk, and returned to the office 5 minutes before the deadline to file the piece.  Apparently, it’s a problem that:

“…last year’s net total of £108bn of new home loans has shrunk to around £40bn this year and could fall below zero next year.”

Huh?  Surely anything else would imply that we were taking on more mortgage debt, when in fact we need to pay some down.  The world has decided that UK plc (among others) has reached its credit limit.  Government thinking also implies an increase in mortgage debt:

“The Crosby report [commissioned by Alistair Darling] suggests that the government should auction its services as a guarantor to banks seeking to tap into financial markets. In return, the government must require that the funds go into new mortgages.”

This makes absolutely no sense.  For starters, the banks are struggling to roll over the money-market borrowing they have already taken out to support mortgage-lending.

It’s also rather dangerous to think that we can put off the evil day when the UK can borrow no more by (in effect) replacing private loans with government loans.  The government can only borrow more cheaply than you or I because they can raise taxes.  If UK consumers can’t pay their individual debts, then it might turn out they can’t afford to pay more taxes either.  Or at least the market might start to think this, and start charging more to lend to the UK government.  There’s a limit to how much the government can (in effect) commit to future tax increases.  Especially as the people who can afford to pay more tax might all decide to emigrate to Australia.

The Guardian’s leader-writer, and perhaps the government, have characterised the problem completely incorrectly.  The problem is not that house-prices are falling rapidly and as a nation we are having to reduce our borrowing.  This is merely a result of the real problem.  Which is that house prices have risen too high and we have taken on too much debt.

Here’s a novel idea: why don’t we simply assume in the first instance that banks will be able to undertake new mortgage lending at a rate equivalent to that at which existing mortgages are being paid off, less losses due to defaults, plus profits due to the differential between the interest rates at which they borrow and lend?

Let’s go back to basics.  The purpose of profits is to act as a signal as to where insufficient investment is being made in the economy.  Let’s say company A reports that it is making a lot of money either lending to homebuyers or building houses, just as a couple of relevant for instances.  Company B may well see company A bragging about this in the boozer and quietly decide to try to obtain some of these profits for itself.  Company B will also start lending to homebuyers or building houses.  Even in the absence of company B or C or D, company A will likely plough more money into these profitable activities, by reinvesting profits rather than paying them out in dividends.

When evaluating government policy, it’s always worth asking oneself whether it would be better for government to do the precise opposite of what is proposed.  There’s my vote of confidence, Mr Darling!

So, if we want the banks to boost or maintain the amount of lending (note I’m not saying “mortgage-lending” – more about this later) in a downturn – which isn’t a bad policy – is it wise to also demand that banks reduce their lending interest rates?

Earlier this month the government insisted banks “pass on” the 1.5% cut in base rates in their SVR for mortgage borrowers.  They may well make the same insistence in December. This will reduce bank profits.  Is this likely to encourage new or existing banks to invest more in the UK mortgage market?  No, because, as we’ve seen, profits have a purpose.  Is it likely to encourage people to lend money to mortgage banks and free up the money markets?  No, because the problem is that lenders are worried that more banks will fail.  They will fail if the profits on their good loans are exceeded by the losses on their bad loans.

“Aha!” I hear you shout, “that’s the point, reducing mortgage rates will reduce defaults on bad loans.”  Really?  Surely interest rates are already so low that the vast majority of mortgage defaults going forward into 2009 and 2010 will be because of unemployment or other losses of income by mortgage-holders.  Remember, we’re in the UK, and you can’t just send back your keys because your house is worth less than the mortgage.  We’re not in the 1990s when interest rates were rising rapidly.

Banks should simply be left to manage their own businesses.  Instead, the Guardian’s leader-writer suggests that:

“… matters have not been helped by the government’s arm’s-length management of the part-nationalised banks, when what is needed is much more hands-on direction of lending.”

Interesting.  Are we to suppose that Alistair Darling has a highly trained army of civil-servants able to replace tens of thousands of the banks’ staff and make sensible lending decisions?  If I’m correct, and of course I’m sure I am, banks will lend more, the more profit they think they will make by doing so.  And people will lend to UK banks in the money-markets if they think UK banks are going to be profitable.  Goodbye recession!  I suspect that, like me, you are starting to wonder what lending criteria will be employed by Darling’s army of civil-servants.

Furthermore, what exactly is our priority?  As a nation we’re maxed out on borrowing.  That’s a key reason why our banks can’t borrow in the money-markets.  Should we really be taking on even more mortgage debt, as the Guardian suggests?  Wouldn’t it be better to make lending to business a priority so that fewer people lose their jobs – the main cause of mortgage default?

It turns out it’s a myth that banks have reduced lending to small businesses.  What I suspect may be happening is that lending facilities are being cut back.  The point is that banks have granted businesses borrowing limits (or at least many businesses leave working capital on deposit).  But the banks have insufficient cash for every business to be up to their limit at the same time.  These limits were set in the boom years, when only a proportion of businesses needed to make full use of their borrowing facilities at any one time.  As we go into recession, most businesses are seeing their sales drop and are borrowing money by drawing on their existing facilities.  But these borrowing facilities add up to more money than is available.  And you can’t get a quart into a pint pot.

Back to the housing market.  New buyers are only going to enter the market when they see the possibility of a profit, or at least (since people need houses to live in) the likelihood of not losing a large amount of money.  The sooner the market bottoms out, therefore, the better.  It is not therefore a given, as the Guardian writes, that:

“The short-term priority must be to allow the property bubble to deflate in as orderly a fashion as possible so as not to send further shocks through an already traumatised economy.”

This appears to be government policy.  But it will only lengthen the slump in activity in the housing market and therefore the recession.  If we want the recession to be V-shaped, then I suggest it’s a mistake to try to slow the fall in house-prices.  The correct policy is to let house-prices drop, paying down mortgage debt and freeing up capital to invest in the economy by lending to businesses.  Keeping as many people as possible in work is a much better way to avoid mortgage defaults.

As is all too often the case, a government policy to please the voters – in this case by trying to maintain house prices at what is still a very high level, relative to incomes – is likely to be counterproductive.  The correct policy is probably the exact opposite of what the government is doing.  As usual.

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1 Comment »

  1. […] printed off the Introduction (actually a Summary) to his report, I am even more astonished than before that Sir James Crosby (a mortgage-banker, of course!) thinks we can or should actually increase net […]

    Pingback by Clarifying Deleveraging, or, Saving the Economy « Uncharted Territory — November 27, 2008 @ 9:59 pm


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