With first quarter results out of Wells Fargo, JP Morgan and Citigroup this week in the US, and Barclays over here, you might be forgiven for starting to think that the financial crisis is well along the bumpy transition to the next phase, ie a global ‘real economy’ crisis. To some extent, I think we’d have to agree. We have come a long way from the week that Lehman went, when it felt like AIG would go the very next day. But we also firmly believe that the transition will not be smooth. And I would also like to point out a substantial risk that current measures are likely to meet further down the road.
Regulatory forbearance is a term that gained currency during the savings and loan crisis in the US of the 1980s and early 1990s, and a variant of it was also used during the Japanese banking crisis. It is essentially the relaxation of accounting rules and regulations applied to banks in regards to recognition of losses on bad assets. The idea is that relaxation enables banks to delay recognising losses, which in turn provides the banks with the time and flexibility to return to profitability. This enables banks to start increasing internally generated capital through retained earnings, which enables them to better cope with the latent losses they have on their balance sheets. The recent relaxation of fair value accounting methods by FASB in the US is a form of just this policy.
But this time round, I think we can coin a new phrase for the forbearance of bad assets: monetary forbearance. Interest rates across the western world are at historically low levels, and our view is that rates are likely to stay at or near zero for quite some time yet, given our deflationary outlook. Financial crises simply are hugely deflationary. The direct consequence of this is that yield curves are steep, particularly in economies where quantitative easing programs are underway, because the market’s expectation is that yields will eventually rise when the bonds are sold back to the market, and because QE should, all else equal, be inflationary. Banks borrow short term and lend long term, so with policy rates being so low and yield curves reasonably steep, they are able to post very decent profits. Wells Fargo’s results best demonstrated just this fact.
Another advantage banks gain from low rates is that loan defaults are minimised for those borrowers who have variable rate debts. So the banks get a double-whammy: an excellent net interest income portion of their income statements from low rates and the yield curve, as well as the added benefit of borrowers finding it easier to pay. That is monetary forbearance, here defined. Banks are getting the opportunity to start to earn their way out of the crisis, and low rates mean fewer loans are going bad.
But rates will not stay low forever. Indeed, for investors who believe that QE will be very inflationary, then rates will have to rise, and rise aggressively to control price increases. In the US, where the majority of the mortgage market is on fixed rates, this inflation will be a welcome development, since inflation dramatically increases the affordability of long-term fixed rate obligations. But in the UK most of our borrowings are floating or variable. When inflation returns we can expect the MPC to hike rates aggressively if needed, and this could well spell doom for UK borrowers, whose cost of borrowing will rise along with interest rates. At this point, monetary forbearance will be a warm but distant memory for UK banks, because higher rates will be directly correlated with a rise in defaults on banks’ assets. And this could be a quite brutal period for the economy and the financial institutions. Perhaps, even, a double dip in the financial crisis?
Unfortunately, it seems unlikely that this kind of outcome only comes in the event of severe inflation, and the resulting aggressive tightening of monetary policy. Disposable income is plummeting right now as jobs are being lost and bonuses are shrinking or disappearing. Enforced pay-cuts are likely to spread. Furthermore, an enormous part of the mortgage market was financed during the heady days of 2003 to 2007, which means the average size of existing loans is too large, as property was severely overvalued. This means that all the people who borrowed in this period are particularly sensitive to the size of their interest payments, and therefore particularly sensitive to rising interest rates. So, small rises in rates, along with fewer employed people and less disposable income, could have dramatic effects on people’s ability to pay their debts. This is bad for the consumer, and bad for banks.
How can we avoid this outcome, now we are engaged in QE? Well, if you want to assume an inflationary outcome to all this, the best way would be to move quickly towards the US mortgage market model of fixed interest rates. I don’t see this happening any time soon. The availability of credit at affordable terms has gone: where you could once get a mortgage for more than 100% of the value of the property,you now need around a minimum deposit of about 25%. But huge swathes of homeowners are now in negative equity, so these people are unlikely to have that kind of deposit available to them. If you instead assume that inflation is harder to regenerate, even with QE, then this solution would be a nightmare scenario because fixed rate obligations in deflation become more and more expensive to the borrower.
The outcome to all of this is so unclear as to make this mere conjecture. But it seems that, on all the cases considered above, the outcome is likely to be unpleasant for borrowers and for banks. And it is hard to see how banks’ large reported ‘accounting’ profits can be continued over the medium term.
Secondly, as we wrote in October last year and more recently this February, the credit derivatives market has long been saying that the risk of default on the UK is broadly in line with an AA rated sovereign rather than an AAA rated one. This chart (data as at the end of yesterday) shows the 5 year CDS on a range of European sovereigns, and as you can see the premium for insuring against the risk of default on Germany and France (both rated AAA) has been considerably lower than the premium for the UK for quite a while. Since the end of last year, the implied risk of default on the UK has been more in line with AA rated issuers such as Belgium, Portugal and Spain. (Note that if the credit derivative market is anything to go by, Switzerland and particularly Austria may soon find their AAA rating under threat too).
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