Monetary Forbearance, and the threat of a double dip financial crisis

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.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Categorised as: macro and politics

Discuss Article

  1. Jake Foreman says:

    Thank you for this informative blog. I am a little confused about HMG's QE program and your suggested actual steepening yield curve. Of course, I too believe that QE must be inflationary in the medium term and do not trust enough political and BOE MPC courage will be found when the time comes to sell those gilts – and perhaps even more- back again. But you are suggesting that this view is doing the opposite of what surely the Bank wants with QE, which is flattening, because investors are acting immediately according to the expected next stage 2? Would it then not be easier to announce the opposite of what is intended: announce Quantitative Tightening and then see gilts fall and yields rise and internal banks capital regeneration increase? Then again, the BOE's- and Treasury's- aims seems to be contradictory: do they  want lower long-term rates to ease overstretched debtors or stronger banks and steepening yield curves?

    Posted on: 18/04/09 | 12:00 am
  2. Chris Ramsden says:

    Thanks for the information on this brilliant blog. This is my first comment but as you can see I am trusting you with part of my pension fund so please take care of it:)

    On the subject matter the BOE currently has an inflation target of 1-3%. this is at a time when currentish indices are RPI (which includes housing) at less than 0% and CPI at greater than 3%. Hence two ways of measuring the same thing span the target range!!!. In addition BOE uses CPI for a target but IL gilts track RPI!! This is like flying a plane with two definitions of horizontal.

    It seems to me that inflation has a number of independent components that should be independently targeted.

    – House price (asset bubble) inflation: Extremely dangerous. Always enjoyed and ignored until the roof caves in.

    – Wage/ price inflation. Watched extremely carefully like generals refighting the 1970s wars. Leads to BOE keeping interest rates too high for too long when price rises occur (even if wages don’t rise) (eg early 2008)

    – Commodity inflation. Not much BOE can do about this. However it leads to above as prices rise without wages.

    – Import price reduction. (eg Chinese goods early 2000s) Compensates for dangerous inflation and leads to BOE holding interest rates too low for too long (early 2000s)

    Wouldn’t it be better to target these different and contrary components independently

    Also, many commentators talk of deflation being always a problem. Well the reduction in fuel prices seems to me an undeniable good thing (since we have now used up most of the oil). I have never known anyone deciding to defer the purchase of significant quantities of petrol (or food) until tomorrow because the price might drop!! Some things have to be bought today.

    I would be interested in your comments. the quality of this site is one of the reasons I invest in your funds.

    Keep up the good work.

    Posted on: 12/05/09 | 12:00 am
  3. Ben Lord says:

    Defining 'inflation' and deciding what to target is a controversial topic. It's quite possible/likely that central banks aren't doing it correctly right now, and the implications of this are that interest rates are set at the wrong level. (It's worth bearing in mind that central banks haven't been inflation targeting for very long – in the 1980s it was all about targeting the money supply, and this didn't work very well). Central banks do ask themselves these questions too though.

    (as an aside, it's not that obvious when you're in a bubble until it's popped – central bankers have very little info on top of what the market has)

    You're absolutely right about 'good' inflation/deflation and 'bad' inflation/deflation. If deflation is due to energy and food prices falling then it's good. Likewise, if deflation is due to increases in productivity (eg US economy in late 19th century) then that's very good. But if deflation is due to consumers reining in spending because they're too indebted, or technically insolvent, then that's bad because deflation increases the real value of debt and makes things worse. And if these consumers observe falling prices and then delay spending (it does happen – I delayed buying a laptop for almost 5 years), then it's very bad as a vicious downward economic spiral can develop.

    As for targeting different measures of inflation, it's nice in theory but less easy in practice The overall level of inflation takes account of things like wages, the price of manufacturing and (in this country) food and energy prices so they all contribute to the overall inflation level. And they can contribute in different ways – in the last few years we've had a house price bubble, so interest rates should probably have been higher. But then wage growth was almost non existent in most of the developed world, which means rates should have been lower. (I did a blog on impact of wages on inflation last year here

    Posted on: 12/05/09 | 12:00 am
  4. Mike Riddell says:

    Defining 'inflation' and deciding what to target is a controversial topic.  If central banks aren't doing either correctly right now, then the implication is that interest rates may be set at the wrong level.  Central banks do ask themselves these questions too though.

    You're absolutely right about 'good' inflation/deflation and 'bad' inflation/deflation.  If deflation is due to energy and food prices falling then it's good. Likewise, if deflation is due to increases in productivity (eg US economy in late 19th century) then that's very good.  But if deflation is due to consumers reining in spending because they're too indebted, then that's bad because deflation increases the real value of debt and makes things worse.  And if these consumers observe falling prices and then delay spending, then it's very bad because a vicious downward economic spiral can develop. 

    As for targeting different measures of inflation, it's nice in theory but less easy in practice  The overall level of inflation takes account of things like wages, the price of manufacturing and (in this country) food and energy prices so they all contribute to the overall inflation level.  The different components can move in opposite directions, so targeting individual components doesn't really work.  And it makes things even harder if you want to start targeting asset price bubbles (which is very hard since it's difficult to identify a bubble until it's popped).  Even if policy makers could easily identify bubbles, it doesn't necessarily solve the problem of where rates should be.  We had a house price bubble up until H2 2007, so interest rates should probably have been higher than they were. But then wage growth has almost non existent in most of the developed world this decade, which means rates should have been lower.   (I did a blog on impact of wages on inflation last year here

    All that said, in practice, central banks do try to balance up the different components.  They typically take a 2-3 year view, so if they thought there was a big risk of a house price crash and a great recession one year in the future, you'd think that they'd not hike rates when perhaps the data at that point in time suggested that they should. You can see evidence of this in the UK – in the first half of 2007,UK interest rates did rise 3 times as the economy was booming, but they didn't continue increasing rates when UK inflation shot above the 3% upper limit for CPI in 2008.  When inflation was at its peak in H2 2008, they were actually cutting rates. 

    Posted on: 08/06/09 | 12:00 am

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