13 October 2008

Economic Myopia

Just when I thought the government couldn't find any more ways of fouling up the banking system, they go and prove me wrong. As part of the plan to bail out RBS and Lloyds TSB/HBOS, the government has announced that it has made these banks commit to:

"maintaining, over the next three years, the availability and active marketing of competitively-priced lending to homeowners and to small businesses at 2007 levels."

The wisdom of maintaining high levels of lending to small businesses is debatable. The wisdom of maintaining high mortgage lending isn't; it's just plain stupid.

The reason mortgage lending has dried up is that house prices have increased far faster than income levels, driven by cheap credit and they are now unaffordably high, causing mortgage defaults to rise. House prices are falling as part of a natural correction. Trying to force people to take on more debt in order to keep a debt driven house price bubble growing, when people are struggling to service the existing debt, is clearly going to create bigger problems. It's a bit like trying to keep a pyramid scheme going by pushing more people into it; it might work in the short term, but eventually it will crash and the longer it takes to happen, the worse the crash will be.

By adding in the requirement that mortgages should be "competitively-priced," the government has made it even worse. One of the reasons that the banking crisis has been so bad is that mortgages were priced far too cheaply. Many banks foolishly assumed that house prices and income levels would continue to grow smoothly and constantly and perceived the credit risks associated with mortgage lending to be almost non-existent. This pushed lending margins down and left banks horribly exposed to increased defaults and reductions in house prices. These government funded banks need to ensure that their mortgages are realistically priced for risk before they even consider competing against other banks, which might be setting their interest rates too low to cover the risks they are taking.

In reality, I expect the opposite will occur and the government backed banks will price much lower than the fully private sector banks, which I expect to restructure their mortgage portfolios, by increasing interest rates to more accurately reflect risk and push their less attractive customers elsewhere. RBS and LloydsTSB, with their obligation to maintain lending levels, will probably be forced to acquire these customers by the government. The end result will be that the majority of banks will restructure and stabilise their portfolios, while the taxpayer will be left with a large stake in two banks holding large amounts of junk debt. What happens then is anybody's guess.

The strategy that the government is pursuing is comparable to using taxpayers' money to put pressure on a section of the brewing industry to continually increase production of lager, keep prices low and sell aggressively to alcoholics, in order to ensure that they don't sober up and suffer from a nasty hangover. It might satisfy some short term goals, but in the longer term, it will achieve nothing.

1 comment:

Mark Wadsworth said...

Yup, that sums it up. But it won't work. House prices are crashing and that is the end of the Nulab economic miracle.