Credit Extension In The UK Looks Set To Slow - Fast!

Adrian Ash - Thu 13 Sep, 2007

Credit extension in the UK looks set to slow fast! The Bank of England might not know a collateralised loan obligation when it sees one. But it said Tuesday that the average variable rate mortgage issued in August rose by 0.25% to a nine-year high of 7.69%. "Fear of retailing bloodbath when interest rates hit home," screams The Times in response. JJB Sports has cut its full-year forecast by one quarter. The CEO of Next warns the real crunch could hit just as Christmas arrives.

"It is a fraud to accept what you cannot repay," said Publilius Syrus way back in the first century BC.

But Syrus was just a Roman hack...and a freed slave to boot. So what would he know about collateralised loan obligations? No more or less than today's Bank of England, perhaps.

"British venture capital heavyweight John Moulton told a reporter," says Sean Corrigan, "that at a recent breakfast meeting with Bank of England officials, none of them knew what a 'CLO' actually was..."

Your correspondent confesses that he has no firm idea of what a collateralised debt obligation is, either. Nor does The Economist magazine, judging by its latest stab at explaining this haute-finance wheeze to its readers. And unlike the policy wonks on Threadneedle Street, your editor's not paid to defend the UK's financial stability. He's just here to make a few quid working out what might go down — or up — thanks to the stupidity of central bankers and investors alike.

"Perhaps it all was just a quirk of fate," continues Sean Corrigan — former Daily Reckoning stalwart and now chief investment brains at Diapason Commodities — "that the 'Victorian' Bank of England finally succumbed to its critics and offered both to allow banks to increase the reserves they hold with it by 6% and to lend up to a quarter of the total at base rate, rather than at its penalty rate a full percent higher."

Clearly, the Old Lady's sudden change-of-heart "had nothing to do with the sharp rise in credit-default swap spreads," says Sean, "nor with the threat posed to the UK's very own sub-prime, buy-to-let punters by struggling mortgage lenders."

Pure coincidence, gentle reader. No need to panic and flee the banking or real estate sectors.

"It is too soon to quantify the impact on the economy as a whole," says Mervyn King, the Trimmer himself, in a note sent to Parliament this morning from his office at the Bank of England. "In the short term, some corporate loan rates will rise in line with inter-bank rates. Banks that are unable to sell pools of loans that they had securitised , or who need to support off-balance sheet vehicles, may cut back on new lending."

What's a central banker to do? "The provision of [extraordinary] liquidity support [by the Old Lady] undermines the efficient pricing of risk by providing ex-post insurance for risky behaviour ," says Dr. King, entirely guiltless in getting us all here in the first place. "That encourages excessive risk-taking, and sows the seeds of a future financial crisis."

Thus the Trimmer's choice: to make free with financial support for the country's biggest banks? Or to let the market ‘reprice’ their risk-taking and take a gamble on financial stability?

"Mass delusions are not rare," wrote Garet Garrett, editor of the New York Tribune, nearly 2,000 years after Publilius Syrus scratched out maxims in Latin. In his 1932 tome, A Bubble that Broke the World, Garrett noted how mass delusions "salt the human story. [But] a delusion affecting the mentality of the entire world at one time was hitherto unknown. All our experience with it is original."

Garrett was speaking of the late '20s bubble on Wall Street, but his words do more than echo today. "This is a delusion about credit," he went on. "And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than ten years debtors and creditors together have pursued the same deceptions. In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower."

Fast forward to Sept. 2007, and has the folly of lenders exceeded the extravagance of borrowers once again? In June this year, some 30% of first-time homebuyers in Britain resorted to an ‘interest-only’ mortgage, just so they could make the repayments and get the keys to the door. That might sound like extravagance.

But fewer than one-in-three first-time buyers presented an investment plan to their lender to cover repayment... leaving one-in-five of ALL first-time buyers paying the interest alone, with nothing set up to cover the base debt itself.

On the part of the lenders, that sounds like folly. Five years ago, just one-in-twenty of Britain's first-time homebuyers opted for interest-only with no plan for repayment.

"The market has it wrong in that it calls this the sub-prime crisis," says Barry Wilby, former fund manager at Oppenheimer and a sharp cookie no doubt. "I think it's really a crisis in the underwriting and packaging of debt. That means it has implications for the extension of credit, because of the trust that people will have in institutions."

"It's a big psychological problem for capital markets," Wilby warns of the spike in interbank lending interest rates — now at fresh two-decade highs just shy of 7% here in London — "which will result in a slowdown in credit extension which I think will result in the slowing down of the global economy."

Credit extension in the UK looks set to slow — fast! The Bank of England might not know a collateralised loan obligation when it sees one. But it said Tuesday that the average variable rate mortgage issued in August rose by 0.25% to a nine-year high of 7.69%. "Fear of retailing bloodbath when interest rates hit home," screams The Times in response. JJB Sports has cut its full-year forecast by one quarter. The CEO of Next warns the real crunch could hit just as Christmas arrives.

Borrowing what you cannot repay is indeed fraud, but the great fraud of limitless consumer spending looks done. Lending what you cannot hope to get back, on the other hand, is pure folly. And now that game is up, you might want to check just who owes what to whom in your stock-market portfolio.

Regards

Adrian Ash
For The Daily Reckoning

Adrian Ash is head of research at BullionVault.com the world's fastest-growing and best-value gold ownership service.

http://www.bullionvault.com/from/dailyreckon