Debtor's Prison

Greetings fellow inmates:

Today, we’ll be taking a look at the most current credit conditions in the good ol’ United Kingdom, courtesy of Uncle Merv. To frame our discussions, we’ll update how the Quantitative Easing (QE) program is doing, look at inflation surveys and even briefly discuss some of the Bank of England’s bizarre history. We are extremely interested in how this market develops for the following reasons. For starters, the Great British Peso (GBP) is one of the reserve currencies, so what happens to this credit market has ramifications for the whole world. Also, Uncle Merv is fully engaged with QE, along with Uncle Benny and the rest of the reserve currency gang. We fear that this collective hysteria on their part will lead to a broad fiat currency crisis within 2-3 years time, thus stoking the fires of superinflation (in excess of 25% annualized for 2 straight quarters) and a reworking of the current reserve currency system. Ultimately, in this post, we aim to provide some color on the general state of the UK credit market and what, if anything, these circumstances might mean for the eventual prospects of long-term inflation expectations.

We’ll begin by taking a look at the latest Credit Conditions Survey (Q2 09) published by Uncle Merv. The survey was conducted between May 26^th and June 12^th. We highly recommend the whole reading, but as usual, we provide a succinct summary for your convenience, our comments in italics. The ‘net balance’ refers to the proportion of lenders that leaned in one direction in favor of the alternative (ie, cheaper/dearer credit).

Secured Credit to Households

• Lenders reported that they had increased slightly the availability of secured credit to households in the three months to mid-June. The main contributing factor to this was the improved cost and availability of funds to lenders. A net balance of lenders expected a further increase in the availability of secured credit to households over the next three months.

The increased availability marked the first time since Q3 07 that this happened, as you can see from the graphic below. The report also states that while the deteriorating economic outlook continues to weigh down on availability, the impact of this has been smaller than in other surveys. As we often say, one point does not a trend make. It remains to be seen if, as expected, availability will continue increasing. The report implies that this is partly the result of commitments the banks made with the government as condition for participating in the Asset Protection Scheme (APS). As a brief interjection, ask yourselves exactly whose assets were they scheming to protect? Though we have become disenchanted with the fractional reserve money multiplier model, an increase in the monetary aggregates, brought about by increased lending will compound the GBP-driven inflation. This is why we will remain vigilant to these forward-looking indicators of an eventual inflation.

Below is a chart of default rates and losses on defaults for secured house lending. In spite of the apparent pickup in supply and demand of credit, there remains a huge amount of debt that will go sour. Notice that 60% net lenders, a hefty amount, believe defaults will continue rising.

The credit scoring criteria for granting loan applications are also expected to ease, in large part due to the expected rise in credit availability for high loan-to-value (LTV) borrowers. Is this really a good idea? In an environment of rising defaults and falling house prices, do we want another wave of unsustainable debt to pile up? It would appear to us as if this was more politically motivated to spur remortgages and forestall the inevitable.

• Demand increased for secure lending for house purchase increased in the previous three months, but is expected to remain unchanged over the next three month. Demand for home remortgages dropped for another three months.

Demand is obviously a key factor in net credit growth. Once again, this does not make a trend and could have been due to a variety of things. Perhaps home prices have dropped sufficiently to attract new buyers. Seeing as inflation expectations are up, as we’ll see below, perhaps this could make sense. But it’s pure speculation at this point. A rise in credit demand will happen eventually however, and thus compound the currency-driven inflation.

Unsecured Credit to Households

• Credit availability was reported to have been reduced and lenders expected a further small reduction in the next three months.

In the vein of reduced credit availability for unsecured credit, lenders reported credit card limits had been reduced and credit criteria tightened. They expect this will continue for the next three months. This will damp spending and supports a deflationary hypothesis in the short-term. Remember that our inflation forecast isn’t for another 2-3 years, in which time this deflationary period will have run its course and the monetary effects of QE, through a distressed GBP (and also a lower USD – higher commodity prices) will lead to severe inflation.

Corporates

• Lenders reported increased availability of credit to the corporate sector.

Unexpectedly, demand for credit from small businesses declined. It is expected to rise over the next three months, though this quarter showed how inexact these forecasts can be. We expect this is due to the fact that the recession has hit those at the bottom the hardest, and small business rely more on unsecured credit, which has tightened.

Though credit availability to corporates rose slightly, the commercial real estate sector continued to go through a significant reduction in availability. This is to be expected. For some time now, the US and the UK have shown a similar curve in the severe deterioration of the CRE market following the residential one. The deterioration of this market will continue for the foreseeable future.

For other financial corporations (OFCs), collateral requirements and maximum credit lines were reported to have tightened further, and they are expected to continue to do so over the next three months. Now, this is something we can get behind. OFCs should not incur any more debt and should instead focus on servicing their existing toxic one.

Defaults

• Default rates and losses given default, on secured and unsecured lending to households and to private non-financial corporations were reported to have risen over the past three months. Lenders expect a further increase in the next three months.

This is unsurprising. After all remember that the UK is one of the most debt-addicted nations, with a huge debt overhang that remains and seems poised to continue deteriorating at a fast clip.

Terms and conditions

• Due to higher expected future losses, spreads on secured lending to households were reported to have widened, but lenders expected spreads to remain unchanged over the next three months. Loan terms tightened for secure lending but were expected to ease over the next three months.

A big reason, according to Uncle Merv, why the credit criteria tightened was in preparation for lending to higher LTV borrowers next quarter. Again, bad idea. It seems clear that this is at least in part politically motivated in order to spur lending and refinancing and to support house prices.

Thus far, we have to conclude that though this survey provided some data that bucked the trend for declining credit availability and demand, it is still scant data to conclude anything. It is still highly inconclusive at the moment which direction credit growth will take. Eventually however, we do expect it to pick up in the foreseeable future, presaging and exacerbating inflation.

For context, before we look at the latest Inflation expectations survey, let’s take a quick look at what inflation has done so far in the UK, as measured by the CPI. As you can notice, as with most countries in the world, it has dropped significantly since its mid-2008 highs. However, it does remain significantly above the US and has not dropped below its early-2008 level. This contrasts with the other three reserve currencies, which have already entered deflation and are at multi-decade lows. Remember that we have forecast that Uncle Merv will lose the battle to superinflation before the other reserve currency bankers.

Now we turn our attention to the latest Inflation Attitudes Survey from May. Again, we recommend the full, short reading, but the highlights are as follows. When asked to give the current rate of inflation, respondents said 4.0%, significantly above the 2.3% CPI reading. Median expectations for inflation over the next year were 2.4% about where it is today. By a margin of 63% to 9%, respondent said the economy would be worse off by a bout of higher prices. 44% of respondents expected interest rates to rise in the next 12 months, compared with 30% in February. This is consistent with our own expectations. When asked if a choice had to be made between keeping rates low or raising them to keep inflation down, 66% of respondents said interest rates should go up. We respect the gall of these survey participants to take the right stand on the inflation front. Ultimately, all discussions of interest rates at this point should consider the mechanisms and effects of QE.

It’s been a while since we updated you on the current state of QE-on-Thames. Most recently, on May 7^th, Uncle Merv decided to increase the size of his QE programme from £75bln to £125bln, which will go towards buying corporate bonds, gilts and commercial paper. So far, in general the size of each side of the Bank of England’s balance sheet (BoEBS) has increased 25% from its low on Feb 18^th, rising from £168bln to £211bln. In comparison to Uncle Benny’s FedBS, the BoEBS is much smaller and has grown by a smaller percentage. However, some similarities apply. The QE program has been financed in both by increasing bank reserve balances. In the BoEBS, they have nearly quadrupled, going from £24bln on Jan 28^th to £109bln on May 27^th. Remember that this is the high-powered money. This is more fuel to a potential inflationary spiral if banks start lending again. But more importantly it is through the effective monetization of UK debt through reserve balances that a severe currency depreciation will take place. We have often warned against the perils of QE and will continue to do so. The replacement of toxic debt with sovereign debt that gets aggregated on central bank balance sheets is a very dangerous experiment that we believe will have severe negative consequences for everyone down the road. These actions are not easily reversed, especially due to the long-term assets they are accumulating which support the very high levels of reserve balances. Higher long-term rates, debased currencies and higher commodity prices are all negative side-effects that we expect will come from QE. The ramifications of these actions could be severe enough to lead to our conjectured superinflation scenario.

Finally, we wish to leave you with a couple of brief historical points about the BoE’s history for nothing more than general education and to gain some small insight into some of the players. After being founded in 1694 by Scotsman William Paterson, it remained a private lender to the government for more than 250 years. As the bank size grew, it also became the banker’s banker. It was given the sole right to issue banknotes in 1844. It was fully nationalized in 1944. In 1977, it was set up as a private limited company in order for it “To act as Nominee or agent or attorney either solely or jointly with others, for any person or persons, partnership, company, corporation, government, state, organisation, sovereign, province, authority, or public body, or any group or association of them....” Weird, if you ask us. The BoE was also granted an exemption from the disclosure requirements and is also protect by its Royal Charter status and the Official Secrets Act. We abhor this veil of secrecy thrown in front of central bankers, especially those charged with handling the stability of the global reserve currencies. All these special exemptions are nothing more than a facility to permit them to avoid telling the truth. After all, the public does not have access to their same information, so central bankers can delay releasing information at their will, similarly to Uncle Benny’s tempo with subprime.

Well, that’s it for now. We’ll be watching Uncle Merv.

May your capital be safe and your investments prosperous,

MAAA