The Stocks and the Flows

The Stocks and the Flows

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There has been considerable pressure in recent months for the Bank of England to start raising interest rates. Some argue that interest rate rises are needed to control the housing market, especially in London and the South East.  And others argue for interest rate rises to "get people used" to the idea that rates will be higher, discouraging risky lending and encouraging people to think about the affordability of debt service in the future. Avoiding another credit bubble and financial crash is on everyone's mind.  

They have a point. London and South East prices have been rising fast, though the pace of increase appears to be slowing. And a significant proportion of new mortgages are at high income multiples (4.5x or more), which are at the limits of affordability. But the Bank of England's Governor, Mark Carney, has made it clear that prudential regulation is the preferred approach to limiting the growth of high-risk mortgage lending, and the Chancellor has recently extended the powers of  to prudential regulators. Prudential regulation is untested in the UK as a primary means of controlling the housing market, and for this reason some worry that it will not be effective. But early signs are encouraging: mortgage lending has actually fallen in recent months due to tighter lending standards recently imposed by the FCA.

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The growth of the housing market is not likely to trigger interest rate rises. But improving economic conditions in the UK suggest that interest rates might need to rise fairly soon, perhaps within the next year. This would benefit those people who have suffered from the very low interest rates in recent years, particularly pensioners on fixed incomes. But it could have disastrous effects on another group – highly-indebted home owners on low-to-middle incomes.

In an excellent new report, the Resolution Foundation discusses the impact on households of forthcoming interest rate rises. They distinguish between two groups:

  • the “flows” of new borrowers

  • the “stock” of existing borrowers

The Resolution Foundation agrees that the propensity of new borrowers to borrow more than they can afford does need to be managed. But it supports the Bank of England's view that macroprudential and conduct regulation is the right approach, not monetary policy. If macroprudential and conduct regulation is both appropriate and enforced, interest rises should not cause major problems for new borrowers.

But the same cannot be said of existing borrowers. Household debt is still over 90% of GDP, only slightly down from its peak of 102% in 2009:

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The Resolution Foundation's principal concern is that a high proportion of iindebted households are over-extended because of falling real incomes, unemployment, under-employment and widening credit spreads. If interest rates start to rise, they could be at serious risk. Modelling a rise in the base rate to 3% by 2018, which is consistent with Bank of England guidance, they find the following:

  • The number of households spending more than a third of their after-tax income on mortgage debt service would rise from 1.1m to 2.3m. That is a quarter of all households with mortgages.

  • The number of households spending more than half of their after-tax income on all forms of debt repayments would nearly double, from 0.6 million to 1.1 million.

This presents a considerable problem for policy makers (their emphasis):

The sequencing of rate rises and the pace and spread of household income growth in the coming years will be crucial. The problem is complicated by the fact that policy makers must simultaneously have regard for both the stock of existing borrowers and the flow of new entrants. Ensuring we learn the lessons of the past means tightening lending criteria and reducing the economy’s dependence on debt; yet moving too hard in this direction risks adding to the affordability problems faced by members of the stock who were lent to at a time when credit was much looser. A one-size fits all approach is unlikely to be appropriate.

It is all too easy for those who would benefit from rate rises to argue that existing borrowers have had years of forbearance and it is time for them to “man up” and accept the consequences of their folly. But many of the home owners who would suffer from ill-considered rate rises are not profligate: they borrowed within their means to buy modest houses, but because of the financial crises and the ensuing recession they have suffered unemployment, under—employment and falling real incomes, which have turned reasonable debt commitments into living nightmares. 

Bank of England data shows that despite historically low base rates, 18.6% of households report having difficulty paying their mortgages:

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It is simply ridiculous to assume that nearly a fifth of all households with mortgages borrowed irresponsibly. A minority no doubt did – though it is worth remembering that for people with stable incomes but little in the way of savings, a subprime high-LTV mortgage can be a good choice and doesn't mean either they or the lender are irresponsible. But the rest have simply been victims of circumstances. Do they really deserve to lose their homes?

It seems likely that if base rates had remained at the level they were in 2007 – or worse, at the level they were in 1991 at the height of the last mortgage crisis – mortgage payment difficulties would be even more prevalent. And it also seems evident that raising rates now is highly risky while household balance sheets remain so fragile. Policy makers must proceed with great caution.

The Resolution Foundation concludes that the debt overhang must be dismantled. And I concur, for two reasons. The first, obviously, is the fact that while households remain over-leveraged, interest rate rises threaten both economic growth and financial stability, since households will be forced to cut spending to meet higher interest payments and a rising proportion of them will end up defaulting. As Mark Carney observed in his speech at the opening of the Commonwealth Games, the UK's households are very sensitive to income shocks, and the consequences for the economy could be serious:

History shows that the British people do everything they can to pay their mortgages. That means cutting back deeply on expenditures when the unexpected happens. If a lot of people are highly indebted, that could tip the economy into recession.

It's worth remembering, too, that high interest rates when nominal incomes are stagnant make paying off debt more difficult, as money that might have gone into debt repayment goes into higher interest payments instead. But there is also a risk that holding rates down for too long would cause distortions and misallocations that require far more aggressive tightening later on. When, and by how much, to raise rates is extraordinarily difficult to determine when household leverage is high. Reducing it before raising rates significantly seems sensible.

But my second reason for acting to dismantle the household debt overhang is perhaps more subtle.

Households that are only just managing to afford debt repayments will go without treats for the kids, lunch with friends, doing up the house, going on holiday or replacing worn-out or broken household items. It's amazing what people will live without in order to ensure they can continue to pay their mortgages. But when discretionary spending is curtailed by a large proportion of households, the businesses that provide these goods and services are forced to cut prices and retrench. This causes wages to stagnate or fall, making debt service more difficult and forcing indebted households to maintain or even increase household austerity. At present real incomes are falling and inflation is low, which suggests that aggregate demand is still deficient despite six years of low interest rates and QE: it seems likely that the household debt overhang is at least partly responsible for this. Even without the risk of interest rate rises, therefore, reducing or eliminating the household debt overhang would be a far more effective demand stimulus than QE has ever been.

The Resolution Foundation comes up with a number of approaches to restructuring household debt burdens, grouped under three broad policy themes:

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(a larger version of this chart can be found here)

These policy recommendations can be summarised in relation to the timing of interest rate rises:

  • Interest rates should not rise until it is clear that there is broad-based recovery, including rising incomes among the most highly indebted households. This requires a distributional analysis that the Bank of England's data sources currently cannot provide. There is therefore an urgent need to improve the information and analysis available to policy makers.

  • While interest rates remain low, highly indebted households should be helped to lock in low interest rates for the future. Lenders must identify households most at risk from interest rate rises and encourage them to refinance at fixed rates. And regulators should discourage lenders from raising margins on existing variable rate mortgages for those unable or unwilling to refinance. 

  • Before interest rates are raised, quality and availability of debt advice should be improved and debt restructuring programmes extended.

The Resolution Foundation's findings are welcome. For the first time they give clear direction to policy makers about the work that will be required to enable interest rates to be normalised without risking debt deflationary collapse. Particularly sensible are their suggestions for a Government-backed shared ownership scheme to enable people who need to exit home ownership to do so while remaining in their homes: and their recommendation that debt restructuring schemes should incorporate an element of saving for unbudgeted expenditures. Both of these would do much to reduce the anxiety that many households feel when faced with income shocks and the prospect of losing their home.

I am however concerned that the report focuses almost exclusively on mortgage debt, when there remain many households whose principal debt burden is unsecured debt. Rising interest rates on mortgages may force many of these households into default on unsecured debt. It is perhaps not widely known that a default on unsecured debt can result in the debtor losing their home, if the unsecured creditor chooses to recover the debt through the bankruptcy courts. This is because in bankruptcy, unsecured creditors have a claim on the debtor's unencumbered assets: if the debtor owns a house on which the mortgage is less than 100% of the value, the unsecured creditor may force sale of the house in order to claim the equity in settlement of the unsecured debt. When credit card defaults were very high after the financial crisis quite a few lenders chose this method of recovery. I think regulators should be tasked with ensuring that lenders do not do so again.

And for me the Resolution Foundation's recommendations actually don't go far enough to meet their objective of "dismantling the debt overhang".  Household debt at over 90% of GDP is only sustainable while interest rates remain very low, but falling real incomes do not allow households to deleverage at the pace that would be necessary to allow interest rates to rise safely. The Resolution Foundation only briefly mention debt forgiveness, but the reality is that if incomes do not improve, widespread debt forgiveness, rather than restructuring, may be the best option for future economic growth. Despite the improving economy, debt jubilee is not yet off the table.

Related reading:

Interest rate rises in Britain? Not yet - The Economist

The not-so-new (but very uncertain) neutral - Frances Coppola

As house prices surge, can the Bank of England help the financial sector absorb the risks? - Jagjit Chadha

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