"Banks to defy Government and raise mortgages rates"

From The Times:

Northern Rock, the Government-owned lender, has announced that it is pulling all its tracker deals for homeowners and landlords and is expected to increase rates when it relaunches the mortgages later this week. It follows a move by Abbey earlier today to increase interest rates on tracker deals by up to 0.5 percentage points.

Umbongo alerted me, in the comments a couple of posts ago, to this fine summary by Paul Krugman, written back in 1999. I can't claim to understand the jargon, but in it he points out that once a depression/recession gets bad enough, cutting interest rates - even to zero - does not stimulate the real economy, what clever economists refer to as 'The liquidity trap'.

This is all well and good in theory*, but there are three far more fundamental and practical points. 

1. To the average borrower, the BoE base rate is completely irrelevant. What matters is the rate that you pay on your mortgage, overdraft, credit card, business loan etc. And real interest rates are basically [inflation + risk free interest rate + risk premium]. Future inflation is anybody's guess - call it 5%. The risk free rate, for UK purposes is the rate that you can earn on UK index-linked government bonds, about 1%. And the risk premium must be at least 1% on top of that, even for a really well run business or a mortgage with only 50%LTV. So nobody is going to lend anybody money for less than 7%. The banks have been pretty stupid over the past few years but they are now learning fast. This is the basic 'cutting BoE rates is like pushing a piece of string' theory.

2. To the average borrower, the interest rate is less important than the total amount the bank will lend him (or her). Whether a profitable business has to pay 8% or 9% on its overdraft is neither here nor, and the same goes for any half-way sensible buy-to-let landlord. What puts businesses out of business is when all of a sudden the bank calls in its loans or cuts the overdraft facility. What is forcing the not-so-sensible buy-to-let landlord to sell up is when the bank decides that a LTV of 90% is too risky and that in future they won't rearrange a loan with an LTV of more than 80%. All of a sudden, said landlord has to stump up 10% of the value of all his or her properties in cash (a 'margin call'). Which ain't going to happen, obviously. Leading to forced sales, further falls in values, further margin calls etc. (and hurray to that, as it happens)

3. Ask yourself why banks are reigning in credit and hoarding cash. It's because they in turn have their bondholders (aka the money markets, aka holders of mortgage backed securities) snapping at their heels asking for their money back. The quickest and fairest way to fix this is debt-for-equity swaps. Such swaps do not cancel a liability (which would be ungentlemanly), they merely convert a short term claim against the bank into a longer term right to participate in future profits of the bank, thus taking the heat off the bank, who in turn can take the heat of the business in need of finance etc.

Here endeth.

* Paul Krugman's theory (sort of) predicted what would happen in Japan over the intervening years; basically Japanese savers would invest abroad in search of higher returns. This is the far more sophisticated 'cutting BoE rates is like pushing a piece of string' theory. And then the Japanese savers went one better and borrowed cheaply in JPY to invest in higher yielding currencies, like AUD. Which worked fine for those prepared to gamble on the 'carry trade', until it suddenly all went pop. But Japan is a country where the government can actually control the interest rate charged to borrowers. We are, luckily, a long way from that here.