Securitisation

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Securitisation involves changing loans into tradeable bonds.

Securitisation can increase the liquidity of banks and enable banks to engage in more lending than previously.

Securitisation was a factor in the credit crunch because it enabled banks to lend more than usual. When there was a shortage of credit in the banking system, banks became over-exposed and faced a shortage of cash (liquidity)

The difference between loans and bonds.

Loans are viewed as assets on a banks balance sheet. Loans cannot generally be sold on or traded. Bonds can be traded and sold to other financial institutions.

What is involved in the process of securitisation?

Any asset with a predictable income stream can be securitised, e.g. mortgage loans have a predicted income stream from the mortgage repayments over the term of the mortgage.

A financial institution (often called Special Purpose Vehicle SPV) sells bonds to investors and uses the proceeds of these bond sales to buy the loans off the bank.

  • The bank gains cash from the sale of its loan assets.
  • Investors gain a bond and the promise of income from the bonds. (e.g. bondholders will effectively gain income from the mortgage repayments)
  • The intermediary makes money from selling bonds at a higher price than the cost of buying the loan bundles
  • Customers who took out loans from the bank won’t notice any difference. They still make their loan repayments to the bank. It is just that now, the bank doesn’t have the loans on its balance sheet. And as soon as the bank receives loan repayment, it passes it onto the SPV.

Why do banks want to pursue securitisation?

Banks have to keep a certain percentage of deposits in cash (liquid). This is to ensure the banks can repay savers who wish to withdraw their deposits at any moment from the bank. (If a bank couldn’t meet depositors demands for cash, it could cause a run on the banks and a loss of confidence.

Keeping a certain percentage of deposits in cash reduces profitability of a bank. Because a bank can’t lend this money gaining fees and a higher interest rate on the loan. Instead, they have to keep cash which earns nothing.

However, if a bank securitises its loans into bonds, the loans are no longer on its balance sheet (it could be described as off-balance sheet finance)

The bank has exchanged loans for cash. With this cash, it can now lend more, making more profitability.

The problem with securitisation

Securitisation enables banks to effectively lend a higher percentage of their deposits. This was fine when market conditions were good. However, there were two major problems.

In the US, customers began defaulting on mortgage repayments. Therefore, banks didn’t have income to pass onto SPVs and onto bondholders.

Previously secure mortgage bonds became worthless and so investors lost money. This led to a shortage of liquidity. No one wanted to lend. But, banks which had lent more than usual now faced real capital shortages. They couldn’t raise money by selling bonds to meet deposit requirements. This was a significant factor in the credit crunch.

Note: the primary cause of credit crunch was the large scale defaults on sub-prime mortgages. But, the process of securitisation meant that many banks and financial institutions lost money indirectly, and banks were much more exposed to these failed mortgage repayments.

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Flexible fiscal and monetary policy

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A good post by Simon Wren Lewis on future UK macroeconomic policy – learning from the experience of the past few years. – Bold macroeconomic policy for a new government.

Essentially, it involves committing to a more flexible fiscal policy which can take into account the different requirements of liquidity trap (ZLB). Monetary policy should also be more flexible having a dual mandate of nominal GDP and inflation.

A summary of possible policy changes.

Flexible Fiscal Policy

  1. Long term goal of reducing debt to GDP to a suitable level (e.g. 40%)
  2. The long term goal should not inhibit expansionary fiscal policy if the economy needs it. If there is evidence of deep recession (i.e. zero lower bound rate – nominal rates at 0.5%) then fiscal policy should be used to stimulate economic growth.
  3. Deficit targets should be flexible to take account of cyclical downturns, i.e avoid mistakes of premature of fiscal consolidation when economy is too weak to absorb austerity.

Flexible monetary policy

A dual policy mandate should target low inflation, but also economic growth. This would give the Central Bank more flexibility to ignore cost-push inflation and also consider the wider economic environment.

Higher inflation target to give Central Bank more flexibility in achieving economic growth. The UK experience between (2008-13) has shown that inflation can be stubbornly above 2% – even if there is substantial spare capacity and unemployment. A higher inflation target makes sure we avoid deflationary pressures.

see: optimal inflation rate

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Policies to increase bank lending

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In a previous post, we saw how bank lending in the UK fell during the credit crunch, contributing to the length and depth of the recession. Because of this the Bank of England and Government have sought to try and increase bank lending – in order to help stimulate economic growth. Fall in bank lending. …

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Economic defeatism

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Economic defeatism is a situation where policy makers accept an economic situation which is well below potential. Another form of defeatism is to see some problems as intractable and concentrate on dealing with side issues.

Economic defeatism is contagious because it can set the tone for the whole economy, making it even more difficult to resolve the situation.

Example of economic defeatism

The response to the great depression. Liquidate the banks!

As Andrew Mellon famously advised Herbert Hoover at the onset of the great depression.

“liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” Hoover, Herbert (1952). Memoirs. Hollis and Carter. p. 30.

This isn’t so much economic defeatism, but revelling in depression. Yet, it is most striking reminder of how embrace of liquidation can create economic misery.

Europe 2008-13

Eurozone-unemployment

Throughout the great recession, the EU have shown little ability, willingness or enthusiasm for decisive action to deal with growing unemployment and the prolonged recession. Instead, policy makers have focused on the necessity of sticking to fiscal targets, arguing there is no option but to deal with growing government debt. The consequence is that the EU have made little efforts to deal with the recession, and are at risk of experiencing a lost decade. Instead, there have been vague talks of supply side reforms and hopes that fiscal austerity will provide a stronger framework for future recovery. (see also: confidence fairy)

An alternative view. The alternative view would be to see the EU unemployment rate as unnaturally high and see the figure as something that can and should be reduced. Loose monetary policy, the willingness of ECB to buy bonds and less damaging fiscal policy could all reduce unemployment and create more signs of growth. With this focus on growth and full employment, European economies would be in much stronger position to deal with the ”less important’ macroeconomic objective of government borrowing.

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Pensioners better off, young people worse off

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I often like to tease my parents because they both now both qualify for free bus travel – one of the many ‘perks’ of being ‘old’. Half-jokingly I say they are the lucky generation. Buying a house in the 1960s, enabled a massive increase in wealth. They benefited from an era of full employment and greater relative job security. Neither went to university (so had no student loan to pay off ). But, in those days, a degree wasn’t so necessary (My Dad was last year to train as an accountant without even an A-level) 30 years later, with their mortgage paid off, their outgoings are relatively modest. Yet, despite the relative comfort of this generation, they are still entitled to a whole host of perks and benefits in kind from our ‘generous’ government.

Compare that to the younger generation. Getting on the property ladder is very difficult –  unless you are willing to take on excessive amounts of debt (probably to add to your student loans) The effect is that young people face high rents or high mortgage payments. Amongst young people, unemployment is very high. (18%) Those with jobs still face the harsher realities of the modern workforce – zero hour contracts, greater job insecurity and the very modern development of under-employment.

However, the baby boomers generation is quite politically powerful. Chancellors never seem to lose an opportunity to give more benefits to pensioners – free TV license, free bus pass, winter fuel discount. However, those who face unemployment and declining real wages, will see only rising living costs and little support. The costs of youth unemployment (both economic and social) are exceptionally high, but politically, there seems to be relatively little concern.

A recent report by the IFS show rising income disparity between the generations.

  • The median – or middle – income of the over 60s grew by 2-3% between 2007/08 and 2011/12, continuing a long-term trend.
  • Yet, the median income of people in their 20s fell by 12% over the same period, allowing for inflation. This was the largest fall of any age group, owing to low or frozen wages and high unemployment.
  • According to dept of work and pensions  1 in 6 children now live in poverty.

The decline in pension poverty is very good and signs of social progress. But, maybe we should be giving free bus travel not to pensioners,  but those who are unemployed or seeking a more permanent job.

Benefits in Kind

It is also important to bear in mind that income is only one factor that determines living standards. If you can live rent free (having paid off mortgage) and you also gain other free perks, that gives much greater security and discretionary income than having to pay a fortune for rent and paying off a student loan.

IFS – pensioners income rising faster at BBC

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Internal Devaluation Definition

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Internal Devaluation – where a country seeks to regain competitiveness through lowering wage costs and increasing productivity and not reducing the value of the exchange rate. A devaluation of the currency is a decision to allow a currency, in a fixed or semi-fixed exchange rate, to decrease in value. Devaluing the currency means that the …

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Shock therapy economics

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Shock therapy is the belief that the best way to fix a broken economy is to implement radical changes and introduce new market oriented policies, in one fell swoop whatever the short term cost. Shock therapy is associated with the economist Jeffrey Sachs who advocated free market reforms for Eastern European countries like Poland and Russia in the early 1990s. (Sachs actually disliked term ‘shock therapy’ arguing it was coined by media and makes it sound more painful that it needed to be)

Shock therapy is different to a more gradual approach which seeks to make incremental changes and transition.

Shock therapy generally refers to policies used for making a transition from a Command (state controlled) economy to a mixed economy. However, shock therapy might also refer to

  • Policies to reduce inflation quickly.
  • Policies to reduce budget deficit.
  • Policies to restore competitiveness and reduce current account deficits.

Shock Therapy policies involves

  • Price liberalisation – ending price controls
  • Ending government subsidies
  • Privatisation. Selling state owned industries to the private sector. It is hoped that under private control, firms will have more incentives to be efficient and cut costs.
  • Tightening of fiscal policy – higher tax rates, lower government spending to reduce budget deficit and control inflation.

Benefits of Shock Therapy

  • It is considered a quicker method to overcome economic inefficiency and deal with wasted resources.
  • With firm leadership, people know what to expect and make efforts to deal with the new situation. For example, if you want to control inflation, it is important to change expectations. Sticking to strict anti-inflationary policies, will help bring down inflation expectations and make it easier to achieve.
  • Stretching out economic reform, can prolong the old difficulties.
  • Jeffrey Sachs, a key supporter of shock therapy, argued it was harder to make the leap to a market economy in two stages. Privatisation, price liberalisation and control of inflation are complementary policies.

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Will China challenge the West?

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Readers Question: 1. Does state capitalism as practised in China pose a fundamental challenge to the Western model of liberal-democratic capitalism?

No, I don’t think so. From a political perspective, no matter how economic successful China might be, there will never be any enthusiasm to replicate China’s one party political system. In fact, it is most likely to be the other way around. Increased economic living standards in China are likely to cause increased demand for political and democratic freedom within China; there is already growing resentment at corruption within the state apparatus. It make take a few years or a few decades, but it is China’s political system which will be challenged by its own economic success.

That’s enough on politics, what about the economics? Does China’s growth pose a threat or benefit to the rest of the world?

From an economic perspective, Chinese state capitalism has been successful in creating very high rates of economic growth over the past few decades. Depending on which measure of GDP you use, China is forecast to overtake US economy at some stage (though recent downward revisions to China’s growth may mean it doesn’t occur until the next century. But, nevertheless, the growth of the Chinese economy has been very significant and has many impact on the world economy.

Challenges from Chinese rapid economic growth

Increased price and demand for raw materials. The global recession of 2008-12 was unique in having a period of recession, but rising commodity prices. Usually, when the western economic go into recession, demand for raw materials falls, and therefore the price falls – cushioning the impact of the recession. However, this time, rising demand from China and Asia, meant in the recession, we saw rising commodity prices – making the recession more difficult. Over the medium term, China’s economic growth will put increased pressure on raw materials and push up oil and other commodity prices. There will be greater competition for limited supplies of raw materials

  • However, this will spur the Western economies to increase fuel efficiency and look for alternatives to fossil fuels, which in the long term is desirable.

Environmental challenges. As Chinese GDP grows, there will be rise in greenhouse gases and other environmental costs, making it more challenging to deal with global warming.

  • However, the biggest levels of pollution still come from Western economies.

Global imbalances from high saving rates. In the boom period of 2000-2007, China experienced a large current account surplus. The Chinese kept their currency undervalued through using surplus foreign currency and purchasing US bonds. Arguably, these large capital outflows distorted markets. Artificially pushing down US interest rates contributing to a boom in US lending – and reducing US exports through keeping the dollar overvalued.

  • However, these global imbalances have been significantly reduced in recent years. The Chinese currency has steadily appreciated as the government have tried to contain inflationary pressures. This shows that Chinese growth can evolve from relying on cheap exports to more balanced with a growing middle class willing to spend and buy imports.

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