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Economics Weekly

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Tighter credit conditions will weaken UK economy and raise default rates

Tue, Apr 8 2008, 06:27 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Credit conditions report shows supply of credit being restricted…
The latest UK credit conditions survey from the Bank of England made grim reading. It suggested that credit conditions will tighten even further for UK households and companies in the next three months, after a pronounced tightening in the three months to March 2008, which itself was more than was expected at the end of 2007. At the same time, the survey reported that lenders also intended to widen spreads, effectively raising the cost of borrowing to households and companies. Thus it was no surprise that the report also showed that a greater number of lenders expected default rates on loans in the UK to rise, after been higher than expected in the previous three month period.

…and a rise in default rates. This could prompt a cut in base rates this week…
From an economic perspective, these trends clearly imply weaker economic growth, as a fall in the supply of loans relative to continued strong demand means weaker consumer spending and also lower than otherwise business investment spending. This may help to prompt a pre-emptive rate cut this week from the MPC, to 5% from 5.25%, rather than wait for a fuller analysis of the economic situation in the May Inflation Report before cutting.

Chart a shows that the availability of mortgage loans will be restricted even further in the next three months than was the experience of the last three months. For unsecured credit, which saw a sharp rise in February - implying that borrowers have turned to that source as mortgage finance has dried up – availability is expected to remain constrained in the quarter ahead, but not by as much as the actual action taken by lenders in the preceding three months. In one sense, the rise in unsecured borrowing showed in official data for February, up £2.4bn, could be taken as a sign of distress borrowing rather than healthy spending though it is also the case that retail sales volume growth has been remarkably strong in the first two months of 2008, up by an average of 1% in each month. Corporate lending conditions are expected to remain restricted but to ease in terms of the expected tightening in the next three months compared with expectations in the preceding quarter, and the actual tightening of credit in the three months to March. However, as chart b shows, lenders think default rates on loans (secured, unsecured and corporate) are likely to rise in the next three months, particularly for mortgages.

…as a lack of credit and higher defaults will weaken UK economic growth
Two questions are probably worth asking at this point: what does this credit conditions survey imply for actual UK default rates and what are the financial markets already pricing in for insolvencies in the period ahead? But first of all what has been happening to actual defaults, have they, as the report implies, been rising sharply recently? Data for the first three months of 2008 are not yet available, but the number of individual insolvencies has fallen and the number of corporate defaults has risen only slightly in the three months to December 2007. Individual defaults in Q4 were 24,846, down from 25,847 in Q3 and company insolvencies were 3,135, just 10 higher than in Q3, see chart c. In fact, if one looked at percentage changes year on year in these insolvencies, they are actually down on the year before, see chart d.

Actual UK default rates are rising from a low level and after recent declines…
It is certainly the case that UK mortgage arrears are rising, so this implies that individual defaults will rise in 2008, or at least the segment that is related to these loans. Our forecast for mortgage arrears though shows that the expected rise is well below that which occurred in the last housing market crash in the early 1990s, see chart e. This forecast takes account of slower economic growth in the UK – our projection is for 2.2% this year - and base rates being cut to 5% in Q2 (more likely now in April than in May but certainly in one of these months). However, the forecast does suggest that this will be the worst year for mortgage defaults in a decade, taking them back up to 1998 levels.

Company defaults are also expected to rise as a result of the economic slowdown, tougher credit conditions and slower growth in the global economy, but the rise will still be well below the average since 1992 and well below the level it reached during the 1992 recession. But our forecasts may be too optimistic and so we have tried to take into account the current market view of likely company default rates in the UK. The first method uses the spread on UK company borrowing for investment grade firms and above. This shows that the market implied view of UK company defaults in the year ahead is well above that in our forecast, taking the ratio of company liquidations to 1.3% of active companies, compared to our 0.8%. However, even this is well below the levels that prevailed during the 1992 downturn, see chart f. An alternative method is to take into account the implied view of the credit market, using the European itraxx index. This implies a similar default rate to the corporate spread approach, only slightly higher at 1.4% of active UK companies.

…but the main concern may be to prevent this from getting even worse because of the lack of credit
If the financial market view is proved correct, the implication is that UK economic growth may be slower than in our central case, and so corporate failures are higher, but even in that case, the rise in UK default rates will still be relatively small compared to the early 1990s experience. This does not support claims that US style rate cuts in UK interest rates are likely, as economic growth is not expected to hit recession levels even by the interest rate profile expected by financial markets. In other words, implied company default rates in the financial markets are not those associated with UK recession. But of course, what it does imply is that there are serious worries about downside risks to UK economic growth.

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Published on  Tue, Apr 8 2008, 11:47 GMT