12 June 2011

Banking Regulators Are Addressing the Wrong Problem

Submitted by Edward C D Ingram

This article is a condensed version of the early chapters of my forthcoming book.

Much has been written about the need for bigger reserves for banks and about sub-prime failures as if these were the central issues. They are not. 

The problem with the Housing Finance Sector is its structure. There is a conflict between Monetary Policy and the safety of the sector because of what I call dynamic gearing in the level of repayments.

In theory, when the level of demand in an economy rises as it will upon economic recovery, say by 1% of GDP due to 1% more economic growth, all values and ALL CASH FLOWS (my addition to the usual economist's guideline) should rise by 1%. The same effectively should happen when incomes and prices both rise by 1% without any economic growth: in money terms this is also a 1% rise in demand. In fact it is Average Earnings / Incomes Growth (AEG) that we are talking about here, regardless of the real economic growth rate.

In this way, if all costs rise at the same rate, or are allowed to do so in their own time, spending patterns within the economy are kept in balance. No jobs are needlessly lost. But low and behold, the Housing Sector and all sectors using the Level Repayments’ System gear up their repayments, up to twelve-fold. A 1% rise in demand results in a 12% rise in the level of payments as interest rates are dragged up by 1% in response. This diverts spending out of consumption and into faster repayments.

For a 1% rise in interest rates, we get a budget-busting 12% rise in the cost of Mortgages, and a 1% of GDP per GDP of that kind of debt, diversion of resources (spending) out of the economy for later injection when the recipients find out what to do with it. But that goes to other sectors, or at least it forms a different spending pattern, creating new jobs elsewhere when people gear up to the demand. This later reverses when the economic cycle turns around.

This is important, because in the 1980s a similar sea-change occurred when the price of oil crashed down to US$11 per barrel. My office was filled with salesmen trying to get me to invest my clients’ money in response to the expected boom in the economy. They forgot that the oil producers might cut back on spending and that this might slow the world economy before people found out how and where to spend the additional money that they had saved on oil. It was six months before mainstream economists discovered this was why the world economy had slowed. So we need to add this ‘maintenance of spending patterns’ clause to our textbooks. We only have the pricing bit, whereby a rise in demand increases the price. We have to add: -

A rise in (money) demand from rising incomes, must not be allowed to change spending patterns and we need to arrange our financial structures like Taxes and Bonds and Mortgage Repayments accordingly. This could come under the heading of Macro-economic Design Principles, a subject that has not seen much development in recent years.

An alternative wording might be: -

There is a price to pay, both social and economic, for any obstruction that is placed in the way of a natural and proportionate adjustment to prices and cash flows when average earnings / incomes increase.

I include Bonds because these also inject instability into economies as currently structured. They do not rise in value with rising demand sourced from rising incomes. They should do. This would align government budgets to their rising revenues, helping to maintain spending and wealth patterns, and it would avoid a front end load of high nominal interest rates which makes repayments of Sovereign Debts more expensive both on the resulting uncertain value (risk) of Fixed Interest Bonds v Rising Incomes, and in terms of the front end load - the high intial interest payments. I can write a whole booklet on this showing how to restructure them so that they will sell easily into the market place and stabilise government finances calming the currency and investment markets as well. But this is not my theme today. We are looking at Housing and Business Finance.

When the Fed raised rates by 4.25% they effectively / potentially diverted around 4% or so of GDP out of spending, except that Mortgage payments, to make this happen and to follow suit, needed to rise by around 50%, which they could not do.

Thus the sustainability of the banking sector involved was a matter of how low the sector could hold the rate of interest and for how long. Sub-prime caught the headlines but the real problem was Prime. Lenders were unable to hold rates down and there was a crash after which rates did fall, but the confidence factor needed to keep any economy going was lost by then.

The problem starts not with the increase, but with the same dynamic gearing that takes Mortgage Payments DOWN and creates a house price bubble as well as the potential for this subsequent rise in payments.

I have a solution to this problem which I want to implement. It is to restructure the sector to eliminate this gearing problem. It will be called the Ingram Lending and Savings (ILS) System.

I offered it to the Fed and the USA treasury hoping to save the world from recession. It is simple and elegant and it was ignored despite a FAX sent to the USA treasury by a well qualified person working for a well known firm of accountants supporting my suggestion, as well as several other people who wrote in support including the Institute of Actuaries in London. If I had money this system would have been in operation long ago. And I also had a letter from the deputy editor of the Building Societies’ Gazette (now Mortgage Finance Gazette and written on that letterhead) stating that I had influenced the lending industry before and that there was more where that came from.

I am now looking for a significant partner to put this ILS System in place so that others can copy it. I can do that. I have done something on that scale before and changed a whole nation’s mindset in the process when I introduced the leading brand of unit trusts into an African Nation which later experienced hyper-inflation. My brand survived that, and took the embryo industry to maturity.

I know that I have to set it up first. Then people will copy me. That (copying my methods) is what happened when I first made an innovation in the Financial Services Sector. People, especially academics, said that I could not possibly do what I actually did. But after I did it a new industry was born by people that copied me, or at least tried to copy me (mostly with much less success). It is now called Broker Bonds. My secret was extremely hard work so that I saw faster than others what economic trends would take place based upon events and expected news items that had not yet happened but which were probable. The oil price saga was just one such example. The result was an out-performance of my investment portfolio most of the time. Another additional insight that I have today, might be the public focus on sub-prime when the actual problem is prime, and the system in use.

The writer can be found at

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