What is the collective name for a crossing of fingers?

Because that seems to be what the Bank of England’s Monetary Policy Committee members are doing. They are collectively crossing their digits in the hope that they have done enough to steer the UK economy out of recession.

They have pumped billions into the UK economy and it doesn’t seem to be having much effect – yet. That is unless you are a banker looking to bolster your balance sheet with freshly minted notes. Banks are happy to swap their assets for the Bank of England’s cash but remain unwilling to lend. Additionally, there is still uncertaintyabout the ability of the economy to grow unaided if the central bank should stop printing money.

And just when you think that things could not get any worse, it just did. It seems another problem has crawled out of the woodwork is inflation. The Bank believes inflation will be extremely volatile. It may fall in September but near-term inflation may exceed initial forecasts. But because it believes the rise in inflation will be temporary, the suggestion is that interest rates can be maintained at around current record low levels for some time.

However, low interest rates, low growth and low prospects of an economic recovery are spooking foreign investors. Sterling recently sunk to levels not seen for five months against the euro. It has dropped from 1.30 euro a year ago to 1.07 euro, though it has since recovered to 1.11 euro.
UK exporters will undoubtedly welcome the favourable exchange rate against our European trading partners. But the fly in the ointment will be more expensive imports from European.

German cars, French wines, Italian luxury goods, Spanish holidays, Irish butter and Dutch Edam cheese will all cost more.

Inflation is the unspoken effect of Quantitative Easing. It is something we need to guard against if we are to ensure that our nest eggs and investments are not eroded over time. Leaving any money you have in savings accounts may seem like a sensible and safe thing to do now. But over the long term, cash has a terrible record at beating inflation. Consequently, it is better to invest in assets that have a proven track record against rising prices.

If you have a mortgage on a property, now is a good time to pay down as much of the loan you can afford while interest rates are low. If you have money that you can afford to put away for five years or more then it should be invested in shares rather than allowed to idle in a savings account.

Crossing your fingers is not an option. Putting your money to work is because things just got a lot worse.

The securities are trading below par – more than 40 percent in some cases before today’s announcement - allowing the bank to reduce debt by buying them back. Cash-rich banks such as HSBC have launched similar buybacks this year to profit from the ABS market dislocation, but it's the first time a Spanish bank has launched such a large public buyback.

Santander has offered to pay slightly more than market prices, suggesting it thinks there is some money to be made by buying these bonds at beaten-up prices and waiting for the mortgages to pay off.

The buyback could also be a sign Santander believes the freeze in the European securitized debt markets is thawing.

European ABS prices have rallied sharply in recent weeks, in part because traders at investment banks have started bidding for the debt again. Some of the more beaten-up Santander MBS have gained by as much as 15 percentage points since June, according to one investor.

Santander is rumoured to have bought back ABS earlier on in the credit crisis through private one-off trades. Perhaps it wants to get hold of as much as it can now in case spreads keep rallying further.

There may also be some political capital in a large public buyback of this kind. It gives a sign of strength to the market, and shows the bank supporting the secondary market for its bonds. That may win Santander some kudos with investors when it comes to issue MBS in future.

What’s not clear is whether investors will bite and sell. With unemployment and mortgage arrears rising in Spain, some may take the chance to get out while they can, even if it means taking some pain. Some hedge funds have piled into the more depressed bonds issued by Santander’s UCI unit, and will likely make a quick profit by selling.

But other investors may decide that if the bonds are good enough for Santander, which in theory knows the assets better than anyone, then they are good enough for them.

Bank Rate has plunged by 5.25 percent since July 2007, and two-year swap rates have fallen by 4.1 percent, but surprise surprise, the only rates that have come down anything like as far are those paid to the hapless retail depositor. For many of those wanting to borrow, the price has gone in the opposite direction - if they can get the money at all, that is.

Put another way, the price of a 5,000 pound personal loan has risen by more than 9 percent relative to Bank rate. This process of price gouging is called "rebuilding bank balance sheets."

What are consumers supposed to make of the latest inflation numbers? Do we have inflation, deflation or a bit of stagflation?

Truth is, it depends on who you are and what you do with your money. The Retail Prices Index or RPI tells us that prices today are exactly the same as they were a year ago. The Office for National Statistics reported that RPI was unchanged at 0%.

But be very careful when bandying around the term “prices”. The RPI includes elements of housing costs. So it is better to talk about the cost of living rather than prices. Prices have risen compared to a year ago, but the total cost of living as measured by RPI has fallen because of the disproportionately large drop in mortgage costs as a result of lower interest rates.

The proof, if proof was needed, that prices have risen from a year ago, can be seen from the Consumer Prices Index (CPI). Instead of 0%, as measured by the RPI, prices as measured by the CPI are 3.2% higher. The CPI does not include housing costs, so it is a better measure for people on fixed-rate mortgage deals, and also for people in rented accommodation.

The upshot is that if you have taken on mortgage debt and chosen to spend rather than save, then you are worse off as a result.

However, it’s worth bearing in mind that both the RPI and CPI are broad measures of inflation. Consequently, the extremely large basket that is used to gauge inflation may not necessarily reflect the true changes in the cost of living that you may experience. Put another way, if we don’t buy exactly the same things that the ONS puts into its basket then we will experience a different rate of inflation.

To measure our personal inflation rates we need to compare our household budgets today with what we spent a year ago. Interestingly, a twice-yearly study by The Motley Fool has shown that personal inflation is consistently higher than the Government’s measure of inflation.

This should set alarm bells ringing for many of us.  If inflation refuses to die in a so-called deflationary economy, then the outlook for the cost of living could worsen when the Government finishes pouring money through quantitative easing or the printing of raw money.

The jury is still out as to whether quantitative easing will work. It is almost anyone’s guess. But history tells us that boosting the supply of money can be inflationary. This is because when there is too much money sloshing around an economy, chasing a limited supply of goods,  prices will inevitably rise.

Investors therefore have two clear choices. They can sit on their hand and hope that their nest eggs will not shrink to the size of quails’ eggs through inflation or they can heed the lessons of history and invest in assets that have demonstrated an ability to combat inflation.

Only two asset classes have successfully beaten inflation in the long term. These have been property and shares. Most homeowners already have a large exposure to property. So, it may be prudent to increase their exposure to shares to rebalance their way their wealth is distributed.

Interestingly, the yield on UK shares is currently around 5%. That is almost ten times more than interest earned in a traditional savings account. Of course your capital is exposed to both ups and downs.

Even better yields may be available from individual shares. But it is vital to choose carefully. After all, dividend payouts are at the discretion of the company’s directors. That said, companies are often reluctant to cut dividends unless they absolutely have to. And a careful selection of companies whose dividend payouts are strong could be just the panacea for embattled investors.

– Read David Kuo’s blog here or listen to the Motley Fool podcast.

It is too early to say whether the latest bank rescue plan will have the desired effect of persuading the banks to start lending again. But it is a step in the right direction and we welcome it as a positive move as it may just remove the remaining stumbling blocks to getting the credit and mortgage markets functioning properly once more.
Clearly, something further had to be done. October’s £37bn bank recapitalisation did little to persuade banks to regain their appetite for lending. Credit continues to be difficult to come by – unless you have a large deposit or equity in your home and a clean credit history.

The latest bailout aims to guarantee lending and insure banks’ bad debts, such as sub-prime lending in the US. The idea is that banks won’t need to hold back vast sums in case of default on loans – something they have been doing until now. What is particularly encouraging is that this is a comprehensive package of measures which taken together is likely to have more of an impact on increasing new lending than addressing one area at a time.

The new £100bn mortgage guarantee scheme to underwrite lending between banks and financial institutions as recommended in Sir James Crosby’s report, is perhaps the most significant development. Before the credit crunch hit, the securitisation market was a key source of funding for the mortgage market, responsible for a third of all lending. This scheme should help rejuvenate the securitisation market, which has all but closed.

There is a danger that it may prove to be too restrictive, however, as only AAA-rated securities are covered.
Much also depends on how honest the banks are about their exposure to bad debt. A fee-based insurance scheme whereby the Treasury and banks will identify bad loans  or toxic debts that will ultimately be covered by the taxpayer should remove some of the blockages in the system that are preventing the flow of mortgage lending. But without an honest and open declaration of exposure by all the banks, it will be very difficult to draw a line under what has gone before and start afresh.

The extension to the £250bn credit guarantee scheme announced in October until the end of this year should also have a positive impact, allowing banks and building societies to roll over new debt, as should the new liquidity scheme to replace the Special Liquidity Scheme allowing banks to swap illiquid assets for gilts.

The change in strategy with Northern Rock is interesting. Instead of encouraging the lender to run down its business and shrink its mortgage book, the government has changed tack. The bank will now encourage existing customers to stay, presumably with more attractive reversion deals. It will also look to attract new borrowers – hopefully those purchasing, not just remortgaging, with more attractive rates.

We wait to see whether this package will have the desired effect and get banks lending again. Mortgages are already becoming cheaper but tend to be most readily available to the lowest-risk borrowers with significant deposits or equity in their homes. An increase in liquidity should encourage more lenders into the market and more competitive rates.

Even in the good times, many British consumers were borrowing against their houses just to fund routine consumption, indicating a big hit to come for retail sales and for the banks who hold the loans.

With house prices falling rapidly and mortgage debt tougher to get, it is no surprise that homeowners are less able and inclined to borrow against their houses in order to spend.

That will be hitting the High Street now - analysts are expecting a 0.6 percent fall on the month in retail sales for November when data are released later this week. But a rise in unemployment next year could expose a really serious weakness in household finances, as consumers who counted on being able to extract wealth from their houses to smooth consumption in bad times find that, when bad times come, the wealth isn’t there and the banks don’t want to lend anyway.

Researchers at Durham University looking at survey data found that 37 percent of homeowners borrowed against their house between 2002 and 2005, typically realising about 6,000 pounds. That’s a lot people borrowing a lot of money against very illiquid and now hard to realise assets.

Even more interesting is the pattern of what householders were doing with the money and what was happening to them when they decided to borrow. Over time the proportion of people borrowing to re-invest in their houses through improvements fell, while more was finding its way into day-to-day costs, according to Susan J. Smith, a professor at Durham and one of the authors of the study.

This was borne out by a high percentage of equity borrowers who had lost their jobs, become pregnant or had a child in the year they borrowed.

How exactly a borrower who has lost his job gets a bigger mortgage is a puzzle, but one that evidently banks and borrowers in Britain together have somehow managed to solve. The record in the United States shows that the housing boom brought with it a tremendous amount of mortgage fraud, much of it abetted by people within the lending industry.

In short, it seems that even during boom times in Britain people weren’t borrowing against their houses simply to buy BMWs and fund vacations, but often to keep their households ticking over during tough times.

“The rising property market was central to encouraging people to borrow more for non housing expenditure,” said Ross Walker, economist at Royal Bank of Scotland in London.  “And with the housing market now in reverse you would expect to see a retrenchment. It reinforces the potential fault line for the UK household sector: there is a big debt exposure and the real test will come next year as unemployment rises.”

BORROW NOW, DEFAULT LATER
The housing safety net, such as it was, simply won’t be there next year when unemployment vaults higher, which is very likely to exacerbate a spending slowdown which itself will feed unemployment. And remember, these weren’t people who were defaulting on their house loans in order to be able to pay their grocery bills, but people who were in part paying their grocery bills because they could borrow against their houses.

I wouldn’t want to be the bank that made those loans, or the government that insures that bank. It also goes some way, in my view, towards explaining the very precipitous fall in the pound, which is down more than 30 percent on a trade-weighted basis this year.

According to a survey of households just released by the Bank of England, credit is much harder to get as compared with a year ago. A total of 16 percent of households said they had put off spending because they were concerned about access to credit, up by a quarter from a year ago.

Only six percent of mortgage borrowers said they had taken out an additional secured loan, compared with 10 percent last year and 14 percent in 2006. Nearly 40 percent took out these loans to pay down other debts. That points to higher credit card losses and delinquencies next year, as unemployment interacts with an inability to access fresh secured loans.

So 2009 looks like it will feature higher unemployment, much reduced consumer spending, impaired access to credit and a default cycle that will worsen the already difficult capital problems of the banking sector. There has been a lot of effort and exhortation to try and keep banks lending to consumers in Britain, presumably on the view that it’s best to sober up gradually.

That can only work so long, and if it comes at the expense of capital for businesses that make and sell things, especially overseas, it may in prove to be a mistake.

And while big ticket items like automobiles, which are easy to defer, are now suffering, next year may see very tough times on the British high street for more basic items.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)