The Council of Mortgage Lenders (CML) today reported a rise in the number of mortgages more than three months in arrears from 167,000 in September to 219,000 in December. As a proportion of the 11.7 million outstanding mortgages, this represents an increase from 1.42% to 1.87%.

In its December forecast, the CML projected a further rapid rise in over three months arrears cases during 2009, to 500,000 or 4.4% of outstanding mortgages by year-end. The Bank of England, in its October Financial Stability Report, has also suggested that the arrears proportion would reach 4.4% in a “severe” economic scenario.

The recent and projected large rise mainly reflects the impact of the recession on homeowner incomes. Other factors include: a lack of refinancing options for those facing payment difficulties, especially given house price falls; government efforts to reduce repossessions, implying that more borrowers remain in arrears; and the arithmetic impact of lower interest rates on the calculated number of missed payments.*

How does current and prospective arrears performance compare with the housing downturn of the early 1990s? The CML series on over three months arrears begins in 1995 but earlier figures exist for cases more than six months overdue. The statistical relationship between the two series can be used to “backcast” the three months plus arrears proportion for earlier years – see first chart.

Three points are notable. First, arrears performance was worse at the comparable stage of the last recession. GDP had fallen for two quarters by the end of 2008, when 1.87% of mortgages were three months or more in arrears. In December 1990, also after two quarters of GDP contraction, the estimated proportion – based on the backcast – was 3.2%.

Secondly, the over three months arrears proportion is estimated to have reached 6.3% in the early 1990s, well above the 4.4% level projected by the CML and Bank of England (although the CML may expect a further increase in 2010).

Thirdly, arrears peaked in December 1992, five quarters after the trough in GDP and around the same time as unemployment. Even assuming an economic recovery from late 2009, this suggests that the arrears proportion will remain on an upward trend until late 2010, or even beyond.

The key reason for expecting arrears performance to be less bad than in the early 1990s is a much lower level of income gearing. Household interest payments as a proportion of disposable income peaked at 11.9% in the third quarter of 1990 but reached only 7.9% at the top of the recent interest rate cycle and should fall to 4% or lower as a result of rate cuts – second chart.

*To explain this effect, consider a borrower whose monthly payment obligation falls from £800 to £200 because of lower interest rates. An unchanged arrears amount of £800 rises from the equivalent of one month’s payment to four, resulting in the mortgage being included in the three months plus total.

The MPC voted 8-1 for the cut of half a percentage point in Bank rate earlier this month, with David Blanchflower again dissenting in favour of a full-point move.

The fact that only Blanchflower wanted a larger reduction, despite Inflation Report forecasts showing annual CPI inflation well below target over the medium term, is significant. Most MPC members appear to accept that a further cut in Bank rate would provide little additional stimulus and might even have an adverse economic impact by reducing banks’ earnings and lending capacity. (This argument was made in an earlier post.)

Quantitative action rather than Bank rate cuts must therefore bear the burden of further monetary easing. The surprise here is that the Committee has already instructed the Governor to seek Treasury authority to conduct purchases of gilts and other securities financed by creating new bank reserves. Assuming approval is granted, a decision to begin unsterilized buying is likely to be taken at the next meeting on 5 March.

My MPC-ometer, like the consensus, predicted the half-point February decline. The model is not able to incorporate the diminishing effectiveness of reductions as Bank rate approaches zero so may overestimate the MPC’s inclination to cut further. It currently suggests a quarter-point fall at the March meeting; as always, consumer and business surveys released around the end of the month will be an important influence on the final forecast.

Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs.

The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3.0% in January from a peak of 5.2% last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5.0% to 4.1%. Moreover, this fall is fully explained by a drop in energy price inflation.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual increase in this index declined from 2.8% to 1.9% between September and January but would have risen – to an estimated 3.0% – without the VAT reduction.

The culprit is the officially-sanctioned plunge in the exchange rate and a resulting large rise in non-energy import costs (import prices of manufactured goods climbed 14% in the year to December). Today’s Office for National Statistics release notes upward contributions to annual CPI inflation from a range of categories dependent on foreign suppliers, including games and toys, furniture, household and personal appliances and package holidays.

The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally. Energy effects will ensure a further fall in the headline CPI increase over coming months but the decline may disappoint MPC and consensus expectations and inflation will rebound in early 2010 as VAT and energy benefits reverse.

The plunge in the exchange rate has worsened the credit crunch by damaging banks’ capital ratios.

In its October Financial Stability Report, the Bank of England estimated that the tier 1 ratios of Barclays, Lloyds TSB and HBOS would stand at over 11%, 12.1% and 12.0% respectively after last autumn’s capital-raising. However, Barclays recently reported a ratio of only 9.7% at the end of 2008 while Lloyds HBOS has indicated a group outturn “in excess of 9%”. These levels are well above the Financial Services Authority’s minimum of 6-7% but imply a much smaller cushion than previously thought.

The declines appear to be due less to losses than strong growth in risk-weighted assets – the denominator of the tier 1 ratio. This growth in turn reflects both higher risk weightings – caused by the unhelpful pro-cyclicality of Basel Accord rules – and the decline in the exchange rate, which has boosted the sterling value of foreign-currency assets. (The sensitivity of capital ratios to currency movements reflects a mismatch between capital – held mostly in sterling – and assets, which contain a large foreign element.)

Current UK exchange rate policy is reminiscent of Japan in the late 1990s. With US approval, the Japanese authorities engineered a large fall in the yen in an effort to reflate the economy via net exports. However, this worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets. The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports.