Uncharted Territory

February 20, 2008

The Darling Buds of Fannie Mae

Filed under: Economics, Housing market, Northern Rock — Tim Joslin @ 10:32 am

Don’t worry, the point of the title will be revealed!

It’s amazing how emotion so often overrules reason. This is how we’ve made the biofuel blunder. Mark Lynas, bless his organic cotton socks, gloats that “the environmentalists” were right about biofuels. That’s really funny, Mark, because I thought the problem was that too many “environmentalists” thought biofuels were a good idea. Their emotions gave them the wrong answer. The greens aren’t really green. My emotions – including a visceral horror at the idea of destroying nature to fuel cars – and presumably yours, are supported by reason.

But when we come to a case like the Northern Rock affair, reason barely has a chance. Because the reds aren’t really red. They don’t believe in fairness. No, much more important to them is the comforting illusion that “the people” are in control (we’ll just blip over the last 80 years of European history, shall we?). So my breakfast is tainted with bile as I read from Volks Comrade Hutton that:

“The free-market fundamentalist proposition that the market is the spontaneous natural condition and any form of public interaction is therefore unnatural – which feeds Northern Rock shareholders’ extraordinary sense of entitlement – is to misdescribe reality.”

And there’s me and Rousseau thinking the state was a necessary evil! Thanks for putting us right, Will! I’m a bit confused though: why isn’t “the market” a “form of public interaction”?

But what I really object to in Hutton’s piece is the throwaway: “Northern Rock shareholders’ extraordinary sense of entitlement”. Here Hutton reveals his true colours. It’s not about fairness at all. He wants to create a public space where he can project his emotions. A dictatorship of the commentariat, perhaps. No, if by “red” we mean greater equality, the reds aren’t red. They just want to return to the ways of organising things that led to rivers of blood in the 20th century. Maybe it’s in that sense that they are “red”.

The problem with the Northern Rock affair is that the State has become involved far too deeply. Brown and Darling (while Mervyn King sits back and breathes a sigh of relief) have been able to use public indignation at the “taxpayer” taking risks over NR to create a smokescreen around the UK’s mishandling of the liquidity crisis – which might otherwise have had the dire consequence of loss of public support for, shock, horror, the independence of sterling itself – and at the same time expropriate for the State assets that are possibly worth several billions. Nationalising Northern Rock is less about the economic needs of the British people (who will be worse off as a result of this sorry little affair because people will be less willing in future to take the risk of lending money to them, with the result that the capital they need to borrow to buy their homes will cost them more), it’s more about their emotional needs. The NR shareholders have become (inappropriate) scapegoats for those bad feelings about excesses in the City. Rather than create a fairer society (by, for example, raising the minimum wage) we’ll all try to feel a little bit better, shall we?

Maybe reason can get us a little further. Let’s try to analyse the situation. Here’s what Larry Elliott wrote in yesterday’s Guardian:

“The bank has a good mortgage book and, given the tendency of house prices in Britain to rise, there is no reason why the taxpayer should lose out. … Once ministers decided against administration, nationalisation was always preferable to a lopsided public-private option that, as illustrated by the £2bn Metronet bail-out, would have meant nationalising the risk and privatising the profits.”

A poor analogy as NR is not being nationalised because it has negative net assets. It’s being nationalised because… um, why exactly is it being nationalised?

It’s always a good idea to ask the right question. In this case , let’s ask who is better off after nationalisation, compared to a private sector solution, and who is worse off? Who is taking what risks in each scenario? The private sector options were that shareholders and/or new investors would put in more cash – at least £700m. The Government would receive a punitive interest rate on the Bank of England loan, an upfront arrangement fee of £200m (maybe more) and a later share in profits of a similar amount (the amount of this the Gov’t wanted was the deal-breaker). Conditions would presumably include no dividends until after the Bank’s loan is paid and Gov’t oversight of the business at least until then to prevent any undue risk-taking. In other words NR would be run in a similar way whether it was nationalised or not.

There are actually 4 cases to consider: nationalisation and continued private ownership on one axis and making money and losing money on the other.

If the nationalised bank loses money the taxpayer will lose the full amount lost, if it makes money the taxpayer will gain the full amount gained. Presumably Gordo is happy to take this risk, which implies he wouldn’t have been taking a huge risk had he allowed the private sector solution. Oh, what tangled webs we weave… But let’s go on.

I must have missed a small detail. Aha! Here it is. After nationalisation the taxpayer may have confiscated all the shareholders’ funds. Let’s say these are worth £2bn (about £4 a share). If it does manage this, the taxpayer will only lose out if the bank loses more than £2bn. If legal action goes against the Gov’t, though, (and I so hope it does!), the shareholders will get their £2bn back and the taxpayer will be carrying all the risk. I hope you’re happy with that, Mr Indignant. Nationalisation only makes sense, it seems, if the Government is able to expropriate shareholders’ funds. Hmm. But let’s just check that conclusion by looking at the counterfactual set of possibilities.

If the bank had remained private, though, and lost money, the shareholders would lose out first. Let’s say the shareholders put in £700m now and another £800m as the mortgage market worsens over the next couple of years. They already have £2bn, we’re assuming. The bank would have to lose £3.5bn before the taxpayer loses out. Hmm, do you suppose the taxpayer is taking more risk, or less, than if the bank is nationalised?

What if the bank makes money as a private entity? Well, the shareholders would make a profit, but only after they’ve paid to the “taxpayer”:

  • say 3 years times 1% above market rate on a loan of £25bn, which comes to £750m;*
  • an estimated £200m arrangement fee;
  • another £200m from profits.

That is, well over £1bn. [*Postscript 23/2/08: Oops. Actually, I’ve seriously overstated the case. The arrangement fee was for converting the debt to bonds to be sold a commercial rate, and putting a Gov’t guarantee on them. At this point, punitive interest would no longer be payable on the debt. But the basic point stands – the taxpayer would have got a few hundred mill under the private sector solution, which it won’t receive now it’s nationalised the bank].

So the “taxpayer” is taking a lot more risk by nationalising the bank than not, but may potentially make more profit, as long as it isn’t tripped up by the “independent” valuer or in subsequent court cases.

These are the two assumptions underlying the Gov’t’s decision to nationalise Northern Rock:

  1. They’re with Larry when he says that: “The bank has a good mortgage book and, given the tendency of house prices in Britain to rise, there is no reason why the taxpayer should lose out.” i.e. they think it’s unlikely they’ll be in that loss-making scenario.
  2. They believe they’ll get the shares in the bank for nothing, or virtually nothing.

Now, I think these two assumptions are actually incompatible. By the time legal avenues are exhausted, the courts will know whether the bank is going to lose or make money in the longer term, and therefore whether the shareholders’ assets were worth anything.

With a bit of luck the courts may also judge that a large part of NR’s predicament has been caused by Gov’t bungling – they should have put liquidity into the markets before NR failed, etc. (bit of a litany, here). The Government is attempting to confiscate assets, pure and simple. Perhaps this is the sort of world Hutton and Elliott want to see. See you in Hell, boys!

There are 2 other reasons why the Government has gone for nationalisation:

  • populism, since they’ve done nothing to dispel the popular notion that the taxpayer is actually spending money “that could be used to pay for hospitals”, etc.
  • control: Brown is a control freak and when it comes to the crunch he wants to keep his cards where he can see them. He’s terrified by the thought of being a hostage to fortunes at Northern Rock in the run-up to the next election. This way, he can put any bad news off until he’s gone to the polls.

Before I finish, I ask myself why else should NR’s shareholders’ have “an extraordinary sense of entitlement” as Will puts it? Well, Will, perhaps it’s because everyone else is exhibiting “an extraordinary sense of entitlement”. Let’s forgive “the taxpayer” who is being kept in a state of appalling ignorance. What about the depositors in NR, whose panic is one of the causes of the present imbroglio? They lent people money to buy houses and then suddenly decided en masse to call in the loan. Nice. The depositors who put their personal interest above that of the bank and the community that rely on it, and above the fellow depositors behind them in the queue, were at the time entitled to £2,000 and then 90% up to £35,000 if the bank ran out of money before they got to the front of the queue. “ffs didn’t they know the risks they deserve nothing more”, to quote (adapted) some graffiti on a Downing Street petition. But, of course, the depositors are Darling’s darlings and the rules can be changed overnight, so that these people don’t have to worry about anyone other than themselves. Just take all your money out, says Darling, don’t worry about everyone else! It’s a wonderful life for some, isn’t it! Will, perhaps you can explain, so we’re all clear, whether this the sort of support for self-interested behaviour is the kind of “public interaction” you’d like to see more of?

Here’s a disaster scenario “Dangerous” Darling is leading us into, in his desire to pander to the public. He’s now going to get the “taxpayer” to guarantee all deposits in the UK, up to say £100,000. So, you and I may as well take the highest interest rate we can find anywhere. Don’t worry about whether the bank might go bust! And he’s encouraging banks and building societies to offer 25 year mortgages, so Mr Diddums doesn’t need to worry so much about his £200,000 mortgage. Oh, and I nearly forgot, funding from retail deposits is doubleplusgood, funding from international capital markets is doubleplusungood. Let’s roll on to say 2020, and house prices have been kept up by Darling’s new babies, those jolly reassuring 25 year fixed rate mortgages! (Because that’s what it’s all about, really – the electorate will not easily forgive a Gov’t that they think has caused a drop in the value of their homes. Remember Major!). But back to the story. By 2020 inflation is rearing it’s head again, and, unlike in the “Panic of 2007-8”, it fails to recede. This time the world really is running out of oil and land to grow food on. The base rate climbs to 10% and keeps on going up. Retail interest rates reach 15%. House prices really do crash to something like the cost of building a house (which is where they should be in the long-run), and keep on going down… (supply and demand, you know). And all those building societies have made 25 year loans at 7%, but are having to compete by paying more than twice that for the cash they have lent… Depositors don’t care, they can just keep shopping around for the best rate for their AAA rated £100,000. So, paying out 15%, taking in 7.5%… What do you think is going to happen? Perhaps Mr Indignant, the taxpayer, will not remember his Darling quite so fondly when he has to pick up the tab for all those failing building societies.

Btw my little story is not entirely dissimilar to what happened during the Savings and Loans crisis in the US in the 1980s and 1990s (but with its causes back in the 1970s). It was a financial disaster that makes the Northern Rock fiasco seem like losing a fiver on the Grand National. And when it happens, what we’ll need are something like the romantically named Fannie Mae and Freddie Mac in the US.

But perhaps Will thinks this would all be a good thing. Perhaps in Will-world the public should take the risk for those lucky enough to have £10,000s in the building society and lucky enough to be able to take out a hefty 25 year mortgage. The bigger the mortgage, the more risk we’ll all take on on their behalf, eh, Will?

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3 Comments »

  1. […] me to think a little more deeply about how the bank will be run after nationalisation.  In a previous post, I suggested that “NR would be run in a similar way whether it was nationalised or […]

    Pingback by A “wunch” of bankers « Uncharted Territory — February 23, 2008 @ 3:20 pm

  2. […] on our behalf suggests it’s systemic problems we should be worried about.  I’ve already mentioned how BS balance sheets could deteriorate if 25 year mortgages become faddish (remember endowment […]

    Pingback by BS b.s.? « Uncharted Territory — February 25, 2008 @ 4:25 pm

  3. […] were owned by institutions and individuals who saw the companies as recovery prospects.  As I noted before, (more than once, or even twice, it seems) at least some of these investors were prepared to put […]

    Pingback by More on the immorality and hazard of policy based on moral hazard « Uncharted Territory — March 26, 2008 @ 3:27 pm


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