Uncharted Territory

October 21, 2009

The Great Crunch: It’ll happen again because we’ve gone soft on bankruptcy (Part 1)

Filed under: Credit crisis, Economics, Housing market, Minimum wage, Northern Rock, Regulation — Tim Joslin @ 10:55 am

The debate as to what to do to try to prevent a repeat of what I like to term the Great Crunch absolutely amazes me. There is virtually no analysis of what actually happened; instead the debate is dominated, it seems, by pre-existing prejudices. The whole financial crisis was caused by a cascade of bankruptcies, starting with so-called sub-prime lenders in the US and ending with Lehman’s failure, after which the authorities finally took decisive action.

Let’s start first with the least of the culprits. I worked myself into a bit of a lather late yesterday after reading a column by Vince Cable in the Times – see my comment there at 10:23pm on 20/10/09.

Why oh why do we persist in trying to devise policies to save people from themselves? Drugs? Ban them! Totally ineffective, in fact counterproductive, in fact worse than counterproductive in that the policy creates worse problems than those it doesn’t solve.

What we should be doing, in general, is equipping people to save themselves from themselves.

Tightening regulation of lending, it seems to me, is part of a paternalistic infantilising trend in our doomed Western societies that has been repeatedly shown to fail. It’s the wrong design principle, as was pointed out – to make a leftfield connection – in a thoughtful letter from Merrelyn Emery in last week’s New Scientist. Merrelyn notes “[t]he unstable nature of DP1 [hierarchical] systems” in comparison to “DP2” type systems “in which adaptation depends on regulatory systems built into the operational parts of the system itself”. Quite so.

Back to Vince in the Times. Vince, it seems, very much approves of the regulatory proposals announced yesterday by the FSA’s Hector Sants. If there is a shred of understanding in my grasp of recent history, the FSA, of course, has shown itself to be entirely incompetent in enforcing the regulations it already imposes, so one has to imagine that tighter checks on mortgage borrowers will also be ineffectual.

The whole proposition makes absolutely no sense. It rests on no sound analysis. Here’s a more subtle way in which it will fail. Mortgage defaults in the UK are an inevitable result of this or any other recession. They arise because mortgages are a 25 year commitment, a long-term loan, whereas income is paid on a short-term basis. Mortgagees are no different to banks which lend long-term and borrow short-term. Proving your income at the time you take out a mortgage has minimal bearing on your ability to pay the mortgage over the long-term. As the economy now comes out of recession the housing market will pick up. Happy days will be here again, and the buyers will be once more out in force. Inevitably a proportion of them will lose their jobs in the next recession.

In actual fact, banks diversify their risk when they offer mortgages to those with sources of income other than regular employment. We know that employees will be made redundant in the next recession. Many some of those with other forms of income may well continue to be able to pay their debts.

If we’re to put the onus on banks the problem never ends: next we’ll be asking banks to evaluate the security of mortgagees’ employment. Then we’ll be requiring them to ensure mortgagees have access to funds to pay the mortgage if they lose their job and so on…

Hey why not take the same approach in other areas of life? Why not, for example, mandate bar staff to ensure customers can actually afford to buy the booze they want? Oh, sorry, our paternalistic policy for drink is to put the price up. That’s odd, because in earlier eras the problem with heavy drinkers was not so much that they destroyed their health or caused a nuisance in the town centre. Rather it was that they destroyed the family finances.

No, no no! What’s needed is tough love. People need to take responsibility for their own finances. What sort of policies would this imply?

Well, first, it might be an idea to tell people that the economy experiences ups and downs. Companies fail. Even in the public sector people can be laid off. So those planning to take on a mortgage need to judge what would happen if their personal circumstances changed. Do they have sufficient savings to tide themselves over? Could a couple pay a mortgage on one salary?

Second, we need to look at the balance between greed and fear in the housing market. When the market is rising people pile in. And I don’t blame them. This time round we’ve sent the message that there’s not much to be afraid of. The dominant narrative consumed and constructed by those who drove house prices to unsustainable levels is characterised by indignation against the banks rather than by remorse, by scapegoating rather than by learning. And there’s more: many have been saved by low Standard Variable Rates (SVRs). There’ve been few stories of borrowers being pursued for their debts. Compared to the 1990s we now have Individual Voluntary Agreements (IVAs) and one year rather than 3 year bankruptcy arrangements. As I pointed out a couple of weeks ago, we’re even allowing people to take banks to court over perfectly clear mortgage terms.

In actual fact, as the ultimate inditement of complete regulatory incompetence, I can’t help observing that right now I’m sure I’m not alone in having just taken on board the lesson that I should have run with the herd and taken on a mortgage when I had the chance! Regardless of house prices.

My recommendations are completely opposed to current mainstream thinking. But perhaps that’s because I’m looking at what actually happened. The whole financial crisis was caused by a cascade of bankruptcies, starting with so-called sub-prime lenders in the US. Why Northern Rock was left floundering when it was, and ultimately nationalised is still completely beyond me, but A&L, B&B and HBoS failed to a greater or lesser extent because of fears about defaults in the UK housing market. NR would presumably have been in trouble later on had the odious Mervyn King not decided to “make an example” of its reliance on money-market funding. The cascade continued as even the soundest banks were stressed by a secondary source of losses: the recession arising from the original financial crisis.

So to snuff out the next one, why don’t we start at the beginning of the cascade by increasing the value of these dodgy mortgage debts?

Here’s my recommendation: treat debts from bankruptcy in a similar way to the UK’s student loans. That is, attempt to collect them directly through a levy on income (above a subsistence threshold) until they are repaid or for life and beyond. In effect, a bankrupt would pay higher levels of tax in the future. (I should add, that the level of interest would be low on bankruptcy debts, because the might of the state is to be employed to collect them). On death, any estate would first be used to pay off bankruptcy debts. The whole concept of bankruptcy needs to be rethought. We need to consider the general interest. At the moment, every time someone goes bankrupt, others must pay, increasing the risk that they too will get into financial difficulty. Why on Earth do we retain the archaic notion that bankruptcy can be “discharged”?

The effect on the bankruptcy cascade would be to increase the value of debts. Those sub-prime mortgage-backed securities (MBSs) would have been worth more than they were when the housing bubble burst.

That’s the stick. But we don’t want to be using it all the time. We also need policies so that the risk of bankruptcy is minimised:
– we need stable house prices;
– we need to hold house prices at the low end at an affordable level for those on the lowest incomes: in short, we need to raise the minimum wage and keep it in line with house prices.

February 19, 2009

Dodgy Ogi?

Filed under: Credit crisis, Economics, Northern Rock, Reflections — Tim Joslin @ 10:18 am

I knew it was too good to be true.  I bookmarked an FT story late yesterday that at the time was titled “Panicked Antiguans rush to withdraw funds”, but is now headed “Storm waves crash on tiny Caribbean island”. The article noted that:

“…a Swiss newspaper reported that former Swiss President Adolf Ogi will be immediately stepping down from the advisory board of the advisory board of the Stanford Financial Group. ‘I don’t want to have anything to do with something that could be dodgy,’ Mr Ogi told the Cash newspaper on Wednesday.”

I know I’m not imagining things because (among others) the FT’s own search engine throws up the original article title and text.  The quote appears all over the internet too.

What amused me was that yesterday I followed a link to the original story which was in German.  This one probably.  What Adolf Ogi appears to have actually said was:

Ich will nicht mit etwas zu tun haben, das unsauber sein könnte.”

Now, despite the efforts of Mr Smith, my German teacher, my knowledge of the language (let alone Swiss German) is fairly rudimentary.  Nevertheless, I suspect that the operative word in the above sentence is “unsauber”.  The English equivalent may well be “unsavoury” and the internet gives a number of other translations for the word, none of which is “dodgy”.

What’s clearly happened, probably at a news agency (Reuters seems to be the source) is the guys have discussed the story.  “‘Ogi’, how do you pronounce that?  As in ‘Oggy, oggy, oggy! Oi, oi, oi!‘?”  “No, mate, rhymes with ‘dodgy’ “.  And the rest is history!

It’s frequently rewarding to read right to the end of articles.  Today, for example, the FT notes that “Gordon Brown took part in transatlantic economic ‘war games’…” and quotes the PM:

“What nobody bargained for was a shock that went right throughout the system internationally and froze the banking system. The regulatory system had designed itself to look at what would happen if an institution failed.”

Interesting.  Because I could swear that I frequently see the odious Alistair Darling on BBC News 24 explaining how Northern Rock, and now HBoS, had deeply flawed business models, because they were too reliant on the money markets rather than trusty old retail deposits.

As I’ve already explained, it should be up to the authorities to keep the money markets open, not individual institutions to plan for them to shut without warning.  Given that large amounts of the money that needs to be lent by Western banks (OK, around $2trn) is owned by the Chinese government, the only way it can get to where it is needed is via the “money markets”.  Does Darling expect the Chinese to send plane-loads of brief-case carrying state functionaries to the UK to deposit the cash in a Nationwide account?

The whole explanation they give for Northern Rock’s failure is pure self-serving deceit by the Government and the regulatory authorities.  Even worse, it may be self-deceit.  If they all believe their own propaganda, then clearly they have become incapable of thinking in straight lines.  Heaven help us!

The Government should just pay the Northern Rock shareholders what the market thought the bank was worth before the start of the Great Crunch in 2007.  And stop screwing the remaining private shareholders in the banks.

February 12, 2009

What’s wrong with money markets?

Filed under: Credit crisis, Economics, Media, Northern Rock — Tim Joslin @ 11:15 am

I’m sure I’ve ranted before about the inadequacies of some of the mainstream media blogs.  Well, I wanted to comment this morning on a piece by Adrian Hamilton in the Independent. The Indy has also run commentaries by Jeremy Warner and by Hamish McRae questioning the wisdom of scapegoating the banks.  There’s still some sanity out there!

Infuriatingly, when I tried to respond to Hamilton’s wise words, I kept getting a “Unicode error” from the Indy’s new interface from LiveJournal.  This happened on IE as well as Firefox.  LJ’s FAQ’s suggested cut and paste text may trigger the problem (Jesus wept! – didn’t they test this?), so I typed my whole effing response in again, risking RSI.  No juice.  What a waste of time.  I recognise I have a very low tolerance for organisational incompetence.  IMHO, Government should in general be ensuring I receive financial compensation for the external costs arising from cost-cutting – particularly on software testing, where I happen to have a modicum of experience. Nevertheless, if the Indy is trying to attract people to their site, perhaps they should tell LJ to sort this, pronto.

Anyway, here’s what I wanted to say:

“Too right. The authorities need to admit their mistakes. Trouble is, unlike at the banks, the culprits are still in situ, so this is difficult. In particular, Mervyn King was arguably negligent in not providing liquidity (cf the ECB) at the start of the crisis – the time of the Northern Rock affair. You write:

You’re right, if we are going to carry on with this counterproductive blame game, we need the Government and authorities to admit the mistakes they made early on in this crisis, such as with Northern Rock right at the outset.”

“And you’re certainly not going to be able to restart it [a functioning market for international financial flows] with a mantra of banks returning to a deposit-loans base that politicians here keep chanting.”

Quite so. It’s daft to insist that direct deposits are a “better” (even morally superior) kind of money (especially as the trade deficit means there can never be enough UK deposits to match UK borrowings!).

Part of the problem is that in order to justify the PR screw-up (why is Peston still a free man?) that led to the run on the Rock, the bank itself has had to take all the blame. Even this week I’ve heard Darling spouting on about NR’s “reckless” business model. The strange thing is, I could have sworn I saw the bank being destroyed by queues of panicking depositors withdrawing their money.

In fact, it was obvious even at the time that if the money markets didn’t recover quickly more banks would fail. The ECB provided liquidity much sooner than did the Bank of England.

The truly scary episode of this crisis was the Icelandic bank collapse. Depositors, such as my local Council, have lost access to large sums of money and may eventually recover only pence in the £. Giving what is in effect a competitive advantage to overseas banks that may refuse to lend (or worse) in the next crisis is rather unfortunate, to say the least. The present strategy to save ourselves relies on the Government being able to dictate to the large UK banks, sorry, make agreements for them to increase lending, in return for certain services. We may not be able to do this twice:


Allowing the Rock to fail also set a precedent that shareholders would be wiped out, making it much more difficult for other banks to raise more private capital.

It took us far too long to arrive at the correct strategy of putting the system on life-support by providing unlimited liquidity and, in return, ordering the banks to recapitalise to restore market confidence in the institutions themselves, and the interbank markets.


You’re right, if we are going to carry on with this counterproductive blame game, we need the Government and authorities to admit the mistakes they made early on in this crisis, such as with Northern Rock right at the outset.”

Damn, forgot WordPress’ blockquote facility doesn’t seem to work properly.  Maybe it has something to do with the huge amounts of HTML that came in when I copy pasted from the Indy’s comment box – it looks rather like Word copy text.

March 26, 2008

More on the immorality and hazard of policy based on moral hazard

Filed under: Economics, Housing market, Moral hazard, Northern Rock — Tim Joslin @ 3:22 pm

They say that the 1930s Depression was a result of a crisis exacerbated by policies to maintain a strong dollar. When the history of the 2000s Crunch comes to be written, they’ll say it was a result of a crisis exacerbated by policies to maintain another sacred cow – the idea of moral hazard. Both policies may have made sense in the 19th century, but not in today’s world.

Let’s first ask ourselves what the priorities of the central bankers should actually be. Well, I’m in the UK and it seems to me that Mervyn King’s overwhelming priority right now should be to slow the impact of the liquidity crisis on asset values, principally housing. Since this is not being done, the danger now is that price declines become self-fuelling, of a housing-market correction turning into a crash. Over the last year or so, I’ve wavered between predicting just a shake-out in the buy to let* (BTL) market in the UK and expecting large house-price declines across the board. The swingometer right now is well into the red of a general crash. And the people who will suffer most are people like the le Roux family reported in Saturday’s Guardian. Working people, IMHO, should be able to afford to buy the house they live in (um, isn’t that why we’re building these houses?). Ensuring they can should be King’s no.1 long-term objective – but more about that some other time.

The point of this post is to clarify my views on moral hazard. I may previously have given the impression that I consider the concept worthless. This is not the case. I consider it a special case of expectations. Expectations matter. If I expect to be robbed in a particular district I won’t go there. Or, say, if I expect a government to expropriate my assets I won’t invest in that country – or will at least demand a higher return for the political risk.

The idea of moral hazard is that we should be wary of behaving in a way that may lead people to think that we will behave the same way in future, when, in fact, we want to give the opposite impression. That is, we should not reward undesirable behaviour. If a child throws a tantrum and is rewarded with sweets to make them stop, then they will learn that next time a screaming fit is a good way to get hold of some more candy. So far, so good, but “punishing” banks – and specifically their shareholders – for becoming illiquid is a bad policy on a number of counts:

1. It is ineffective because it hurts the wrong people. In more ways than one.

a. Subtle differences are important. The devil is always in the detail. For example, it is absolutely critical, as I pointed out a while ago, and as Daniel Gros notes in today’s FT, that US mortgages are “no recourse”. This is not the case in the UK. Northern Rock couldn’t sell or borrow against its mortgages because everyone was in a panic, not because the Rock took on daft risks. The Rock went under because of a US crisis, not a UK one. The institution that has been “punished” is secondary to the crisis, and, here’s another “subtle” distinction, not insolvent, but illiquid. The Rock has been allowed to fail partly because it was relatively small. Larger banks more directly involved in the dodgy lending are likely to survive.

Because we now have an interconnected global market for capital, institutions around the world have been affected by the credit crunch. Central banks should not allow any to fail simply because they are illiquid (at least so long as, prior to a crisis they have met clearly-defined capital ratio and other regulatory requirements). Banks should be allowed to go under only if they are insolvent.

b. But how can you “punish” an institution? Individuals made the decisions that caused the problem. I’m sure many of the Bear staff who’ve (literally, I read) been crying on the stairwells were not involved in buying CDOs based on sub-prime mortgages.

The shareholders in both Rock and Bear have been (pending legal action) pretty much wiped out. This is unreasonable not just because (as noted above) they have not necessarily invested in a business that has allowed its liabilities to exceed its assets, but also because there is no mechanism in place for them to exert control over management to the extent that they could prevent it running into liquidity difficulties. If the FSA couldn’t do it, how could the Northern Rock shareholders?

And what’s more, the shareholders at the time a bank runs into problems are not the same as those at the time decisions are made. Specifically, in the case of both Rock and Bear, large holdings 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 more capital in to these institutions.

2. Moral hazard based crisis management also has rather serious unintended consequences.

As we already know, in the UK we don’t have “no recourse” mortgages. In fact, Gordon Brown has just created real-life counter-terrorism units – I kid you not, 24 should sue for breach of copyright – to be staffed with real-life Jack Bauers who will no doubt, among their other duties, hunt down people who don’t pay their mortgage. So, a company like HBoS is not going to go bust. But what have we got? Short-selling. Now, there’s nothing wrong with short-selling – as Nils Pratley notes in today’s Guardian – but it’s wrong not just to profit from spreading false rumours, but also if the aim of short-selling is to drive a company out of business. And in the financial sector this is possible if the central banks allow runs to occur. Short-selling can undermine the confidence in an institution and cause investors to make an otherwise irrational decision (given that they lose out by withdrawing funds early). This was a factor in the downfall of Northern Rock, and it seems Bear, as well as in the attack on HBoS last week. Rumours are probably impossible to prevent and in any case, the sight of a falling share price may be enough when everyone is on edge. And if destructive short-sellers are actually rewarded – by, say, the nationalisation of Northern Rock, to take an example at random – why, of course they’ll do it again… Hmm, aren’t we talking about moral hazard?

No, if central banks don’t stand behind institutions – or stand behind them sharpening their knives – then it is inevitable that there will be attempts to force some institutions out of business to make a profit.

Readers will be forgiven at this point for thinking that moral hazard based crisis management is more about an assertion of authority, a demonstration of power, than actually solving the problem. Perhaps central banks don’t want to feel they are becoming just another market participant in the global market-place. And perhaps they are playing as well to the mainstream media, who – as is a recurring theme on this blog – consider themselves now to be the conscience of our society, ever ready to allow subjective value judgements to take priority over cold rational, objective decision-making. Maybe I’m being too harsh. I’m sure that ultimately the problem is that people want to read exciting stories of good and evil, not abstruse analysis of systemic failures! JPM good, Bear bad? Yeah, right.

3. Moral hazard based crisis management is an obstacle to fixing the real problem.

Citibank has pointed this out. “They [the BoE] still seem to be concerned about moral hazard, but we are long past that. It is not a question of bailing out the City. We’re faced with the threat of unnecessary damage to the real economy,” say Citi. Exactly right.

But here’s one response: “Isn’t this the bank that has already written off in excess of $20bn, or thereabouts? Doesn’t that mean, by simple rule of thumb, at a 5% Tier 1 capital requirement, this bank has just had to withdraw up to $400bn from the credit markets?”

This commenter has answered his own question. We read that credit markets are seized up, but that US Treasurys are flying. Why? Because the banks have had to write down capital. They can’t therefore lend out deposits without screwing up their capital ratios. But what they can do is lend it to the US Gov’t (or UK for sterling) by buying gilts because then they effectively hold cash. The inflated price of Treasuries tells us, I suggest, that there are plenty of deposits – whether retail or money-market – in the system (cash has to be put somewhere and it’s generally not under the mattress these days), but not enough shareholders’ capital to cover the perceived default risk – or more likely the liquidity risk – of investing it either in mortgages or existing debts, however low risk and profitable they might be. That is, if I find a stash of cash in the attic, and deposit it in my bank, it won’t allow them to write a mortgage for someone else, however low a risk they might be, because this set of transactions would increase the risk of all the mortgages on their books (and no-one will buy mortgages off them). On the other hand, if I suddenly discover I have some money in a bank account, withdraw it, and invest it in new shares in the same bank, then the bank would be able to issue more mortgages far in excess of the amount of money I have invested, because I have invested some more money in covering the risk associated with those mortgages.

I stress that banks can’t lend because they are worried not just about default risks, but also about liquidity risk (otherwise the price of debt would, I suggest, have found a floor by now), that is, to put it bluntly, by the risk of a bank run. Because the central banks (OK at least the Fed and the BoE) have not drawn a line in the sand, no bank is safe from becoming the next Northern Rock or Bear. So the markets are seized up, I suggest, as a direct result of moral hazard driven crisis management. I hope everyone feels better that the “greedy bankers” have been punished (and here’s silly me thinking that the way to deal with inequality is by policies to deal with inequality, not by destroying institutions that have taken many decades to create, reducing competition, and thereby making banking services more expensive for everyone in the future, allowing the surviving bankers to pay themselves even more…).

Now, the problem is not going to resolve itself until we get more capital into the banking system. Since the sovereign wealth funds may not do this, I suggest the banks make rights issues.

Unfortunately, thanks to moral hazard madness, for a bank to suddenly announce a rights issue would be a sign of weakness, and they’d be torn apart by the wolves.

Ergo, the correct central bank policy is to take the illiquid assets onto their books, albeit at a penalty rate, committing to rolling the facility over for (say) 6 months. But, I’m a taxpayer, thanks very much, not in the mortgage business, so the quid pro quo must be that the central banks make the banks commit to substantial rights issues over that 6 month period. At the end of it, they’ll have the capital they need to take the assets back off the central banks and start trading amongst themselves.

It’s very simple. If a huge hole gets blown in the capital base of the world’s banking system then it’s got to be filled in again. Blathering about moral hazard does not achieve this.

4. Moral hazard crisis management is a poor substitute for effective long-term expectation setting.

If setting expectations is going to work – and I agree that it is necessary – then it has to be done on a deep, long-term basis. It has to be drilled into the nation’s psyche over a long period of time.

Just punishing almost at random a few managers, employees and shareholders – most of whom simply happen to be in the wrong place at the wrong time – will not be effective. It will simply leave these people feeling unfairly treated and aggrieved. Maybe they’ll simply invest their time and money in some other sector of the economy.

The sort of expectation it might be worth setting over time is that you have to pay your debts. This would have helped prevent the US housing meltdown spilling over into the whole global economy. Heck, it might even have helped prevent the bubble developing, since, at the margin, a few people might have questioned whether they really could afford the debt they were taking on. Clearly, though, no-one is ever going to be able to sell “no recourse” mortgages on the open market ever again.

Hmm, maybe we shouldn’t say never! This is the problem with moral hazard based policies. Those who are punished essentially leave the game. Those who profit (e.g. the banks that survive) are re-affirmed. JPM good, Bear bad. Yeah, right. And we end up repeating the same mistakes in the next cycle, because no-one’s left to remember the lesson.

5. An underlying cause of instability is the propensity of housing markets to develop bubbles. A moral hazard based approach will not prevent this, since it is not irrational to participate in a bubble (as I said before). Policies are needed to stop prices rising too steeply.

So the underlying cause is the fault of the regulatory authorities.

And their response has made the crisis worse.

Good work guys. But you’re right about one thing. It really is time to put those thinking caps on. This is starting to get a bit irritating for the rest of us.

* Postscript: I meant to say why BTL “investors” deserve to be hunted down by Jack Bauer. They don’t have the excuse of simply wanting somewhere to live, but nevertheless made reckless bets that house prices would continue to rise. They could make no money any other way than by capital gain. The point is that their market was tenants who couldn’t afford to buy property (at first it was people renting for convenience…). How, pray tell, can a rational investor expect tenants to pay the mortgage on a property they can’t afford to pay the mortgage for (otherwise they’d have bought it) and cover agency fees in order to provide the “investor” with a profit? Unbelievable.

March 24, 2008

Northern Rock nonsense: deconstructing demonisation

Filed under: Economics, Housing market, Media, Northern Rock — Tim Joslin @ 5:30 pm

OK, I know I said I wasn’t going to write any more about the Rock.

But this story in Saturday’s Guardian Money section has been bothering me all weekend.

I read the Guardian because, like at least some of the people who write it, I believe in a fairer world, with a great deal less inequality. Maybe it’s incipient middle-age, but it’s becoming increasingly apparent to me that, whereas I live in a world where the economy is based on people buying and selling goods and services, in short, on markets, this is not the case on Planet Guardian. Yes, across vast distances of time and space, in this strange and wonderful world, under the rose-tinted light of a gentle star, people seriously believe that if we vote for the right people they’ll create a fairer society by willpower alone. Nevertheless, I continue to believe I share core values with the institution that produces the newspaper – such as a belief in objectivity. This conviction is still being sorely tried over Northern Rock, although the newspaper’s triumphalism that accompanied the nationalisation of the bank – and the attempted expropriation of the assets of the shareholders – was mercifully short-lived. But it still seems that editorial policy is – in common with the other papers – to demonise Northern Rock.

I was very interested to read “The families who bear the brunt” on Saturday to get a feel as to where the credit crunch is leading. And it’s not pretty.

But it’s not purely NR’s fault. The article doesn’t say how typical the le Roux family are of NR borrowers, nor whether NR have a higher proportion of customers in difficulty than do other lenders. But let’s let this pass. This is a human-interest story in a newspaper, not a peer-reviewed academic paper in an economics journal.

I’ll also ignore the way Northern Rock is referred to ad nauseam throughout the piece, which could otherwise have been presented as an example of a problem no doubt affecting many borrowers with many different lenders. The paper needs a hook for the story. And it would attract fewer readers if the strapline was: “They are trapped in a Bath Building Society mortgage…”

But what I can’t ignore is the apparent spin put on the story itself. First, we are told that:

“The crux of the problem is that they [les Roux] owe nearly £170,000 to Northern Rock, but their home is only worth an estimated £152,000.”

But (OK, OK, I can see I’ve got “but”ter typing fingers today!) when we read the article carefully, we see that:

“They also have a £15,000 secured loan on the house from a company called Welcome Finance that is costing them a further £307 a month.” [My emphasis].

This, it seems to me, is the crux of their problem.

Without this loan they would just need to roll over a mortgage – £139,630 – secured on a house valued at £152,000. Lenders look at two things: the security on a loan and the customer’s ability to pay back the loan. Surely, in the case of the le Roux family, they’d have a sporting chance of remortgaging, were it not for the Welcome Finance loan. They need about 92%. Heck, if they had a car they could trade down they ought to be able to get it down to 90%. But who’s going to touch them with the extra 15 grand secured on the house? Lenders will be put off by the Welcome Finance loan secured on the property much more than they will be by the unsecured NR loan.

Then there’s the ability to pay. In addition to the mortgage, les Roux have not one but two chunky debts. And whilst a lot of borrowers will have the extra unsecured loan with NR or any of the lenders that have offered similar deals, it seems to me the killer is the Welcome Finance loan – an extra £307 a month they have to find. In comparison, the NR unsecured loan would cost les Roux £390 a month if they take their mortgage to another lender.

And the NR loan at least is not at a punitive rate. A box in the article is headed: “The cost of quitting? A massive 15.59%”. I hardly think 15.59% interest on an unsecured loan is excessive (try borrowing on a credit card). At random, there was an ad from Jessops, the camera chain, in the same edition of the Guardian. Jessops’ buy now, pay later deal charges a lot more than 15.59% for credit (though just a relatively small fee if you only need to borrow for less than 12 months). And is 15.59% really a lot more than les Roux are paying on their Welcome Finance loan? Their repayment to Welcome of £307 a month is £3684 a year. If £1500 of this is repayment of capital (i.e. we assume it’s a 5 year loan with constant payments and that the average balance outstanding is half the principal), this works out at a rate of approximately 14.4%.* But (oops, sorry) maybe it’s a 10 year loan (at about 19.5%) since, if we look at the Welcome Finance website, they’re currently offering secured loans from 22.1% or 19.9% for cars (of course, these rates could be a lot higher than those on offer last summer, because of the credit crunch). Welcome’s unsecured loans are a bargain at 64.1% (sic(k)).

So the interesting questions in the Guardian’s human interest story (perhaps we can have another exciting instalment next week) are around the Welcome Finance loan:

  • how did les Roux come to have this additional debt?
  • did it already exist when “[t]hey borrowed £169,630 from Northern Rock last summer“? [my emphasis – actually they changed the security on the debt by moving house]
  • if so, did they tell NR about it?
  • if not, how come they’ve gone further into debt? If I was lending money secured on a property I’d want to know about (and probably veto) any other debt to be secured on the property. Did NR know about the Welcome debt?
  • was the Welcome Finance loan an attempt to keep paying the NR mortgage les Roux could never afford to pay in the first place?
  • is the Welcome Finance loan anything to do with why NR “is not offering them anything else in terms of deals” and that “they would be better off taking their business elsewhere”? Would NR have offered to roll over their mortgage were it not for the Welcome debt?

There’s a lot about this story that is puzzling. But (doh!) my point is this: I get the distinct impression that the Guardian is still – consciously or unconsciously – trying to paint as bad a picture as possible of NR.

The psychologists will eventually have a field day with all this. This is the situation: we now all feel bad because we’ve all been borrowing too much and gloating over our rising house-prices. Now the chickens have come home to roost. So what we’re doing is bundling up all those bad feelings (the shrinks would say) and loading them onto the banks, and specifically the fattest scapegoat that makes the best sacrificial offering – aka Northern Rock. How do I know this? Amazing what you pick up in an MBA these days!

The point about scapegoating is that it does not necessarily – and usually doesn’t – address the root causes of a problem. I’m told that ancient South American civilisations would regularly sacrifice their priests when droughts came. Maybe there were a few fewer mouths to feed, but the value of this behaviour in preventing or even predicting the next drought was approximately nil. If only they’d known about the El Nino climate phenomenon! (Actually, there’s reasonable evidence that some farmers in the region are able to predict an impending El Nino by changes in cloud patterns. Maybe a few priests were on the verge of spotting this when they were slaughtered…).

For some reason I thought the Guardian would be immune from the scapegoating syndrome. I now ask myself why I thought this. How could I be so wrong? I guess it’s because I thought it was in the Guardian’s DNA to be against prejudice of any kind. They don’t even have “actresses” any more on Planet Guardian – we all have to work out some other way whether the “actors” we’re reading about are male or female. A small price worth paying for whatever it is we’re trying to achieve, of course. They have principles at the Guardian. Heck, they’re not even prejudiced against Old Etonians.

* Postscript: this method is highly dubious for the hypothetical 5 year loan – it’s too few years to make the simplifying assumption of even payment of principal. A spreadsheet suggests that paying £3684 a year for 5 years would in fact pay off £15,000 lent at about 7% which is unlikely. Over about 7 years would come in around 15% and 10 years around 20% as I suggest. Incidentally, the £390pcm doesn’t pay off the NR unsecured loan – at 15.59% this just covers the interest.

March 20, 2008

How to play dominoes – FT rules

Filed under: Economics, Media, Northern Rock, Rights issues — Tim Joslin @ 9:12 am

Well, it is very encouraging after yesterday’s post to find Gillian Tett in the FT explaining about sacrificial Bears being led to the slaughter. Gillian asks: “So will this blood-letting work?”. Well, my readers will already know the answer.

But another learned piece in today’s FT also tries to answer the question. Anil Kashyap and Hyun Song Shin agree with me that “recapitalising the banks should be the priority”. Trouble is they don’t understand the existing shareholders either. Apparently these gangsters who are “the very shareholders who allowed their banks to create the current mess, which now threatens to cripple the financial system… will no doubt resist dilution”. Kashyap and Shin note that:

“The quickest solution is to identify some buyers before the next spiral down. One obvious set of buyers are the Middle Eastern sovereign wealth funds. They have stepped up once and were burnt on their first wave of investments.”

It seems they want to sell Wall Street to the sovereign funds. How they intend to make this happen is not entirely clear.

The whole point is that these outsiders may not buy. Probably they are already not buying, as at least some banks are most likely trawling the Middle East and China for investment already. But the sovereign fund managers have now seen NR and Bear. Right now, none are going to put a few $Bns into a bank that actually needs it, I suspect. The risk of being wiped out subsequently in a fire-sale is just too high. No, as I said yesterday, the existing shareholders have the best incentive to keep their banks afloat.

I suggest Merv has a gentle nudge and gets the UK banks to start announcing rights issues, starting with one that is obviously strong – e.g. Lloyds TSB or HSBC could announce they were raising a few £bill to “pursue acquisition and other investment opportunities and strengthen their capital base” – so that the move is seen as a sign of strength, not weakness.

It might help if a few FT writers stopped demonising shareholders. The shareholders in the world’s major banks are all of us – through pensions and mutual funds; blameless employees (and ex-employees, such as yours truly, and I’m lilywhite, I can tell you!) – those delivering the internal mail are often keenest to join staff share purchase schemes, etc etc. I find this attitude bizarre. We’re not talking about Division 2 football clubs here.

I also meant to mention yesterday that there is another unintended consequence of the scapegoating going on at the moment. Size is becoming a significant determinant of banks’ chance of survival. If you don’t like the fat cats in the City, then it might be worth bearing in mind that the bigger and fewer the institutions, the bigger and fatter the fat cats will get. Bigger pots of cash with cream on top to skim off and less competition to keep them honest. And more potential for bigger errors to blow bigger holes in the finances of the banking system in the next crisis. Diversity is one way to defend against this.

I also meant to mention I liked this piece by Stephen King in the Indy, which makes some recommendations to address the liquidity squeeze part of the problem (a second order effect, which we appear to be thinking is a first order effect, incidentally). The “mark to market” accounting is daft.* If done over a short period at a time, it could value all bank’s assets at the firesale prices achieved by one or two distressed market participants. The market price has to be averaged over a significant period – a year or more – IMHOP. The job of the authorities should be to slow market adjustments. This – and policy based on market hazard, Merv – speeds them up instead. Foot, meet gun.

I’d add to King’s list though, another regulatory change. Banks’ liquidity (capital ratio) requirements must take account of off-balance sheet vehicles, that are either a) vital to their business model (e.g. NR and Granite) or b) have to be taken onto their balance-sheet in extremis for reputational reasons (several examples). In other words, such vehicles should be on banks balance-sheets for capital ratio purposes.

And of course we shouldn’t forget John Gieve’s regulatory reform, which makes a great deal of sense.

*Postscript: More on mark to market in the FT here.

March 19, 2008

How to play dominoes

Filed under: Economics, Film, Media, Northern Rock, Rights issues — Tim Joslin @ 5:21 pm

I keep getting an error (good old Beeb) when I try to post on Robert Peston’s blog. What I wanted to say was:

“Rob, Why does the link to this blog entry [Postscript: broken, i.e. story changed – unprofessional by the Beeb, as usual, where’s the audit trail?] refer to a ‘secret bank meeting’? Be careful. Btw, I don’t agree with Robin Bruce that the NR accusations against you are ‘unfair’.”

Here, in my space, rather than Rob’s, I’ll go further. I fail to understand why Peston is receiving awards for the scoop of the year (the NR “emergency” loan). I suggest that we make appropriate laws so that the next reporter that provokes a bank run instead finds themselves “helping with police enquiries”. Laws that will also ensure that the next media organisation that allows this to happen is instead the organisation that has to lay off 1/3 of its staff and whose shareholders are “punished” and executives disgraced.

And now it’s happening all over again with Bear. People who’ve invested their entire working lives into the organisation have been wiped out overnight: “‘My life has been flushed down the drain,’ one senior figure [said]”. Imagine how this must feel, all you so quick to apportion blame. Imagine, Mr King, as you still apparently smugly believe: “…there should be some ‘moral hazard’ in the system and… banks should not expect the central bank to step in to ease their funding crisis.”

I went to a discussion yesterday evening about “money” – the topic being “where does it come from?”, I think. It was quite clear that the average (educated) person has little clue how the financial system works, so perhaps it might be best if I don’t bandy about terms like “liquidity” and “risk” on the assumption that people will be clear what I am trying to say. Let me first try to explain a few points, and maybe convince a few people that “moral hazard” is a bankrupt concept, morally and intellectually.

First point – I know nobody understands money – but let’s nevertheless talk about risk. Who takes the risk when a loan is made, say to buy a house? Well, the answer is it all depends. In some US States, the bank takes all the risk, as I noted before. Yeap, can’t pay the mortgage, just walk away, yippedee doodaa! And this, of course, is the root of the entire global credit crisis.

That may seem a bit odd to those out there who, like me, lay awake night after night in the early ’90s worrying about the negative equity over their heads. No, indeed, ‘cos over here in the UK, we’re tough. Walk away and the banks will hunt you down. In fact, there’s still the occasional story in the papers of court cases from the ’90s crash, only now finally being resolved.

Let’s put it in starker terms. You’ve all been to the movies. I watched “Mean Streets” on DVD the other day. Borrow off the local hoodlum, and it’s you that’s taking the risk, not him.

See what I mean, there are risks to all parties involved in a lending transaction – and, as Scorsese demonstrates in “Mean Streets”, to third parties as well.

For the record, IMHO, the UK system is superior. It is in the general public interest for losses to the banking system, in which we all have a stake, to be minimised. It won’t stop people making mistakes, but it is in the general interest for people who take on debts to pay them back (and IMHO, bankrupts and IVA beneficiaries should have to pay back their debts forever, if necessary, as long as they are earning enough money, in a similar way to student loans, or by having a higher rate of tax).

So, second point, what is a systemic problem? Answer: it’s a problem that affects an entire system. While house prices are rising, all those involved in the mortgage-lending transaction are hunky dory. When prices start to fall, then problems arise for those carrying the risk, which, as I’ve demonstrated, is arbitrary – it depends to a large degree on local circumstances.

One way to contain the problem is for individual home loans to be as isolated from each other as possible. That is, they have to be paid back (i.e. via mortgage indemnity insurance and/or being hunted down by Jack Bauer). The impact on the bank – and the banking system which we all rely on – can only be minimised in that way. This is why I believe the UK system as it operated in the ’90s to be superior. Somehow the Building Societies survived, perhaps against the odds. Who knows what this daft Government will try to do this time, though.

A systemic problem, then, is one affecting a whole system, in the case in point the US housing market and banking system – at first parts of them, and now pretty much the whole caboodle, not to mention much of the rest of the global economy. Whoops.

What we have is a uncontained systemic risk problem. One that we have so far failed to solve.

Third point, let’s introduce another concept: scapegoating. Scapegoating – making one or more people the scapegoat – is a great way to deal with systemic problems. Instead of fixing the system, those involved agree that only some people are wholly to blame for the problems – whether they are in fact solely guilty or not. These people can be stoned, sacrificed or shot depending on societal preferences, or, in the case of financial systems in our civilised modern world, bankrupted and/or disgraced.

Fourth point, scapegoating works best when people can be convinced that it is not in fact scapegoating, but true apportionment of blame. In the modern world, some kind of intellectual justification tends to work best. And this is where the concept of moral hazard comes from. It is at best a bit of fashionable pseudo-science. The idea is that if you bail people out when they run into problems “of their own making” – especially due to risks they’ve taken – then they will repeat the same behaviour.

And that’s why, when Northern Rock ran into difficulty, the people who had bought mortgages from it were forced to sell their houses to pay the bank’s depositors who wanted to withdraw their money. And with everybody selling at once, most people had to sell their homes for less than they bought them for and were hunted down by Jack Bauer… Oh, sorry, that’s not what happened.

No, moral hazard is why Northern Rock’s depositors lost their savings… Oh, sorry…

No, in this case Merv and Gordo decided (while Darling fetched their coffee) to blame Northern Rock’s management and shareholders. That’s right, the intermediary between the lenders (the depositors) and the borrowers (the mortgagees) was deemed solely to blame for the “excesses”. Get rid of them and we don’t have to fix the system. We are not all to blame – we, the depositors, the homebuyers, and most of all those (Merv and Gordo) supposedly overseeing the whole system and responsible for its health, no, we‘re not to blame – so we can blame Adam Applegarth and the Northern Rock shareholders. And we’ll try to regulate the banks even more… and history will repeat itself (with a few twists) in another 10 or 20 years.

Let’s sum up:

  • scapegoating doesn’t solve the problem because it doesn’t fix the system (and in fact makes it more difficult to fix the system, because it implies the cause is understood – it was those wicked people, um, doing their job);
  • moral hazard is a pseudo-intellectual justification for scapegoating.

What might improve matters?

Fifth point, let’s introduce another concept – expectations. It is scientifically proven that people make decisions according to their expectations of the future. Momentum investing (buying assets that are already rising – or falling – in value) is illogical (since the market should already have determined the value of particular assets), but works [I’ll supply a link if I find it].

The moral hazard concept is insidious, because it is partly true – it is based on not setting false expectations. The trouble is, it does nothing to address movements in the value of assets such as houses. It is in fact entirely rational to buy when house prices are rising. And to loan money to people buying such houses. Everyone expects prices to continue to rise, because they know that’s what everyone else expects. No-one has any way of knowing when house prices are about to peak. And, as I say, it has been scientifically proven that whatever the absolute value of an asset, such as houses, if it is rising, it is more likely to continue to rise than not.

Hmm, so how do the authorities stop bubbles and subsequent busts? Well, they can either adopt policies aimed at keeping price growth at a certain level or they can try to slow the crash. And they’ve done neither.

House prices are not included in the otherwise successful targeting of inflation.

And back to our game of dominoes, the authorities have made the problems worse by failing to assist the intermediaries – banks and building societies – enough. Or rather, they’ve failed to make it easier for them to help themselves.

Let’s introduce some more concepts.

Point six is the idea of the balance sheet. Banks have assets – in particular, loans, such as mortgages, which provide an income, and which they could sell – and liabilities – in particular, deposits, which could be withdrawn at any moment. Assets minus liabilities gives some idea of the value of the bank.

Now, what’s happened is that some of the assets for some banks have suddenly become worthless. Now, assets, such as mortgages for x pounds, are risky – they may be worth £x + interest or somewhat less than £x. Nobody knows yet. Banks have to avoid the value of their assets falling below their liabilities at all costs. When some assets turn out to be worthless, they can do two things:

  • stop lending to ensure that the x pounds they have remains worth x, instead of an indeterminate amount;
  • raise more capital (or retain more profits).

That is, they can sell more shares in the bank, so that the difference between their assets (those mortgages) and their liabilities (those accounts) is higher. This gives them more headroom for taking on those risks, that is, for writing mortgages. Allowing people to buy houses again and stop prices falling

So, point seven, and this is what I’m leading up to, what you really want to do, is to get more private capital into the bank – and, if you’re Merv, or Ben/Hank – and I should say, Hank has stated this explicitly (link when I find it) – into the banking system in general.

So what’s happened? NR: shareholders willing to put up £700m. Amount of extra capital put into the UK banking system by nationalisation instead? £0.

Bear: Citic (China) offering to invest $1000m. Amount of extra capital put into the US banking system via Bear Stearns? $0 (JPM took out Bear with shares rather than cash, Citic cancelled investment).

Now, point 8, we have certain beneficiaries of these exercises to wipe out those shareholders as the evil Professor Roubini puts it. Let’s try to work out who these are:

  • the UK taxpayer – but only in the long-term if they succeed in privatising NR and don’t lose court cases to the expropriated shareholders (and I think they’ll lose hands down);
  • JPM;
  • competitors of NR and Bear (who may have had a hand in cutting off their lines of credit);
  • short-sellers in NR and Bear, rumour-mongers among them.

Remember, you need shareholders to provide the capital to take risks. Writing mortgages is inherently risky, and until banks restore their capital, they can’t write mortgages, house sales will be sluggish, and house prices will keep falling, and there will be more defaults, wiping out bank capital… perpetuating a vicious spiral.

Now, NR’s assets are very likely greater than its liabilities. Why should the UK state benefit? And why should short-sellers of NR and Bear stock benefit?

Ditto, Bear, though there is some doubt as to the value of its assets. But why should JPM Chase benefit?

Now, maybe the NR and Bear shareholders are less deserving than the UK state and JPM, but let’s just take a step back from all the judgementalism and emotion. Let’s try to be practical. There are two important questions to answer from a general public interest pov:

Q1. Will the nationalisation of NR and Bear takeover lead to more capital being put into these banks than would otherwise have been the case?

Q2. Will the nationalisation of NR and Bear takeover lead to more capital being put into the banking system as a whole than would otherwise have been the case?

A1. This is very easy to answer. No. It would be illegal for the UK Gov’t to put more capital into NR. That’s sorted! And if JPM wanted to raise more capital it could have done so anyway.

A2. OK, so far, we’re £700m of risk capital down on NR and $1000m on Bear. That’s ultimately a bit of a bummer for the old Ango-Saxon housing market, but not that much dosh in the great scheme of things. But, and here’s the $64billion question, is it now more or less likely that people will go to their 100% taxpayer guaranteed UK or US savings account, take the money out and buy shares in their bank instead? Well, my friends, I need hardly spell out the answer. Yours truly will not be buying any more bank shares in a hurry. And certainly not while short-sellers are trying to wipe out HBoS and LloydsTSB.

The domino effect is that the failures of NR and Bear have made further bank failures more, not less likely. Boils may have been lanced, but MRSA has infected the wounds.

Now, here’s the big idea.

Instead of saying the shareholders should be “wiped out”, a less face-spiting idea (not everyone’s nose is insured) might be to say: “the shareholders better put up some more capital or risk being wiped out”.

What I suggest is that in the event of the next NR or Bear the bank in question (could be anybody now) is taken into a sort of Chapter 11 for banks. Protected by the overseer (Fed, BoE, ECB) and ordered to raise more capital on pain of bankruptcy/firesale etc. I believe it is rational for at least some existing shareholders to invest more. The value of the bank is uncertain. If they don’t invest more they definitely have £0. If they do, they have the £x they put in, plus £y that the bank is actually worth. Unless they believe £y to be negative they should put up more dosh.

Like quite a few other people, I thought exactly this sort of capital raising exercise was what was happening in the case of NR, which is why my opinion of Messrs Brown and King is now unprintable.

I fundamentally do not believe that banks should be allowed to fail because they run out of liquidity alone, if shareholders are prepared to put up more capital. This is a recipe for dominoes to fall. The financial system should in any case be a machine to find out which risks were ultimately worth taking and which weren’t. For this to happen the game must finish. If only the biggest banks can survive each crisis, then even bigger losses are ultimately possible. Because, the way the game is being played now, at least some banks are going to fail in every crisis. And we have no way of knowing whether this was because the business they did was bad or not.

But the main point is that when we stop this childish game of punishing shareholders, we start to see that there are ways of getting more capital into the banking system.

If the Fed and the BoE end up holding vast mortgage portfolios, whilst no-one is writing mortgages, because they’re losing money year after year, and can’t raise capital, because investors see their stock as a gamble and not as an investment, then the taxpayer will really suffer.

I see no reason why house prices anywhere – US, UK, Europe – wouldn’t drop by 50, 60, 70% in such a scenario, before enough people could afford to buy property outright to arrest the fall.

So, Rob, if HBoS ever were in trouble, then I’d hope Merv and Gordo were having secret meetings. Put the kettle on, would you, Darling?

February 27, 2008

Blast-off from Planet Hector

Filed under: Economics, Media, Northern Rock, Rights issues — Tim Joslin @ 3:06 pm

This is positively my last post on Northern Rock.

I’ve recently taken to listening to Radio 4 in the mornings. As a communication medium TV has much greater bandwidth than radio (visual awa aural), so why do they fill it with garbage?

Anyway, yesterday we had the former Treasurer of the Rock, who noted passim that “a £5bn problem” was turned into a £25bn one by the bungling authorities. Would have been nice if he’d broken cover before nationalisation. Still, it’s more than his successor has done – he’s quietly left the bank. Not surprisingly, since basically liquidity is a Treasury issue and I presume it’s the Treasurer’s job to stand up to a Chief Exec who gets carried away.

Today we had Hector Sants of the FSA, who explained how it would all not have happened had they paid a little more attention to NR. What self-serving twaddle! Any system that relies on a single group of experts (a) seeing something that’s going on that no-one else (auditors, the markets) can, and (b) being able to quietly solve the problem behind closed doors, will always fail. No, the Tripartite Authorities need to concentrate on setting objective liquidity (and other) measures for the banks, that can be policed not just be the FSA, but by the market and the banks’ own internal and external auditors. Because liquidity is a collective property, the behaviour of the BoE also needs to be predictable – i.e. to inject liquidity into the markets if particular thresholds are crossed. The 19th century approach Sants and King would like (I wonder why) is no longer appropriate. We need “water” – transparent liquidity – management. Planet Hector must resemble Mars.

After the Guardian rejected my exceedingly witty letter, I thought of writing a piece for their “Reply” column. Trouble is, the issue will now have to be resolved in court, so bashing my head against a Rock trying to change a few minds can no longer have any real world effect, so I left it unfinished. Here’s my draft, anyway:

“Public support for the nationalisation of Northern Rock is based on a misunderstanding. The false impression has been given that nationalisation is the least risky option for the taxpayer. In fact, two private sector proposals were rejected last weekend because the Government judged the potential to be too low for profit to accrue to the public purse.

The shareholders’ preferred option was that of the in‑house management team, led by Paul Thompson. This proposal included a rights issue of £700m. The shareholders would have invested another £700m in the bank. This will not now happen. By nationalising the bank, the taxpayer is therefore taking more risk than necessary. As a Northern Rock shareholder, I am baffled that the Government has spurned my offer to take on this risk, and distressed to be vilified in the Guardian and other media.

Northern Rock would have been managed similarly whether nationalised or not. Bryan Sanderson has said that he will operate “at arm’s length” from the Treasury. Even if it had not nationalised the bank, the Government could have imposed constraints on the payment of dividends and the extent to which Northern Rock could take on new business.

It’s perhaps worth remembering that among the people who will suffer most as a result of this fiasco are financially stretched Northern Rock mortgage-holders. The essence of the situation is that Northern Rock is simply an institution established to intermediate between those prepared to lend money and those who wish to borrow it. Following the run on the bank, Northern Rock now has a lot less money to lend. Something has to give. It seems that the nationalised bank intends to try to drive mortgage business away at the end of existing fixed-rate periods. But some mortgage-holders will be unable to find another lender, because every bank has reduced the maximum loan-to-value ratio it is prepared to offer, and, in any case, house prices are starting to fall. The most vulnerable homeowners will be forced to remain on expensive variable rate mortgages with Northern Rock. As a shareholder right up until nationalisation, it’s difficult to reconcile the moral opprobrium heaped on myself with the fact of the matter that borrowers were let down by depositors. Hadn’t they seen “It’s a Wonderful Life?”.

Under the Thompson proposal shareholders would have put another £700m in Northern Rock. It is completely untrue that the taxpayer would have been “retaining all the risks”, as claimed by, among others, Vince Cable, on this week’s BBC Question Time. Let’s imagine that there is indeed a serious house-price crash in the UK, and, in a couple of years it becomes clear that Northern Rock is insolvent. If the bank had remained private, the shareholders would have lost everything, including the £700m of fresh capital. In the same scenario under nationalisation, the taxpayer will have to cover all the costs. The taxpayer will be at least £700m worse off under nationalisation than with the private sector solution. It’s a shame that so much energy has gone into pouring vitriol onto shareholders, and so little time spent understanding their role. I’m no happier with the state of Northern Rock than any other taxpayer, but, unlike most, I would have been prepared to invest more money in the bank with the risk of losing it all. Now, every taxpayer is having to take on that risk.

Two typical comments have caught my eye this week. Will Hutton referred (in a Comment piece in the FT) to the “Northern Rock shareholders’ extraordinary sense of entitlement”. And someone left a message instead of their name on a petition on the Downing Street website: “ffs shareholders should know the risks – u deserve nothing”. But during the run on the bank, the government guarantee to depositors was dramatically improved, at great risk to the taxpayer. No‑one said: “ffs depositors should know the risks”. Perhaps that’s why shareholders expect to be treated a little more fairly than they have been.

The nationalisation route has been taken for purely political reasons, and is certainly not the least risky option for the taxpayer. From a shareholder point of view it is laughable for the Government to tell shareholders such as myself that we’ll be treated as if the bank is being wound up, when in fact it is being run as a going concern. Naturally, if the Government does find an “independent” arbiter willing to accept the terms of reference it is proposing, I’ll join with other Northern Rock shareholders in taking legal action, as long as I consider it likely that a judge will see the situation my way. Otherwise, I’ll have to shrug and walk away. The Northern Rock shareholder could have had such a beautiful relationship with the taxpayer. Now I guess we both feel as if we’ve just been screwed.”

That’s it, there are other fish to fry. See you in court, Darling.

February 25, 2008

Spanish practices

Filed under: Economics, Housing market, Media, Northern Rock — Tim Joslin @ 8:01 am

There are voices of sanity out there. Tim Congdon has written several sensible pieces on the Rock affair in the FT. He points out in the latest that the ECB has bailed out the Spanish banks in a way the BoE refused to do for NR. I’m a little surprised, though, that he doesn’t mention that at least one Spanish bank – Santander, which owns Abbey – directly competes in the mortgage market with UK banks. They – and all other European and US banks who might want to operate in the UK retail market, perhaps by snapping up A&L, B&B or even NR itself – have now been put at a significant competitive advantage. Knowing how the ECB will behave in a liquidity crisis, they now know they need to maintain less liquidity than their UK peers and can therefore use their capital more efficiently.

But, from a BoE view, of course, the NR cock-up has been self-defeating. No major bank operating in the UK market will ever allow itself to be totally reliant on the BoE again. They’ll make sure they can also draw on funds from the ECB, the Fed and/or other central banks. Presumably they need to retain a relationship with the BoE if they want to offer banking services in the UK, but they will rely on this as little as possible. The BoE will become marginalised. Hmm, maybe I’ll see the day when I buy my UK daily paper with euros.

Unless, of course, the BoE lets everyone know that it has learnt lessons from the liquidity crisis, and will take specific actions – working in concert with other central banks as central banks should, or they’re not really central, are they? . Scapegoating Northern Rock makes it more, not less difficult to calmly identify what mistakes were made by who, and what policy adjustments should be made by whom. And, of course, so does reappointing Mervyn King. Perhaps we should start calling the BoE the UK’s peripheral bank.

Postscript (1) : An article in the Telegraph this morning shows exactly how small UK banks (and building societies) are being penalised by having to use a back-door (larger UK banks with a direct relationship with the ECB) to access liquidity in the euro which is unavailable in sterling. Of course, the British consumer will ultimately pay for this. The Telegraph reports that: “Bankers said the fact that UK lenders were having to access the ECB through the back door exposed failures at the Bank of England.” Quite.

Postscript (2): And the Guardian notes that “… mortgage experts are trying to predict the winners from the credit crunch and concluding that Abbey could come out on top because of the funding available to its Spanish parent, Santander, through the European Central Bank.” Surprise, surprise.

February 23, 2008

A “wunch” of bankers

Filed under: Economics, Media, Northern Rock, Rights issues — Tim Joslin @ 3:20 pm

Wunch, n.: a population suddenly expert in a highly technical domain in which the vast majority have no qualifications whatsoever.

It’s amazing how the media – if not the British people in general – have suddenly become expert on retail banking.

They’ve decided, for example, that bank charges for overdrafts must be much reduced. Maybe they’re right: maybe these charges are excessive. But they’re certainly a deterrent. I can’t remember anyone pointing out that it might not necessarily be a good idea to let people take on unlimited overdrafts until they go bankrupt (or their bank does). The alternative, of course, is to stop the account. This is what happened to me when I ran out of money as an undergraduate back in the Jurassic. My cashpoint card was swallowed and the machine ordered me to go into the branch (sadly long since amalgamated with a larger one – they kept the postal address for about a decade, for old times’ sake). I had to submit to a telling off from the bank manager. My personal finances were nationalised, my debt restructured and I was eventually allowed to return to the private sector. I’ve never exceeded my overdraft limit since, not just because I’m afraid of another “little chat”, but mainly because I’ve heard about the really very nasty charges I might incur if I did borrow money again without asking. Today, of course, with so much of our personal banking now totally automated, stopping an account would cost someone going overdrawn for a short period far more in failed Direct Debits and so on, than they would incur in bank charges. It’s all about striking the right balance. Maybe we should leave it to the professionals.

I really must stop reading the newspapers about the Northern Rock affair. Today there’s another nonsensical piece in the Guardian (Money section). To be fair, the columnist, Patrick Collinson, does make some original points and has provoked 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 not”. Patrick has clearly thought a little more about what this means. But he reaches a strange conclusion.

As Collinson points out, NR is currently offering rather generous rates to savers. But he seems to see these as a way of competing with the private sector, rather than a desperate attempt to rebuild NR’s balance sheet. Let me explain, Patrick. The idea is that banks and building societies charge an interest rate to depositors that is (say) 1% less than they can lend the money out for – to mortgagees, for example. That 1% pays for all the buildings, staff, bad debts and so on. Hopefully there’s a little bit of profit when all these things are paid for. If NR offers mortgage rates similar to those of the other banks and building societies, but continues to pay out 6.49% in interest rates (as also advertised in today’s Guardian), that would constitute what’s termed in the trade “pissing money away”. In this case, the taxpayer’s money.

In fact, strictly speaking, if NR really has a “100% government guarantee” and other banks don’t, it should be able to attract funds with a lower interest rate. Of course, the world now knows that their money would be safe – in terms of “liquidity risk” – in any UK bank of NR’s size or larger, because the BoE will not let such an institution fail unless it proves to be insolvent. The competition issues arise because the nationalisation solution implies the taxpayer is now taking on NR’s credit risk as well as the “liquidity risk”, a distinction the Times (writing about Japan) and the FT (Scandinavia) don’t seem to be too bothered with.

This is why the Government has been dishonest. The shareholders were quite happy taking on additional credit risk (via a rights issue), and a private sector solution would have left open the possibility of winding the bank up should it actually prove insolvent at some point in the future (in this event, as I’ve already pointed out, the taxpayer would be at least £700m better off than they are now). But I put “liquidity risk” in quotes because I think it (or at least the threat of bank runs) should be designed out of the system. It already is, to some extent, for high value interbank payments. UK banks, for example, can’t pay out more sterling through CHAPS than they have on deposit at the BoE. Next time the casualty might not just be too big to fail, like NR, but also too big to bail. Perhaps the BoE and other authorities (since many banks are now international) need to do some work on procedures for preventing or rationing retail withdrawals in the event of the next run on a bank, instead of treating depositors as a privileged class of people and rewarding them (bit of a “moral hazard” here, now). After all, if we’re talking about mortgages, the money is tied up in property. If commercial property funds in the UK are allowed to close to withdrawals for months (as they have), surely the same logic should apply to building societies?

One way NR could try to avoid “pissing money away” as it tries to rebuild its balance sheet, is to charge more for mortgages (to those coming off an agreed fixed rate). That is, it could raise its standard variable rate (SVR). But this really screws those unable to find a mortgage elsewhere, which will be a lot of people, as there’s a double whammy: banks are reducing their maximum loan to value ratios, and house prices are starting to fall. Of course, there’s a limit to how much NR could put up its SVR, as it makes no sense for any bank to push too many of its customers into default. But for a private sector organisation to hammer its most vulnerable customers in this way would be bad enough. If a nationalised NR does it, though, how is this going to go down with the public?

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