Weak Labour Markets and Repo Market Disruptions

Central Banking

Low interest rates contribute to weak labour markets

In the latter part of August, the cream of the world’s central bankers convened at the annual Kansas City Fed gathering at Jackson Hole, Wyoming. Every year the Conference has a theme. Last year’s was Quantitative Easing (QE): when and how it would end. This year’s topic was unemployment, under the rather grandiose title “Re-Evaluating Labour Market Dynamics”.

Ms Yellen, chair of the Federal Reserve, seemed at last to acknowledge one of this Newsletter’s recurring concerns; namely, that official unemployment data mislead because they ignore the number of citizens so disaffected with prospects that they no longer register as looking for work. She is warming towards a new Fed Board developed Labour Market Conditions Index (LMCI) which takes account of workforce participation rates and various other measures. She considers LMCI a better indicator of employment market strength or weakness than the raw unemployment percentage number. By this measure, unemployment is still substantially above the pre-crisis level. Accordingly, Ms Yellen remains concerned about the present strength of the US recovery:

the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate”;

Nonetheless, she indicated that interest rates would rise if future, stronger than expected, labour market data were reported.

Similar concerns are now paramount among UK central bankers. The Bank of England now overtly links its ‘forward guidance’ about the timing of interest rate increases to evidence of growth in wage levels.

The ECB’s President Mario Draghi had absorbed the summer’s deterioration in European data suggesting that another slowdown is underway. Only this time, it is impacting primarily the core, France and Italy, and even Germany. Finance Minister Schaeuble recently said that ‘the ECB have already done enough’ so Germany is firmly against more stimulus at this stage.

President Draghi’s speech put labour market worries at the forefront of Europe’s problems. In Europe there was a second surge in unemployment 3 years after the financial crisis. From early 2011, when it became apparent that a number of countries would, without bailouts, default or renege on sovereign debt, heavy job losses drove up the Eurozone average to levels that have only recently topped out. Draghi took the opportunity of the profile of this occasion once again to express doubts whether unleashing QE in the Eurozone would make any difference to labour market conditions, because national governments have failed to implement substantive structural reforms. Like a physical trainer addressing a group of failed slimmers after 3 years of group therapy, he berated that he has done all he could do in the group sessions, those dissatisfied with their progress should look to themselves.

Although these presentations reveal doubts among leading central bankers that near zero interest rate policies (ZIRP) may not result in economic stimulus, there is still a gulf between these doubts and the scepticism about ZIRP policies, doubt that have been strongly expressed by the Bank for International Settlements (see our July Newsletter).

An even stronger counter view is beginning to gather mainstream support; namely, that ZIRP is a primary cause of the continuing weak labour market conditions. The reasoning is as follows. By reducing the cost of borrowing money substantially below its ‘market’ level, capital goods for businesses have become disproportionately cheap compared with the cost of employing people. When weighing up the cost/ benefit of, say, installing a machine to sell tickets in train stations compared with employing staff to do the same job, low interest rates reduce the cost of the machine option. Businessmen make such decisions using discounted cash flow analysis, whereby future costs are assessed a present value using average market interest rates over the term. So ZIRP has a double whammy effect; not only is the borrowing cost of the machine lower, but by applying a discount rate of close to zero to the employee option, the present value cost of the stream of wages is increased. This may go some way towards explaining the trend of low to moderate-income jobs being replaced by machines in areas such as supermarket checkout services as well as transport ticketing.

This is a classic “misallocation” as per Austrian economics. It follows that, when rates rise, firms will find their overall operations burdened by excessive (now expensive) capital equipment. What they will then want are more productive employees. However, the lack of skilled workers–those out of the labour force for several years tend to be less productive–will make competition for skilled labour intense, wage pressures will rise, and the combination of excess capital capacity and rising wage pressures will intensify the stagflation we have already seen to date (see our July Newsletter).


Concerns about Repo Market Disruptions.

In August, concerns were reported that the US repo market, one of the largest engines of liquidity in global capital markets, was experiencing disruptions to its otherwise smooth functioning owing to a reduction in repo activity by banks. Banks explained this by citing increased capital costs under the recently introduced Leverage Ratio (see our February Newsletter).

Before considering this further, since repo transactions can be confusing, let us set out an example. A repo counterparty, say an investment fund, might hold a 5-year US Treasury bond. There has traditionally been a deep and liquid market enabling the fund to enter into a contract with, say, a bank to sell and buy back the bond, usually on a very short-term basis (overnight). However, medium term funding can be obtained by rolling the position every day. The sale and repurchase price are pre-agreed, the differential constitutes the return to the provider of cash. Banks have been encouraged to play the role of repo cash provider (otherwise known as Reverse repo Counterparty) as the market for derivatives, particularly interest rate swaps (IRS), has grown.

Thus it can be seen that not only have banks been lured to the repo market by the modest net interest income generated by being the repo cash provider against very low credit risk, but also because repos provide a steady source of government bonds that are useful for other hedging activities of the bank itself.

So why are they now pulling back? Even though the Basel Capital weighting applied to banks’ holdings of non-defaulted government bonds is zero, such holdings are indeed caught by the Leverage Ratio. Therefore, there will be a cost from the new rule’s effective date of 1 January 2015.

But is the pullback entirely attributable to new regulations, as claimed in the mainstream press? We are not so sure. There also appears to be a shortage of available collateral (Treasury bonds) in the maturities most popular with market participants. Perhaps this results from the Federal Reserve’s mopping up of so much of the US Treasury security market via its QE programme. The result is that banks providing cash into the transaction in which the underlying security is becoming scarce (e.g. 5 years), now expect to make a negative return on the loan of the cash. The loss would materialize if the price they will have to pay in the market to buy back the bond for delivery back to the counterparty has risen owing to scarcity. In these circumstances, it is hardly surprising that banks would prefer to deposit their cash with the Federal Reserve at a better rate of return and without the negative Leverage ratio consequences.

Under normal market conditions, repo provides a cheap and easy way to releverage an asset. If trend described in the previous paragraph persists, does it presage the start of wholesale reductions in systemic leverage? We doubt it. The thrust of ‘legal’ financial innovation, especially since the outbreak of the crisis, has been for banks to find new ways of leverage through collateral transformation, swapping collateral with each other in ways that either slip by, or are tacitly approved by regulators. One such example is asset rehypothecation, which we discussed in our January Newsletter.

Finally, is this repo market disruption an ‘unintended consequence’ of the new Leverage Ratio regulations? The prevailing view appears to be negative. A small number of senior US Reserve bank governors have long memories of the 2008 crisis, and fear a recurrence of the repo market seizure. Sceptics may take the view that those bank governors are overly focussed on the symptoms of that crisis rather than on its cause. As has been amply documented, at the peak of the crisis (before any talk of bailouts), repo and other markets froze up because a number of insolvent counterparties reneged on obligations to deliver cash or collateral, triggering a collapse in confidence upon which these interbank markets rely. Shrinking the repo market will not prevent a recurrence of system wide crisis when such insolvency worries resurface.

[Editor's note: Please find the IREF Newsletter here]


Europe’s accounting rules are destroying its banks

Late last year, a group of institutional investors sent a letter to officials in Brussels, warning that European Union accounting standards are “destabilizing banks” and “damaging national economies.”

Accountancy may rhyme with geeky, but the investors were right and addressing the issue they highlighted is essential to restoring Europe’s financial health.

The European Commission officials were sufficiently worried by the U.K. investors’ charge — namely that because of EU accounting rules, banks may have systematically overstated their assets and distributed nonexistent profits as dividends and bonuses — that they said they would open an inquiry. Last week, the board that administers the rules put forward its own proposals. These are likely to perpetuate, not fix, the problem.

The rules concerned are called the International Financial Reporting Standards, and they’re used across the EU and in a growing number of other countries around the world. The potential misreporting involved is significant. In the case of just one U.K. bank, Royal Bank of Scotland Group Plc, I and others calculated that IFRS rules resulted in the bank understating its 2011 losses by 19.5 billion pounds, or roughly twice the U.K. taxpayer bill for the 2012 Olympic Games.

Deceptive Flattery

If this is correct, then the state’s 45.5 billion-pound ($67.7 billion) bailout of RBS in 2008 and 2009 was calculated against a balance sheet that probably also flattered to deceive. The risk of such faulty numbers is clear: If RBS fails to recoup this hole in its accounts through genuine profits, then the U.K. taxpayer may be on the hook for about 20 billion pounds more than the government bargained for. Last week, RBS reported a larger than expected loss in 2012 of slightly less than 6 billion pounds.

Like the U.S. generally accepted accounting principles, better known as GAAP, Europe’s accounting standards are detailed guidelines for the presentation of financial information. Just as governments publish manuals on how to drive a car safely, so they have encouraged the production of accounting guidelines for financial reporting.

The legal impact of the guidelines differs widely in the two scenarios, however. Driver’s manuals are nothing more than that, manuals, which no court would substitute for the law. If a driver starts to brake at the correct distance from a stop sign, but still fails to stop, it is no defense to have followed the manual — he or she broke the law. Under European accounting law, following IFRS standards is a defense and the guidelines have been allowed to override national laws.

The rule that concerns investors the most restricts provisioning against expected future loan losses. Under IFRS, loss provisions can only be booked (thus reducing this year’s profits) if a loan event, such as a default, has occurred. The U.S. rule makers who oversee GAAP have refused to follow the IFRS in this. Talks aimed at converging U.S. and EU expected- loan-loss accounting rules ended without result last July.

It is misleading to shareholders and dangerous for the banking system if commercial banks can declare a profit when they expect a loss, as it perversely incentivizes bank executives to wreck their banks. This is because bank executives tend to prioritize short-term risks and rewards: If they know that any negative outcome of a loan decision can be parked in the blue yonder, delaying ill effects on the bank’s performance and bonus pool, they will be more likely to ignore the risks and make the deal.

Prudent Accounting

U.K. law deals with this issue in sections of the Companies Act, called the capital maintenance rules, which require that directors prepare “true and fair” accounts, guided by the conservative principle of “prudence.” This approach means that banks should report the value of each loan at the lower of either its original cost or current market value. Because of IFRS, however, this part of the Companies Act isn’t enforced.

Equally dangerous is the effect on regulators. Working with accounts that underreport losses damages their ability to accurately assess the capital adequacy and stability of banks’ balance sheets.

Steve Baker, who in 2011 submitted draft legislation to Parliament to repeal the IFRS rules, puts the problem succinctly:

IFRS create a death spiral. Banks silently destroy their capital under the guise of profit, then they require taxpayer support, then the process starts again.

Defenders of IFRS say that these rules promote neutrality and objectivity — after all, if you estimate future losses for reporting purposes, why not future profits, too? They say the rules were changed to prevent “smoothing,” in which companies would time the recognition of income in order to create an artificially steady stream of profits. But surely smoothed profit streams cost shareholders and, in the case of a bailed- out bank, taxpayers less than exaggerated ones? Besides, profit smoothing was always illegal so long as laws were enforced.

What really changed in 2005, when the U.K. amended its laws to give banks the option to prepare accounts under IFRS rules, was that underprovisioning for losses became compulsory.

The evidence that revealed RBS’s Olympic-scale overvaluation came from the accounts of the U.K.’s bad-bank insurer, for which IFRS has different accounting rules. Unlike banks, insurers are required to value their assets and liabilities, taking into account probable future losses. This reporting difference highlighted the almost 20 billion-pound discrepancy in RBS’s 2011 accounts that the two sets of accounting rules produced.

Scrutiny Needed

Let’s hope that the European Commission will scrutinize the IFRS standards closely — it won’t be easy. The International Accounting Standards Board, which drew up the rules, doesn’t appear to accept the gravity of the problem. At a meeting last year, I explained to three senior board officials why profits calculated under the current rules aren’t safe for distribution. The officials acknowledged the problem, saying that banks should maintain two profit calculations, one for reporting to shareholders, and the other — not following IFRS rules — to determine distributions to shareholders. Surely this is false accounting?

Now the IASB has proposed a fix for the problem, recognizing that the delayed recognition of expected losses has proved “a weakness” during the financial crisis. Yet their proposed solution is to add more micro-rules that define the specific situations in which banks should be allowed to declare an impairment and book losses.

This approach is fundamentally wrong. The IFRS rules are the problem, because they interfere with enforcement of the law. Banks should decide when to provision for a loss, and the full force of the Companies Act should be used to punish them if they do so dishonestly. More detailed standards will just encourage more manipulation of them.

This article was previously published at


Reshaping risk-taking incentives

The evolution of banking as I have described it has satisfied the immediate demands of shareholders and managers, but has short-changed everyone else. There is a compelling case for policy intervention. The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis.

Wise words from Bank of England’s Executive Director responsible for Financial Stability, Andy Haldane.

I commend Mr Haldane’s excellent essay to Cobden Centre readers.  It is true that he fails to emphasise the role of central banks in assisting this malaise:

  1. the steady, artificial reduction of interest rates, and
  2. when rates had no further to fall, the printing money via QE.

Mr Haldane’s omission masks the role of central banks in propping up asset values.  This in turn has led investors and ratings agencies to conclude that the riskiness of many asset classes has been more benign than free markets would have exposed.  And this concealment of true risk has then driven the increase in bank capital leverage from 10 to 30 times, which results in cataclysmic collapse.

Whilst this omission is regrettable, let’s cut Mr Haldane some slack.  He is a senior Bank of England official who has written a damning indictment of banking excess, perverse incentives, and a passionate call for radical reform which could have come straight from the pages of “Alchemists of Loss” co-authored by his university tutor, Professor Kevin Dowd.

And let us hope that Mr Haldane will embrace the specific proposals to be laid before Parliament February 29th by Steve Baker MP which in my opinion represent the very “reshaping of risk-taking incentives” which Mr Haldane seeks.  Steve Baker will present a Bill that will end this nonsense by restoring unlimited personal liability for main board directors of banks.


Mainstream support for accounting reform

The established UK newspapers, The Telegraph and The Guardian, are regarded as the standard bearers of the political right and left respectively.  The gravity of the banking crisis is clearly apolitical and public awareness is now growing that employees at RBS, effectively civil servants, are simply plundering taxpayer bailout funds for personal gain via wrong accounting.  The taxpayer owns just under half of Lloyds HBOS, and despite this minority shareholding the same point applies.  Failure of the state regulators to act many months after this news was broken outrages everyone from Telegraph readers to the Occupy movement.

The significance of the failure of the UK ‘s Coalition Government to back Steve Baker MP’s March 2011 Bill is now dawning.  It should now be embraced by the Chancellor as an essential first step to understanding how badly the bailouts have failed.

Most importantly, payments of bonuses this month should be frozen whilst these accounts are properly assessed.  If we at Cobden Partners are correct, and the payments are in truth planned to be made out of capital, not profits, then this is a breach of UK Company Law and proceedings should follow.


Credit easing – expect more fruitless searches for sponges in the Aegean Sea

The UK government recently announced a “credit easing” plan.  According to a junior minister the rationale is:

  1. Small businesses (SMEs) are unable to borrow funds from either the main banks or in the shadow banking markets;
  2. The UK needs SMEs to thrive in order to drive the economy;
  3. The Treasury/ Bank of England can raise funds or make guarantees to such businesses, and will do so, in order to fix this problem.

By way of further support, the US precedent has been cited.  Yet it has been widely reported that a $528 million loan to a green energy company called Solyndra, guaranteed by US taxpayers, has been written off.  It may be less than half of a basis point of the $14 trillion US national debt, but it’s still a lot of money to mere mortals. That company would never have procured the loan but for the US Government’s guarantee.

For Einstein, a hallmark of insanity was the repetition of a failed action in the hope of a different result.  Of the various ill-conceived UK government interventions in the banking system, all of which have failed to stimulate the economy, the three worst are probably:

  1. setting the price of credit (interest rates) to zero.  The mistaken thinking was that this should make it cheaper to borrow.  Sadly, the policy has had the obvious ancillary effect of maximising the prices of all fixed assets, such as properties and business rents;
  2. pouring cash into failed banks via QE in the hope that this would be lent to “deserving businesses”;
  3. nationalising the insolvent RBS and supporting others, yet turning a blind eye to the banks’ loss-making business models which, masked by the EU’s IFRS accounting regime, allow managers to pay themselves bonuses out of losses using the QE cash.

As the CEO of brokers Tullett Prebon, Terry Smith said “If you thought the banks were bad at lending, wait until …the government tries it”.[1]

Why are Mr Smith and so many others worried that any UK ‘credit easing’ will be a disaster for the taxpayer and fail to channel funding to meritorious borrowers?  The answer is that money donated is likely to be less effectively deployed than money lent in search of a profit.  Allow me an example from personal experience.

Many moons ago I showed up for the first day of my three year course at Warwick University.  I immediately embraced campus life and looked forward to the comfort of my taxpayer-funded accommodation, the conviviality of fellow students, and to relaxing in campus cafes and bars.

Within a few days I heard about one of the University’s main benefactors, Lord Rootes.  This generous philanthropist had done a great deal for Warwick.  He had donated the funding for a block of luxury student apartments on campus.  I soon realised that there was an effective lottery every year for one of these snappy penthouse pads, and one year I passed the official building just as the names of the lucky winners were being posted on a notice board.  One or two had been queuing in anticipation, and their whoops of joy that morning surpassed the delirium later expressed by some on my own course who were awarded top-rated degrees.

Lord Rootes also established a research fund.  Any Warwick student could apply for a grant to undertake interesting and valuable research during the summer vacation break with a view to making the world a better place.

Call me naïve, or a man of limited horizons, but I never seriously thought of applying.  A few ideas flitted across my mind, but I would have felt awful had I won some funding and failed to come up with powerful research that might have helped cure cancer or free innocent prisoners on the death rows of jails located in banana republics.

But not my friend Jim.  Unlike me, Jim was a cool dude, tanned and swarthy.  He was always invited to the best parties.  He did not appear to study very hard, he coasted easily through his course.  On one sunny Spring morning I learned that Jim had won that summer’s award.  It seemed an astronomical amount, perhaps £10,000 in today’s money.  The foundation’s trustees had been bowled over by his proposal to research sponge formations in the Aegean Sea.

When campus reconvened the following October, there was Jim, even more tanned.  He had spent the summer Greek island hopping, swimming and scuba diving.  He produced a one-line report for the disappointed trustees: “There are no sponges in the Aegean Sea”.

You may seek to distinguish the Rootes trustees’ business model (donations) from the UK’s putative credit easing model (a lending business), but the scepticism of Mr Smith and others reflects concerns that career civil servants will simply not be motivated by an entrepreneurial lender’s zeal to earn a return on funds lent.

If the UK’s credit easing plans materialise, expect taxpayer funds to flow into new businesses aimed at commercially exploiting sponges in the Aegean Sea.

[1] Oct 4 Wall Street Journal p 8


Ringfencing retail banks – just rearranging deckchairs on the Titanic

The 363 page ICB report implies more rules, more regulation, substantial taxpayer costs in drafting, implementing and overseeing.  Will this approach work to protect the taxpayer from future bailouts?

I would make three comments:

  1. the establishment of this Commission has received insufficient recognition for what it is – a formal acknowledgment that our present bank regulatory triumvirate of the FSA, Bank of England and HM Treasury has failed dismally to date and cannot be relied upon to protect us in the future.
  2. The substantial increase and regulatory cost implied by the Report (it must be noted that this is only a report; draft legislation is not yet available) will have the unintended effect of erecting even greater barriers to entry for competitor banks.  This will in turn provide no incentive to our banks to address their culture of entitlement, of high and unwarranted compensation, of disdain bordering on aggression towards customers.
  3. Having skimmed through its 363 pages, I sense the ICB is unaware of the kernel of the problem: deeply flawed accounting standards and treatments of transactions leading to falsification of profits and capital.  RBS for certain, and perhaps other major UK banks, are insolvent.  Their liabilities exceed their assets and capital, properly measured and reported.  RBS cannot continue as a going concern, and it at least should simply be put through an orderly liquidation process rather than conferred the respect that the ICB proposals imply.

In the context of ‘respect’, I would say that I have considerable respect for the ICB.  Martin Taylor, in particular, strikes me from his media appearances as understanding the severity of the crisis and the task he shares with the four others.  It is not my place to make apologies on his behalf, but others have commented on the framing of the terms of reference limiting the scope of their responses.

Sadly, however, the measures will fail to achieve their objectives, primarily because the doctors do not appear to understand the cause of the illness.

Early in the Executive Summary (page 10) the ICB refers to one advantage of ringfencing as being to protect retail banks from “external financial shocks”.   This implies that the 2008 crisis was caused by such external factors.  But the crisis that began in 2007 and continues to this day was not a function of “external financial shocks”; it was a crisis stemming from the insolvency of the banks, as even the Bank of England now accept[1].

IFRS accounting rules, despite the 2009 MTM reforms still allow or encourage banks:

  • to “mark up” to market assets whose prices they can claim have risen, thus reporting a profit despite no actual transaction;
  • to transfer assets whose market values have fallen (such as Greek sovereign debt)[2] between “accounting classifications” (e.g. onto the “Held to Maturity” book) to avoid recognising losses;
  • to pay bonuses despite such banks being loss-making under UK Company Law accounting standards – in other words to operate as Ponzi schemes – and furthermore not to deduct promised bonuses from reported profits.

Retail banks “should have different cultures” the ICB Report pleads (page 11).  Dream on.  Regulators cannot influence cultures. Only markets, shareholders and the threat of job losses, as feared by workers in insolvent companies outside of the banking sector, will.

I mention shareholders, but when the shareholders are the public sector they seem to impose no such corrective influence.  There has been not a whimper of concern from these shareholders in response to the staggering contents of both MP Steve Baker’s and Cobden Partners’ Press Releases of May 15th and 17th exposing RBS’ overstatement of its 2010 profit and capital by about £25bn.

Further, the concept of the ring fence implies that, in a crisis, the investment banking bit can be cut off and allowed to fail, yet exceptions to the ring fence[3] are permitted for banking services that involve an exposure to the sister investment bank.  This is not a ring fence, and if this rule survives, expect substantial gaming.

The ICB will counter that they are providing the regulators with sharper teeth.  The regulators will not use them.  Why should they?  As Professor Kevin Dowd points out[4], in 2009 after presiding over the worst financial crisis in living memory, FSA staffers were paid record bonuses after submitting to their pay committees testimonials from the banks they were supposed to have been scrutinising.

[1] “Right through the crisis from the very beginning …an awful lot of people wanted to believe that it was a crisis of liquidity” Sir Mervyn King said.  “It wasn’t, it isn’t.  And until we accept that we will never find an answer to it.  It was a crisis based on solvency.” Financial Times, 24th June 2011.

[2] Step by step guide how to do this provided by Barclays Capital’s Equity Research team July 2011

[3] ICB Report page 235, footnote 6

[4]Alchemists of Loss


Buffett’s $5 billion ‘vote of confidence’ in Bank of America

Warren Buffett is the most successful investor on the planet and a very smart fellow.  His core team also gave me a job in October 2000 at GenRe Financial Products, and I have always held him in high regard.

He has invested $5 billion in Bank of America on 25th August. But was the Wall Street Journal correct to headline the deal a “Vote of Confidence” in the bank?

My analysis is based purely on the facts presented in this weekend’s WSJ.

In return for his $5bn cheque, Buffett will receive:

  1. Preference shares bearing a ‘coupon’ of 6%.  Technically, preference coupons are dividends; the payment can only be made out of profits.  Allow me nonetheless to use the term ‘coupon’ in order to compare the risks and returns of this deal with a bank deposit.  The structure here is as close to a coupon as preference share terms allow.  Even if the bank experiences a choppy ride, so long as it survives and returns to profit at some future point, any unpaid dividends in loss making years are payable under a contractual cumulation provision.
  2. Warrants (these are options to buy shares at a pre-agreed price) over 700 million shares of BofA common stock at a strike price very close to Thursday’s share price. The WSJ values these warrants at about $3 billion. Assuming that is correct, Mr. Buffett could either sell them for $3 billion or retain them as he sees fit.
  3. The deal is not even Tier 1 equity for BofA and is considered expensive ‘bridge financing’ . However, Mr Buffett has secured a 5% penalty charge ($250 million) should BofA redeem the preference shares.

Short term deposit rates are 1% or less in US banks. On this basis, the deal can be characterised as a net investment of $2bn at a coupon of 15% (5/2x 6%).  This equates to about 15 times the return on cash short term deposit accounts.  Similarly, the redemption premium becomes not 5% but 12.5% of net invested funds.

Let us consider the ranking of the investment in a potential liquidation of BofA.  Secured creditors of the bank take precedence over depositors.  Preference Shares rank below depositors but above common equity.  And yet banks have pledged so many assets to each other via repo and “failed sale” transactions that who can tell how much quality collateral could be viewed as actually supporting the deposit base?

Bearing in mind the recent history of western Bailouts, consider the following range of possible outcomes:

  1. BofA survives and thrives.  Happy days for all stakeholders, excellent return for Mr. Buffett;
  2. BofA fails.  Either there are enough assets in liquidation to redeem deposits or depositors are rescued by a possible Heurta De Soto or Baxendale plan or fresh taxpayer bailout;
  3. BofA fails and (2) above extends to pay off unsecured creditors but not preference shares;
  4. BofA fails and preference shareholders are covered by (2) above;
  5. BofA fails and (2) above extends to protect common shareholders.

Politicians have rarely breathed the words “moral hazard” and “perverse incentives” when they are actually engaged in formulating the bailout package, so outcomes (4) and (5) cannot be completely dismissed, but surely they are unlikely.

But how likely are outcomes (2) and (3)?  I just cannot see how governments can attempt a second bailout given that Ireland is now on its fifth.  But I don’t know.  I suspect Mr Buffett does not know either.

Mr Buffett, like the rest of us, knows that the banking system is in a critical state. Yet like many of us he has a problem: we all need to keep some cash in banks.  When you have the quantum of funds under management that he has, you can forget about deposit insurance.

What a smart deal he appears to me to have made.  A good chunk of the cash element of his investment portfolio can be parked at a fixed coupon of 15% for the foreseeable future.

Either paper money collapses, in which case all of his cash funds are in turmoil, or there will be another rescue attempt, or hyperinflation, or QE 3,4,and 5 or some ‘unknown unknown’ attempt to prop up the banking system.  It is possible that a future rescue might specifically wipe out common and preference equity, and so Mr Buffett’s is seeking a huge upside against the risk of that specific downside.

So what of the headline?  I concede that he picked BofA rather than another US megabank, but it is still rather a stretch to term this a “Vote of Confidence” in BofA.


The UK is facing a sovereign debt crisis

Whilst the international attention is all about the Greek crisis, last week’s report by the UK’s Office for National Statistics reveals our own country’s parlous financial condition.

As at May 31st 2011 Public Sector Net Borrowing (PSNB) was £920 billion, or 61% of GDP.    When the present coalition government came to power twelve months ago the debt was £778 billion.  When the UK went to the IMF for help in 1976, the inflation-adjusted figure was half of this.

And of course the £920 billion figure is the most understated representation of the national debt that the government’s statisticians can produce.  A more holistic measure of UK debt would aggregate £250 billion of now on-balance sheet Private Finance Initiative (infrastructure) liabilities and £1.2 trillion of unfunded public sector pension exposures together with the PSNB figure.  And this sub-total assumes no long-term cost in respect of the bailed out bank stakeholdings.

Excluding bank bailouts, the deficit (rate of growth of the debt) for May 2011 was £17.4 billion compared with £18.5 billion for May 2010.

The coalition have boasted of bold and brave cuts.  Police budgets, armed forces expenditure and local government subsidies have been cut, yet total public spending is up 4% year on year.

Other cuts have been announced and then rescinded in the face of fierce counter campaigning.  Forestry was to have been sold, the NHS was to have been radically restructured, and the welfare (benefits) system overhauled.  These supposed cuts have either been officially rescinded (forestry) revised and watered down (NHS) or, in the case of welfare reforms, likely both to increase public expenditure and harden the divide between the generationally workless and those actively seeking work.  Frank Field, a Labour MP boasting excellent social inclusion credentials, recently observed [1] that  these two groups will be further divided as a direct result of two new Coalition proposals.  He describes the combination of means tested benefits and lightly regulated government support for businesses taking on the unemployed, as “Gordon Brown on speed”.   The recently laid off will be targeted by such businesses, not the long-term unskilled workless who will have little incentive under the benefits rules to apply for work.

International readers might think this a good opportunity for the opposition Labour party, ousted in 2010 after 13 years in power, to exploit the Coalition’s economic plight.  Not so.  Mindful of their role in presiding over the accumulation of the debt their Treasury spokesman, Ed Balls, refused [2] to regret any of his government’s borrowing.  He explained that the need for retrenchment today stems only from the 2008 banking collapse which was a global problem and therefore not one to be laid at the door of the then incumbent government.  He did admit that he and his colleagues were not strong enough on bank regulation.   Far from criticising the Coalition for failing to get the debt under control today, Labour prefers to focus on the social costs of the modest cuts undertaken and argues that they would have made broadly the same level of cuts, but implemented them more slowly.

The two political sides therefore differ very little on the measures to be undertaken, giving little impression of expertise in addressing the impending debt crisis.  Perhaps, however, both sides know what needs to be done but are scared to say so, let alone embrace the necessary policies.

One of the UK’s major problems is its appeal as a migration centre.  The UK’s generous benefits system and lax checks on qualifications unsurprisingly sees the population growing rapidly.  In the last 12 months, 87% of the 400,000 new British jobs have gone to migrant workers.[3] Membership of the European Union is a common policy of each of the three major UK political groups, and all EU citizens are welcome and no British party has any plans to curb the steady influx of people as the EU enlarges itself.

The ONS report reveals that the national debt is no longer within the government’s control.  A significant volume of the debt is inflation linked.  The effect of near zero interest rates and money printing has caused retail prices to rise strongly.  The interest bill for the last 12 months was £45bn, or 1/3 of the £133bn in the y.o.y. increase in national debt.

Borrowing is literally therefore out of control and truly radical measures are needed to address it.  The benefits system and the National Health Service should be significantly pruned.  The difference between the UK and Greece is that the UK has its own currency and can print more of it.  Unless the Coalition gets control of its expenditure I fear the launch of our own QE2.  A second dose of QE would be disastrous, leading to currency failure and hyper-inflation.


[2] June 19th Andrew Marr show, BBC2 – TV.

[3] Frank Field article, as at 1 above


Five Days to Save Britain’s Taxpayers from the Consequences of False Accounting

As things move on, it looks as if pressure is mounting for Parliament to have its Second Reading of Steve Baker’s Bill on 10th June 2011.

Ireland is only just waking up to the frightening consequences of IFRS accounting in the midst of its fifth bailout. IFRS means that the Irish Central Bank appears powerless to make its banks produce accounts revealing the sad but true extent of their loan problems.

Ireland’s government now accepts that IFRS requires banks to hide loan losses, i.e. compels false accounting. It is imperative that the UK Parliament swiftly enacts Steve Baker’s Bill to ensure that taxpayers and scrutineers can inspect our banks’ prudent accounts of true capital and profits.

The exposures may be greater than the cost of the first round of bailouts, but we need to know.

This clarifies the importance of the story about RBS reported in Thursday’s Telegraph.


The Delayed Effect of Printing Money via Quantitative Easing

Gold reaches £913 per ounce

If political leaders and central bankers think that they can curb the currency debasing effect of QE merely by turning off the tap, they are mistaken.  Markets reflect not just today’s monetary policies but also rational players’ expectations as to future activity.

At a lunch recently with Ewen Stewart, the parallels between the UK’s QE and the Weimar Republic’s printing of paper Reichsmarks became starkly apparent.  Since QE began, Ewen explained, 69% of all gilt issuance has been bought by the Bank of England.  This makes sense when one digests the transactions entered into by the Government to create money and then issue gilts.  Consider the following transactional steps:

  1. The UK Treasury’s Debt Management Office announces its intention of buying  specified financial assets, either gilts or bank loans;
  2. Life funds and other institutions willingly compete in this ‘buy back’ auction to sell gilts and other ‘high quality’ assets to the DMO, and prices are moving in favour of the seller given the DMO’s initiative;
  3. The Bank of England presses a button on a computer and transfers the newly printed cash to the DMO in order to settle the buy back trades.  The DMO credits the accounts of sellers with the newly created money;
  4. The DMO subsequently announces a conventional gilt auction whereby gilts are issued by the DMO for purchase by banks.

What are the commercial drivers of these four steps?   Why would the DMO issue at Step 4 given that it has purchased at Step 1?  The only conclusion is the creation of money, which necessarily entails the debasement of the currency.

Would the DMO agree with this summary?  Perhaps not.  It explains the QE operation in different language.   According to its pamphlet “Quantitative Easing Explained”, the exercise stimulates the wider economy by ‘injecting’ money.

The MPC’s decision to inject money directly into the economy does not involve printing more banknotes. Instead, the Bank buys assets from private sector institutions – that could be insurance companies, pension funds, banks or non-financial firms – and credits the seller’s bank account. So the seller has more money in their bank account, while their bank holds a corresponding claim against the Bank of England (known as reserves). The end result is more money out in the wider economy

But this denial that banknotes are being printed is mere spin.  The term ‘injection’ is misleading – it implies that the substance being injected is already in existence.  This is not the case with QE.  A pamphlet purporting to explain QE should clearly state that the money is “created” before being injected.   It is true that banknotes are not actually physically printed as they were in Germany in the 1920s.  But that is because today, unlike in the 1920s, bank accounts are represented by computer entries.  Therefore it follows that the creation QE and the transfer of QE proceeds to a bank by increasing the bank’s account balance with the Bank of England is, in plain English, printing money.   It is an exact modern equivalent of rolling the printing presses and sending a pile of banknotes round to the physical headquarters of RBS or Barclays under the watchful eye of a bevy of burly bank stewards.

Indeed, the sophistry of the DMO’s denial that QE is money printing, based on the technical point that physical ink and pieces of paper are not required at the point of QE money creation, is exposed by the diagram summarising the above quoted paragraph from page 8 of the pamphlet:

The Bank creates money and uses it to buy assets such as government bonds and high quality debt from private companies

Upon recently re-reading Adam Fergusson’s detailed daily chronicle of the collapse of the German fiat currency in 1923, I was struck by what economists call the J-curve effect.  It was a matter of years, not weeks, before the full and dire consequences of the policy of printing money became apparent.  All of the characters whose lives Fergusson recounts, with the exception of the politicians, could foresee the dreadful consequences of money printing.

But the crisis evolved in phases.  As it started to bite, clever Germans worked out that debt would be inflated away and that hard assets would quickly rise in value.   At page 109 we learn how in 1922 the clever Hans-Georg von der Osten, borrowed in February to buy a substantial estate, then paid off the entire loan in the autumn with a modest crop grown that year on the land.   During that summer he also bought 100 tons of maize from a dealer for 8 million marks, only to sell the same crop back to the dealer a week later for twice the price.  With the profits “I furnished the mansion house of my new estate with antique furniture, bought three guns, six suits and three of the most expensive pairs of shoes in Berlin, then spent eight days there on the town”, he boasted.

There are of course many differences between the UK’s economic circumstances now, and those of Germany in the early 1920s.  But there are also many parallels.  One significant parallel is that Germany’s rulers knew that the country was unable to pay its war debts, and possibly embarked on their programme of currency debasement, to the ire of the Reparations Commission and creditor nations, as a deliberate policy to inflate the problem away.

So in March 2009, in order to address the banking crisis, the UK believed that a £200 bn programme of quantitative easing was an essential monetary policy tool to stimulate the economy and “control inflation”:

The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

I can only assume that the German government believed that, when the nirvana of modest national debt had been reached, they could end the debasement and somehow revive the economy.   However, by 1924 many Germans could not afford food because confidence in the currency was so low that nobody wanted marks.  Fiat currencies depend entirely on confidence, and when the confidence bubble is punctured, no matter how slowly the air escapes, it proves exceptionally difficult to repair.  Both the US and the UK are now experiencing this.   When the UK launched QE in March 2009, gold stood at about £600 per ounce, today the same ounce costs over £900.

I would be grateful for any Bank of England officials to enlighten me as to where my above squaring of QE with Weimar money printing may be mistaken.  If our central bankers are unable, perhaps they would be so kind as to acknowledge that their website quotation above is grievously mistaken.  QE, far from being a technique of inflation control, represents the introduction of the germ of hyperinflation which, unless stopped or preferably reversed very soon, will continue to grow like a virus within our economy and in turn may wreck our society.

At what level of the pound to gold would the BoE start to lose confidence in the merits of QE?  Or is the price of gold in pounds irrelevant?  Was Isaac Newton therefore confused in his insistence on a clear relationship between the pound sterling and a specified weight of gold?  If that is their view, perhaps the BoE ought to take that famous bar of gold out of their own museum.  That would be more consistent with the BoE’s apparent present beliefs: we should forget that the pound was once a hard asset backed by gold, and learn to appreciate that the paper pound exists as a pure confidence asset.

Fergusson’s final paragraph should appear next to those absurd sentences on the Bank of England’s website.

In hyperinflation a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano.  A prostitute in the family is better than an infant corpse; theft was preferable to starvation…..

Thanks to Ewen Stewart and Andy Duncan who have contributed to this piece.