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By Gordon Kerr, on 20 January 12
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.
By Gordon Kerr, on 5 October 11
The UK government recently announced a “credit easing” plan. According to a junior minister the rationale is:
- Small businesses (SMEs) are unable to borrow funds from either the main banks or in the shadow banking markets;
- The UK needs SMEs to thrive in order to drive the economy;
- 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:
- 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;
- pouring cash into failed banks via QE in the hope that this would be lent to “deserving businesses”;
- 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
By Gordon Kerr, on 12 September 11
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:
- 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.
- 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.
- 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, 24 th 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“
By Gordon Kerr, on 30 August 11
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:
-
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.
- 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.
- 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:
-
BofA survives and thrives. Happy days for all stakeholders, excellent return for Mr. Buffett;
-
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;
-
BofA fails and (2) above extends to pay off unsecured creditors but not preference shares;
-
BofA fails and preference shareholders are covered by (2) above;
-
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.
By Gordon Kerr, on 1 July 11
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.
[1] http://www.frankfield.com/media/articles/q/date/2011/06/20/these-welfare-reforms-won-t-hit-the-spot/
[2] June 19th Andrew Marr show, BBC2 – TV.
[3] Frank Field article, as at 1 above
By Gordon Kerr, on 6 June 11
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.
By Gordon Kerr, on 27 April 11
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:
- The UK Treasury’s Debt Management Office announces its intention of buying specified financial assets, either gilts or bank loans;
- 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;
- 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;
- 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.
By Gordon Kerr, on 12 April 11
214 Pages Displaying No Confidence in Solving the Banking Crisis
My disappointment in the content of the ICB’s preliminary report published yesterday morning was, like the report itself, generally anticipated and strangely muted. The pointlessness of the ICB exercise was perhaps underlined by the response of the market in UK bank shares – flat to up 3%.
Sadly, the report’s most striking impression is its authors’ lack of confidence. The report does not convey belief in the Commission’s understanding of the commercial drivers of modern banking – the hunger for accelerated profits via derivatives, the effect of the moral hazard of banking bailouts, bankers’ fears that, without huge overcollateralization, any non-governmental customer could go bust and should either be avoided or charged maximum possible margins and fees.
Surely the commercial drivers that have brought about the present crisis should have been set out, considered and addressed within the ICB’s recommendations. But what do the ICB actually recommend? Here is a sample:
- contingent capital “could be a useful tool” in helping banks deal with future crises
- “universal banks” can continue to operate investment and retail banking operation so long as retail banks hold 10% capital against their assets and implement other measures designed to protect depositors….
- on competition, Lloyds should sell more branches…
Rather worrying is the dumbed down nature of this long report. On page 15 there is an introduction to the Financial System:
What is the financial system for?
2.4 The financial system supports the wider economy by:
- providing payments systems;
- providing deposit-taking facilities and a store-of-value system;
- lending to households, businesses and governments; and
- helping households and businesses to manage their risks and financial needs over time.
Deeply worrying are the uncorroborated assertions that clearly bound the ICB’s thinking early on in the report. These weaken the reliability of the report. At page 19 the report states two reasons why bank failures are much worse than the failures of non-bank businesses. The second of which is “bank failure imposes collateral damage. To a much greater degree than is typical for other firms”.
Not only is no analysis suggested for this strong point (since bailouts have prevented UK bank failures, how can the ICB be so strident?), but also the communication of the point in glammed-up, non-scholarly imagery such as “collateral damage” reinforces my fear that this is really showmanship rather than the much-needed statesmanship.
Why has this report been commissioned and what is its significance? All our major politicians have pronounced the banking crisis a “global” phenomenon. Indeed, since even before the onset of the present crisis there has been an international institution tasked with producing global banking stability measures that has met and reported regularly, the Financial Stability Board.
The UK’s membership of the EU and participation in the Irish bank bailout imply that the Coalition regard the banking crisis as a tricky issue best left to other authorities. The British Bankers Association’s published submission to the ICB makes note of the above two points and brazenly advises the ICB to do nothing pending further FSB guidance.
The UK public are angry at the failure of the banks, the costs of bailing them out, and at the austerity measures seen to stem directly from the bailouts.
“Conventional Wisdom”, a term of derision coined by J.K. Galbraith, leaps out of the ICB’s preliminary report. In politics, the convention has been that, when faced with a disaster, set up an independent commission to investigate and report, but take care to:
- restrict the commission’s remit;
- ensure that it is chaired by a distinguished establishment figure
- perhaps even appoint a sharp civil servant as secretary to ensure the commission’s focus never strays from the narrow remit
Unfortunately the cost/benefit analysis of the ICB may prove just to be a few more pounds sterling added to the UK’s tab for the banking system’s failure.
By Gordon Kerr, on 5 April 11
BlackRock Inc., the independent stress-tester of Irish banks, has discovered a €24 bn capital black hole in their balance sheets. For a fifth time, citizens of the Emerald Isle are told that this bailout will be the last.
As reported by the Wall Street Journal on April 1st, the tab will increase from €46 to perhaps €70 bn as a result, or €15,000 per capita.
Even if this were the final bailout, the evidence cited Thursday 31st by the WSJ correspondent David Enrich supports the view that, contrary to the Irish Government’s assertion, the Irish taxpayer will not in fact fund these amounts and sadly Ireland will be unable to avoid a default.
As any professional in the mortgage markets knows, a housing market in which 5.7% of mortgages are delinquent (90 days past due) is on the brink of a price collapse. When I was securitising European mortgage portfolios in supposedly stable conditions before the systemic banking collapse, my team would raise eyebrows if the 90 day figure was a tenth of this level.
This 5.7% figure, and the trend up from 3.6% at the end of 2009, should have been focussed on more closely by the Irish Central Bank. The problem with the stress tests is that they are static in time, as opposed to forward looking, and fail to factor in these expected future price declines.
Irish house prices, as expressed by wage multiples, will decline further as these delinquencies turn into forced sales and Irish citizens put off buying until a price bottom is felt to be reached.
The historian Niall Ferguson queried whether we should compare our big banks to dinosaurs on the verge of extinction in the Financial Times in December 2007,
The big question for our time is: are we on the brink of a “great dying” – one of those mass extinctions of species that have occurred periodically in the history of life on earth, such as the Cretaceous-Tertiary crisis that killed off the dinosaurs?
The answer to this question is yes. And the proof is in the last 3.5 years of major European bank bailouts.
Let us distinguish the 2007-2008 bailouts (Phase 1) from the recent and future bailouts (Phase 2). The importance of the comparison is that Phase 1 bailouts were accompanied by interest rate cuts. Now that we are in Phase 2, Central Banks have no further scope for reductions.
Promoters of Phase 1 bailouts failed to mention at the time the circular effect of the price inflation of bank-credit-dependent assets triggered by the bailout itself. Right after each bailout, house prices tend to rise, especially so because of the interest rate reductions.
Phase 1 supporters also failed to mention the artificial boost to banks’ apparent profit lines directly attributable to the interest rate cuts. Yield curves were shunted downwards and all bank owned assets subject to mark- to-market accounting were boosted in value, triggering the recording of future hoped for cashflows as higher up-front profits under poor accounting rules that exaggerate the apparent financial health of banks. These rules were brought into effect in an environment in which global authorities did not believe that banks could fail en masse.
During Phase 1 taxpayers were assured that economies would recover relatively swiftly and that the need for the bailout was a unique and unforeseeable banking liquidity hiccup which would be fixed by the proposed drastic action.
But the bailout surgery has failed. The drain of lifeblood from economies by way of tax to fund bailouts will be looked back on with amusement by future generations just as we smile when reading in our history books about unnecessary surgical operations performed on medieval patients. Our never-ending bailouts are simply worsening the condition of each national economic patient.
The cuts required to finance various national austerity programmes are provoking civil unrest (UK) destabilizing governments (Portugal), and stifling economic recovery (UK again – Dixons Retail and other “discretionary spend” businesses continued this week to revise downwards their profit forecasts).
Few of the banking big beasts have perished because of the scale of bailouts by Western governments.
These bailouts should now end. As the Irish case demonstrates, they cannot work. Their impacts are trivial and short lived, and their long term costs cannot be absorbed by taxpayers.
By Gordon Kerr, on 17 March 11
Imagine, for the sake of argument, that we discover a little-known, unpopulated territory within the EU, on which to establish a colony. Let’s call it “Ruritania” and allow it to use sterling.
We establish our fledgling colony on Ruritania with four people:
- a depositor, Alice, who arrives with £103;
- a builder called Bob;
- an entrepreneur, Matilda;
- and a banker (Mallory) with a colourful recent past in Iceland and Ireland.
Interest rates are 0.5%.
Mallory establishes a bank. He persuades the other 3 inhabitants of the importance of a healthy banking system, so Ruritania’s constitution contains a limited guarantee from future taxpayers of £10 in favour of the bank. Under European Banking Authority devolved authority, Ruritania classifies this guarantee as core Tier 1 bank capital.
Alice, seeking to keep her money safe, deposits it in a demand account at the bank.
Matilda, the entrepreneur, wants to start a business.
She approaches Mallory for a loan. He retains a reserve of £3 from Alice’s deposit and lends the entrepreneur, at interest, the remaining £100 of cash deposited by Alice.
The entrepreneur then employs Bob the Builder, who wants his year’s wages up front. So the entrepreneur hands over the £100 to Bob, which Bob deposits in the Bank.
Let’s set aside for the moment that the bank just doubled the money supply of Ruritania.
The banker now has two liabilities: a deposit of £103 from Alice and a deposit of £100 from Bob. Offsetting these, he has two assets: a 25-year loan of £100 paying 7%, plus cash of £103.
Mallory wants a Ferrari, today, which he can buy for £20. His compensation contract is 20% of bank profits. He needs to record an instant £100 in profit for his bank, and he knows how to optimise his profits under EU bank accounting rules.
He phones an insurer active in the credit derivatives market – let us call it ‘GIA’ – who agree to write a credit derivative known as a “Credit Default Swap” for a fee of 1% per annum.
The bank quickly establishes an off balance sheet company, an “SPV” which buys the future £275 loan cashflows. The GIA trade is executed directly with the SPV. The SPV finances its purchase of the loan from the bank by issuing two notes:
- a 95% senior note rated AAA by two US rating agencies because GIA is so rated
- 5% junior or “equity” note.
The bank buys the two notes for £100 in cash. These funds then flow back from the SPV to the bank to settle the purchase contract.
The equity note is a £5 deduction from the bank’s £10 Tier 1 capital. This capital is, you will recall, a future taxpayers’ pledge rather than hard cash.
Under marking to market rules, by holding the senior note on trading book the bank records an instant but unrealised profit of £105. After replenishing Tier 1 equity with £5 the bank shows a £100 clear profit.
The profit of £100 has been recorded even though the bank has not received any income from the loan. But the banker is not too concerned about that, as he has his Ferrari.
The banker and his shareholders have taken £100 of the £103 total money supply of Ruritania, declared it as profit and spent it abroad.
Mallory seeks to grow his bank and obtains liquid funds by repo’ing the Note at its market value of £205 with his central bank.
He receives £205, and uses the fresh liquidity as collateral for further bets, derivatives with other banks and low priced Irish bank issued bonds in the hope of more very fast profits.
Unfortunately the bank becomes insolvent when Matilda misses a loan payment. The central bank take ownership of the repo’d note. Depositors ask for their funds but the bank cannot pay.
Liquidation position:
- Two depositors have claims for £203.
- There is only £6 in cash – all other cash had been pledged as collateral.
- Nobody was aware that the senior note had been repo’d with the ECB. Under accounting rules amended in 2010 it remained on the balance sheet of the bank.
- Banker is laid off but enjoys his Ferrari.
The regulatory response to the 2008 collapse has not been effective. I would argue, as demonstrated above, that many of the post-2008 rules ostensibly intended to address the crisis are unfortunately exacerbating it.
The regulatory umbrella continues to encourage more exposures to be marked to market. The example above highlights the dangers.
Regulators need to be aware of the extent of these exposures in order to help avert any future threats. This requires the publication of parallel accounts with derivatives and other investments recorded at the lower of historic cost and their marked to market value. Steve Baker MP has introduced such a Bill in the UK Parliament. It should be supported.
With thanks to:
Steve Baker, MP for Wycombe
Kevin Dowd, Visiting Professor, Cass Business School
Margaret Woods, Reader in Accounting, at Aston University
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