November 11, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

One of the big mysteries out there relates to the strength of Spanish banks. According to the Spanish government, house prices in Spain have now fallen by 15 per cent. And yet, while all around there is panic, Santander seems to rule supreme. At least it does in the Eurozone, where it is now the region’s largest bank.

Santander, which, assuming the Lloyds TSB HBOS merger goes ahead, is set to be the fifth-largest bank in the UK, has scored where others have failed. And yet, it almost seemed to reveal a bit of a crack this week.

In Spain, the government said you can’t have your paella and eat it. If you are going to lend out huge sums of money as mortgages, then you better make sure you have got lots of capital.

So, the Spanish banks may have lent out a lot, and may have got themselves exposed to the fragile Spanish property market, but at least they were less reliant on the wholesale market for money.

But then the last few weeks have seen a cloud appear on the horizon. The awful truth has dawned that the economic crisis is not just a crisis for the US, UK and a handful of other countries – it’s worldwide – and that means Latin America is exposed, too. Maybe, went the fear, even Santander was in danger.

But then the bank reassured us all. It was fine, and despite all its purchases, there was no need for extra funding. Does that remind you of anyone? Well, RBS said something similar for months, before reality bit.

And while everyone was relaxing on last week’s announcement that Santander didn’t need any more money, it then went out and put the cat amongst the pigeons.

All of a sudden, it is raising 7.2bn euros. And at an apparently nice price too, shares will be sold at a 46 per cent discount.

The bank’s capital tier one ratio was 6.3, but once the costs of recent acquisitions were taken on board it was thought the ratio would fall to 6.

But, after the money is in, its capital tier one ratio will be 7; that’s pretty good.

Emilio Botin, Santander’s chief executive talked about “self-imposed” guidelines and said: “Banco Santander has always had a very clear approach to capital strength. This is a magnificent opportunity for shareholders.”

No doubt the new ratio will be fine – but it is all a little odd.

Meanwhile, HSBC revealed some more write-downs, but still the bank cuts a bullish figure. Its capital tier one ratio is 8.9. And that really is impressive.

HSBC is the biggest bank in the world (by market capitalisation) these days, but even it has vulnerability. Its exposure to Asia is its strength, but now even Asia is feeling the economic winds.

And before we leave, just one point about these capital tier ratios. In all the hullabaloo about banks not passing on rate cuts, if seems to get forgotten that the banks are supposed to be repairing their capitalisation. And it seems you can’t have improving capital ratios and high lending at the same time. That really would be akin to having your paella, pasta, foie gras and Victoria sponge cake, and eating the lot, all at the same time.

October 28, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

Yesterday, the Bank of England released its bi-annual financial stability report. The headline figure was enough to send a shiver of fear everywhere. Total losses related to the financial crisis in the US, UK and Eurozone to date are now thought to come in at around $2.8 trillion. You may recall that, earlier this year, the IMF made the headlines when it predicted total losses would amount to $945 billion.

Bear in mind that these losses don’t include losses elsewhere in the world – and, as you know, they are mounting all the time.

But beneath the headline figure, the Bank of England report had some fascinating findings, and they weren’t all bad.

The first question we should be asking is why forecasters so utterly failed to call the seriousness of this crisis. In its April financial stability report, the Bank of England did allude to certain risks, but its central forecast assumed banks would successfully go out and re-capitalize, and by now it had expected things to be very different. Then of course, Henry Paulson made the decision to let Lehman Brothers go bust, and the world changed.

The collapse of Lehman Brothers is being used as an excuse by just about all forecasters for failing to predict the seriousness of this crisis.

You need to understand that part of the problem relates to the controversy of mark-to-market accounting. If a bank goes bust, and assets are sold at fire-sale prices, then all the banks are forced to revalue their assets at these prices. Many are up in arms about this accountancy approach, but you know, it is a little rich for bankers to protest too loud. If you run a small business and request a loan from a bank, they will usually insist on placing a fire-sale valuation on the business’s assets.

But the point is, when the Bank of England makes its headline figure for total losses, what it is really saying is that is what the losses will be if assets are valued at current prices. And, right now, assets are cheap.

In its report, the Bank looked at the reasons for the crisis. It may seem obvious to you what those reasons are, but the Bank does explain it nicely. “In 2001, UK customer lending was comparable to customer deposits, but by 2008 there was a funding gap of £700 billion,” it said.

In other words, we borrowed £700 billion more than we saved. “Much of this funding was ultimately sourced overseas. In particular, the United States acted as an intermediary, attracting capital inflows from the rest of the world and exporting these funds to other countries,” said the Bank of England.

But now that losses are mounting, what is there to do? Will government-backed bail outs help? The Bank’s answer to that question is fascinating, but not especially encouraging.

In the medium term, the funding gap can only be filled by one of two means. Either UK consumers need to save more, or lending levels must fall. Rising savings levels might be just what is required to solve the burgeoning pension crisis, and for individuals of course, increasing savings will be highly beneficial. But across the economy as a whole, a rise in savings right now will be disastrous, and could make the recession far worse. It is what Keynes called the paradox of thrift.

So, what about all that government money, won’t that help? The Bank of England says: “Capital injections should also smooth the adjustment process for banks, allowing balance sheet deleveraging to be orderly, and minimizing spillovers to the real economy caused by restrictions of bank credit. But these injections alone may not be sufficient to reduce fully banks’ leverage to a lower equilibrium level. For example, even after accounting for recently announced capital raisings which the UK Government will help underwrite, the largest UK banks would need to shed around one sixth of total assets to reduce leverage back to, say, 2003 levels.”

The real point here, though, is that capital injections will do little more than smooth the transition to higher savings and lower borrowings.

Bear that in mind when you read about government plans to get banks to lend at 2007 levels – even with government money, they just can’t do that. Furthermore, when you hear protests that banks are not passing rate cuts on to borrowers, bear in mind that banks desperately need to reduce risk, and they can do this by charging higher margins. Those who blame banks for taking too many risks, and then criticise them for not passing on rate cuts, are just trying to have their cake and eat it.

The Bank of England report was bad news for buy-to-let investors. This is what it had to say: “In the BTL market, tighter credit conditions, combined with falling house prices and rising LTVs, are likely to lead to substantial refinancing costs for many landlords. In recent years, expected capital gains from house price appreciation may have made landlords willing to subsidise these costs. But falling house prices — and expectations of further falls — may erode this willingness and lead to increased arrears and/or selling of properties. The BTL sector accounted for 11 per cent of the total mortgage debt outstanding in 2008 Q2, compared to just 2 per cent in 2000.”

But, finally, here is some good news: “Corporate insolvency rates remain near historical lows,” said the Bank. It added, “Many companies extended debt maturities during the recent boom, with Dealogic data suggesting that only about 10 per cent of the stock of sterling-denominated bonds and loans outstanding are due to mature in 2009.”

Mind you, even then it had worries. It said: “But within that aggregate picture, there are pockets of vulnerability. Company accounts suggest that the proportion of debt held by businesses whose profits were not large enough to cover their debt interest payments picked up sharply in 2007 to around a quarter of the outstanding stock of debt. As the economy slows profit growth is likely to weaken, increasing corporate vulnerability: particularly at businesses heavily dependent on the retail and property markets and some highly leveraged companies.”

October 20, 2008 | posted by Michael Baxter in banking rescue plans | comments (1) |

Consider these words uttered by the last but one Labour Prime Minister in 1976: “We used to think you could spend your way out of recession by boosting government spending. I tell you, in all candour, that option no longer exists.”

As an undergraduate, yours truly once had to write an essay discussing whether James Callaghan was right. Many years later – but precisely how many years is a secret – that essay question is more relevant than ever before.

This time, Al is at it. During World War II we dug for victory. Well, now the government is spending for economic victory.

Forget the Golden Rule and the Sustainable Investment Rule; they are dead in the water. And all of a sudden Keynes is back.

It is one of those oddities. Only the other day, someone asked the question why isn’t Keynes as famous as Darwin? It is true that many people in this country, the land of his birth, have never heard of John Maynard Keynes. When BBC2 voted for the all-time great Britons, he didn’t even show up on the shortlist. And now he is coming back. But, simultaneously, others place all kinds of sins at his doorstep.

The truth though is that Keynes’ theories were really designed for dealing with an economic depression. The mistake UK governments made, ever since the end of World War II, was to use the ideas of Keynes for everything. For decades Keynes was used as a kind of economic panacea. His theories were used to try and end the economic cycle. And yet the cycle endured.

But this time it is different. Yesterday, the Sunday Telegraph quoted Mr Darling as saying: “Much of what Keynes wrote still make sense.” Well, is he right?

It is an important question. If our chancellor is right, and Keynes did indeed have the remedy for our times, then we can all breathe a sigh of relief. But supposing Mr Darling has made the wrong call. If that is so, then things are set to get a whole lot worse.

The big snag with recessions is that they can turn into a downward spiral. Times are tough, so we save more. The rise in savings means there’s less demand throughout the economy and, as a result, business suffers all the more. So job cuts mount, and we save more. That was what it was like in the 1930s.

If the UK has a problem of too much debt, then the obvious solution is to save more and repay debt. Keynes showed, however, that this rise in savings could make things worse.

Yet, if Mr Darling chooses to pump money into the system, the result will be even more debt. You see the dilemma.

This morning, the ITEM Club from Ernst and Young revealed its latest economic report for the economy. This is a highly respected economic group, and their conclusions should always be listened to.

The ITEM Club reckons the UK economy will contract in 2008, to the tune of 1 per cent. The following year will see miserable growth of just 1 per cent.

Its main warning went like this: “The credit crunch will now hit the economy very hard even if the wholesale markets reopen and the equity markets stabilise. Credit was very tight even before the recent intensification of the crisis. The downward momentum in the housing market will be difficult to arrest and is now spreading to other sectors.”

It went on: “With the exception of a few end-cycle industries like aerospace, there is no residual strength anywhere. Widespread reductions in investment and employment are now inevitable, maintaining the squeeze on household budgets just as the commodity price pressure eases.”

Above, we warned how the last thing you want to do in a recession is get people saving more. Yet, consider these words from the ITEM Club: “The funding gap – our reliance upon wholesale bank deposits to make up for the paucity of domestic deposits – will be more difficult to solve. That is because it is a reflection of the deep-seated macroeconomic imbalances in the world economy, and in particular the high level of borrowing and the low level of saving in the UK…. Long-term, we need to rectify this situation by increasing savings, but that is not going to happen overnight.”

Bear this in mind, however. It is true we have high personal debt in the UK, it is also true that in recent years the government’s annual budget deficit has risen. But overall, government debt is still lower than any other G7 country, and by a long way, too.

Mr Darling can get spending up, he can spend a lot of money on new infrastructure without pushing the UK into any more debt than other major economies, such as the US, France or Germany. The sustainable investment rule was supposed to limit net debt to 40 per cent of GDP. Okay, it is going to rise. But, even if debt rose by half as much again above that level, the UK would still have less net debt as a percentage of GDP than any other G7 country – although, admittedly, the Public Finance Initiative distorts figures on UK public debt.

The point really is this. 70 years ago, Keynes outlined his ideas for what to do when an economy is in economic depression. For the length of an average lifetime, economists have debated and argued his ideas. It is easy to blame the theories of Keynes for many of the UK’s problems, especially during the 1970s, but his defenders say that Keynes’ theories were taken out of context. The real test of Keynes is whether his ideas work in a real economic climate. So, the test begins today. Mr Darling has unveiled a plan that only has Roosevelt’s New Deal as historical precedent. The jury is still out whether Roosevelt’s plan, which, by the way, was inspired by Keynes, worked.

October 15, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

Earlier this week, the Nobel Prize in Economic Sciences was awarded to a Bush-bashing, Gordon Brown-loving American.

Paul Krugman, Professor of Economics and International Affairs at Princeton University, and a regular columnist for the New York Times, has made many fans and critics over the years. His fans love the way he has used his New York Times column to lambaste Bush and US economic policy. His critics say he seems to be running a one-man, anti-Bush show.

But his Nobel prize was awarded for something more important than all that.

First of all, he worked on something called New Trade Theory.

As you know, right now, US politicians are screaming blue murder at the injustice of developing countries still growing behind a wall of protection and subsidies, while US companies suffer.

You can see the argument. In some parts of the US, in areas that are reliant on the auto industry, economic depression has already descended. It is not fair, they say, we are losing jobs, not because manufacturers in other countries are more efficient, but because they are subsidised.

But, there is another side to the coin.

You may be familiar with the Law of Comparative Advantage. This is the law which is supposed to show, beyond all doubt, that free trade is best and that any tariffs are bad. The law is possibly the most important economic principle there is.  It shows that it pays for two countries to trade with each other, even when they produce exactly the same goods and one country has an absolute advantage in every single product produced.  What counts, instead, is relative, or comparative advantage. So, for example, it makes economic sense for a high-powered lawyer, who happens to have a knack for cleaning, to pay someone to clean his house, even though a cleaner may take longer than the lawyer to make the house look all pristine.

There is a snag with this argument, however. It does not take into account economies of scale.

Any new business will always struggle to compete against traditional business, because it is simply not big enough to enjoy the full benefits of mass production. It is at a disadvantage against the larger company.

And that is why, it is argued, it does make sense to protect infant industries.

Krugman then took the idea of New Trade Theory and asked why it is that some countries export and import similar products? Why does Japan export Toyotas and import BMWs? Why does Sweden import Volkswagens but export Volvos?

The answer lies, in part, with economies of scale.

The public want variety. But as companies specialize and grow, and then exploit further economies of scale, each company becomes a specialist in its own niche. And BMW becomes especially good at producing BMW-type cars, but not so good at Japanese-type vehicles.

Krugman also looked at why individuals might move from towns to cities. Again, it seems to have a lot to do with economies of scale, with the specialist pool of labour on tap in a city, accentuating its own advantages.

Krugman’s theories are not easy to understand. He himself said they are: “… pretty well incomprehensible to laymen.”

But this is the curiosity: Krugman has done something that has left many economists fuming. He has talked to the mass market, and tried to express his theories, including other less academically oriented ideas, via his newspaper column.

Some see the Nobel award as a kind of posthumous award, for a former economist who has become a populist..

The truth is, those criticisms are themselves arrogant. Some academics become too precious by far about their discipline.

Krugman has had very little good to say about George Dubya, and was one of the economists who warned most vociferously that there was trouble ahead. This has not endeared to him to many.

As for Gordon Brown, he has heaped eulogy on Brown’s banking rescue plan. Earlier this week, his Monday column for the New York Times began with the sentence: “Has Gordon Brown, the British prime minister, saved the world financial system?”

He said: “The Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own.”

Mind you, Krugman is also a big critic of Gordon Brown’s friend, Alan Greenspan.

He also argued in his recent New York Times post that the George Dubya regime has effectively driven out “knowledge professionals”, meaning there was no one left at the US Treasury “with the stature and background to tell Mr. Paulson that he wasn’t making sense.”