July 1, 2008 | posted by Michael Baxter in credit crunch | comments (1) |

“You there, Bernanke, isn’t it? Go to the headmaster’s office. You, King, join him.” Just then there was a knock on the door; it was last year’s head boy, who had returned to re-take a course. “You asked to see me, Sir,” said the former top boy. “Greenspan,” came the reply, “you are expelled!”

Yesterday it was a lot like that. The Bank of International Settlements has been described as the central bank’s central bank. Yesterday it seemed to take on the persona of that really strict teacher everyone was frightened of. And the boys and girls under the rap were the great and the good of the economic world.

They were slammed. The problem that haunts the global economy was laid out in clear, and quite distressingly lucid, detail, and a solution, was proposed.

Of the great economic crisis of 2008, yesterday saw one of the most important developments.

The most deadly venom was saved for the report’s last sentence: “Businesses” it concluded, “and banks are expected to undertake business continuity planning in advance of trouble. Surely we should expect as much from policymakers.”

And in a way that says it all. Our policymakers, it appears, let us down. The answer: quick, transparent, decisive action. None of this business of trying to appease shareholders with big dividend payments. Massive bonus payments must stop. Losses must be declared. Debts repaid.

It will be tough, “But,” said BIS, “if history is any guide, failing to make such efforts will eventually entail recourse to still more expensive and dangerous measures during the crisis itself.”

But there is a snag. You may have had that experience at school, when your teacher leans over you, face red with fury, admonishing you, telling you to fix your mistake, but not telling you how. The BIS report did smack a little of that.

The problem, according to the BIS, is that central banks and governments misdiagnosed what was going on. “For many years,” it said, “global inflation was maintained at low levels, aided by the tailwinds of numerous positive and overlapping supply shocks arising from deregulation and technical progress, but perhaps due even more to the entry of major emerging economies into the global trading system. However, instead of temporarily allowing inflation to drift lower, analogously to the past treatment of negative supply shocks, policymakers interpreted this quiescence of inflation differently. They took it to mean that there was no good reason to raise interest rates when growth accelerated, and no impediment to lowering them when growth faltered. It is not fanciful, surely, to suggest that these low levels of interest rates might inadvertently have encouraged imprudent borrowing, as well as the eventual resurgence of inflation.”

Well, over five years ago now, Investment and Business News said: “If inflation is not the result of the current monetary and fiscal policies of governments and central banks, then every economic text book ever written will have been torn up.”

The good news: the text books can remain. The trees that were felled in their creation were not lost in vain.

The bad news: well it seems the banks made a massive mistake. You may recall, a few years ago the talk was of deflation. Greenspan and Co were scared we were in danger of experiencing a Japanese style period of deflation. So they slashed interest rates. But they were perhaps a little mixed up. Back then, low prices were not down to low demand, which is what caused deflation in Japan; prices were falling because the world had got better at producing things. It was a good thing prices were falling. Wages were not falling, we were getting better off.   But, in this wonderful environment of improved technology and increased specialisation that comes with globalization, we celebrated too much. The result, asset prices shot up. House prices went through the roof.

The fundamental problem, it seems, is that we, that’s all of us, you and me, are not good at learning from the past. Churchill once said: “The further backward you look, the further forward you can see.” Mark Twain said: “History never repeats itself, but it rhymes.”

Yet, whenever there is a boom, the same old clichés are dragged out. “This time it is different.” “It is a new paradigm, now.” The BIS called it an “inherent tendency to ‘procyclicality’ in liberalised financial systems. That is, as credit expansion fuels cyclical economic growth, asset prices and optimism rise while perceptions of risk recede. This further supports credit expansion, not least through the provision of more collateral to allow more borrowing, leading to spending patterns that could eventually prove unsustainable. Initial rational exuberance might in this way become irrational, setting the stage for a possible subsequent collapse.”

The central banks, by slashing interest rates, created the seeds for today’s crisis. Then the temptation to overdo things when times are good got the better of us.

And boy, is the problem intractable? The BIS is worried about inflation and deflation. “There are dangers in saying that food and energy prices can be ignored in setting domestic policy because they are externally driven,” it said. “For the world as a whole, these are not external supply shocks, but rather seem to have been primarily demand-driven. These examples indicate that our domestic frameworks for policymaking need to be better adapted to the realities of globalisation.”

The solution then, is that interest rates need to go up… everywhere. This will curtail demand, and bring inflation under control. This may of course create recession in some countries, the UK, US, Ireland and Spain, presumably the favourites.

But then there’s another danger. The BIS said: “… that households facing heavy debt burdens, and sometimes falling house prices, will seek to raise secularly low saving rates by cutting consumption quite sharply. The fact that in the United States and some other advanced industrial countries the stocks of houses, cars and other durables already seem rather high could encourage such behaviour. Unfortunately, everyone cannot save more simultaneously, since one person’s spending is another person’s income. The end result of such a process would be lower economic activity and employment, not only in these countries, but also in those reliant on exporting to them.”

And the conclusion: “If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks and palliatives will only make things worse in the end.”

“Government’s actions should be quick and decisive, with the clear objective of removing all uncertainty about future private sector losses. This happened in the Swedish banking crisis of the early 1990s, whereas in Japan the government took too long to act decisively.”

“… losses should fall heavily on those who incurred them in the beginning: first the borrowers and then those who lent unwisely to them. In practice, however, the possible implications of widespread household bankruptcies (including resulting litigation) would also have to be seriously considered.”

“If the public sector chooses to socialise the losses, it should be done explicitly and transparently, without shifting potential losses onto the balance sheets of central banks. In practice, however, as was seen in Japan in the early 1990s, inadequate legislation pertaining to deposit insurance gave the central bank very little alternative to providing emergency assistance to insolvent institutions.”

Finally, says BIS: “The moral hazard associated with the use of government money should be counterbalanced by the introduction of forward-looking measures to prevent similar problems arising in the future.”

June 26, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

A long time ago, in an economy far away in our memories, there was no credit crunch. 

Think back, if you can bear it, all the way to December 2006.  The base rate of interest was 5 per cent.  Since then, the Bank of England has sat and cogitated, and changed interest rates five times, so that today, the base rate is … 5 per cent.    That’s right, it went up, then it went down, and now we are back to the level we started at.

But of course these days, in their credit crunch era, interest rates are determined by other factors – not just the whims and wiles of the wise men and women who make up the Bank of England Monetary Policy Committee.

According to research from Defaqto, that’s us, in December 2006 a five year fixed rate mortgage typically carried an interest rate of 5.42 per cent.  By contrast, this June the rate was more like 6.71 per cent.  Meanwhile, the arrangement fee has soared from an average of £622.90 to £823.19. 

Here are a couple more examples for you to take a gander at:
Fixed rate mortgages

  Of course, the credit crunch also means fewer deals.  In December 2006, Defaqto found that there were 465 discount mortgage products.  In June of 2007 the number had increased to 570.  Now, there are just 112. It’s a similar story, although less extreme, with fixed rate mortgages.    In December 2006 there were 917 fixed rate mortgages, in June 2007 1,355, but now just 841.

David Black, Principal Consultant of Banking for Defaqto.com says: “The mortgage world is a completely different place from eighteen months ago as the wholesale funding model has largely dried up. We’ve seen low volumes of business accompanied by increases in rates and arrangement fees and a reduction in the amount that people can borrow.

“It’s astonishing to note that the average arrangement fee charged by 3 year base rate tracker mortgages has increased by 121%. In terms of rate increases the most significant increase has occurred in the two year fixed rate market where the average rate charged has increased from 5.42% eighteen months ago to 6.71% now.  The worst hit part of the industry has been the sub prime sector but there’s also been a lot of dissatisfaction amongst the mortgage broking community with provider distribution channel issues and dual pricing.

“Best buy mortgages often aren’t staying on the shelf for very long and this means that speed really is of the essence if you see a mortgage deal that you want.”

 Mr Black added “mortgage borrowers are increasingly turning their backs on new 2 year fixed rate mortgages in favour of 3 & 5 year deals. This is because  they’ve witnessed the rapid increases in rates recently and want a longer deal and they don’t want to fork out the fairly substantial costs incurred in remortgaging every 2 years.”

June 2, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

One man’s poison is another man’s meat.  And in Europe distress is creating opportunity.

Nomura, the number one investment bank in the economy of the Rising Sun is moving in where others fear to tread, and buying up European distressed assets.

In all it is looking to invest 2.5bn euros.  Well, actually, it is only stumping up 25 per cent of the amount, the rest of the money is being raised by Nomura from Japanese, European and Middle Eastern investors.

Nomura has had an awful year so far.  In its first quarter, it made a loss of $1.46bn, but then again, for US investment banks it was a lot worse, so the bank is relatively well poised to exploit the opportunity of plunging valuations.

The idea is to buy distressed companies in France and Spain and unsold senior and mezzanine loans in Europe.

The point though is this.  Debt has gone from being to expensive, to possibly under-priced.

The Bank of England said as much recently.

This means opportunity sits with those with money – so that’s Nomura, yes, but of course the Sovereign Wealth funds too.

But that could be how this financial crisis ends.

When bubbles burst prices always fall too far, and that’s when seeds for the next boom are laid.

The same will apply to other bursting bubbles too.  Not yet, but when house prices fall to a level that is so low buy-to-let investors can’t resist them, and renting looks expensive relative to buying for tenants, then the recovery will occur.

In the meantime, opportunity sits for those who recognise bottom.

May 20, 2008 | posted by Michael Baxter in credit crunch | comments (2) |

Sure, the credit crisis has passed bottom, and the financial world is apparently on its way up, but don’t think that means the economy is past its worst.  Earlier this week, that man George Soros, once vilified for betting against sterling and the John Major government in 1992, and now something of a philanthropist, gave another of his nasty warnings for the economy.  And meanwhile, in the US, Paul Samuelson, a man who for the last four decades has sometimes been called the world’s greatest living economist, put his boot in too.

George is worried about how markets tend to go to such extremes – you know how it is, one moment everything is wonderful, the next everything is awful, and they never seem to find that happy middle ground.  “Never the twain shall meet,” as they say.

“The fact is,” Soros told the BBC, “markets are not tending towards equilibrium, ….if you leave markets to themselves they go to extremes and the authorities have to come in and bail you out.”

And that is the problem.  As markets overreact to the period of too much credit,  businesses with sound plans and solid projections may struggle to raise the money they need.  

“Once you’ve made terrible, overly optimistic errors, that paralyzes you for some time,” Samuelson told Bloomberg.

So, what about the recent return of optimism, the view things have hit bottom and are on their way up?  “I think we are past the acute phase of the credit crunch,” said Soros, “but it is the job of the authorities to provide liquidity, and it is quite remarkable how long it took them. But that is now largely behind us, but the fall out, the impact on the real economy, is yet to be felt.”

Then Soros turned his miserable science on the UK: “I think that unfortunately the situation for the UK is in many, (some) ways even worse than for the United States.”

George the doomsayer said the UK was suffering from house prices which were even more over-priced than in the US, even greater levels of personal debt and over-reliance on the City and financial services, which are of course suffering the most.

It is true that we appear to moving towards a second phase.    So far it has been the banks and financiers that have suffered.   Many business leaders have looked on with puzzlement: “Why all the doom?” they say, “Business is good.”

Now we are entering the next key phase; at least the US is, the UK still lags 12 months or so behind.   Frankly, right now it is not clear how bad, or indeed how mild, this second phase will be.    

In the post-credit crunch world, banks will be cautious, lending won’t be like it used to be. 

This morning, Bloomberg quoted Peter Hooper, chief US economist at Deutsche Bank Securities in New York and a former Federal Reserve official, as saying long-term growth in the US may drop to 2.5 or even 2 per cent from the 3 per cent we had become used to.

The real danger though is how banks value risk.

They made a massive mistake with the way they quantified property.    But property investment does nothing, or next to nothing, to promote real changes in an economy’s ability to generate wealth.  National wealth produced by rising house prices is an illusion.

Real wealth is enhanced by innovation; new ideas and products, new ways of doing things.   The danger has to be that in the backlash against the banks’ foolish lending, the victim will be innovation.

This is what governments should be turning their attention to.

We will leave you with the thoughts of a man who probably pulls rank not only over Soros and Samuelson, but every other economist who has ever lived –  Adam Smith, the man often known as the Father of Economics.    This is what he said:

“A dwelling-house, as such, contributes nothing to the revenue of its inhabitant; and though it is, no doubt, extremely useful to him, it is as his clothes and household furniture are useful to him, which, however, makes a part of his expense, and not of his revenue. If it is to be let to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue which he derives either from labour, or stock, or land. Though a house, therefore, may yield a revenue to its proprietor, and thereby serve in the function of a capital to him, it cannot yield any to the public, nor serve in the function of a capital to it, and the revenue of the whole body of the people can never be in the smallest degree increased by it.”

May 6, 2008 | posted by Michael Baxter in credit crunch | comments (2) |

“So what’s in store for the economy,” asked the hack. “I haven’t the faintest idea”, replied the elderly gentleman, “We never talk about it. It never comes up in our board meetings or other discussions.”

Okay, so maybe we would be better off looking elsewhere for thoughts on the economy.  It is just that that this self-confessed ignoramus happens to be Warren Buffett, the richest man in the world, perhaps the most successful investor of all time, and a man who drips wisdom where others of lesser wealth drip jewellery.

And for a man who knows so little, Mr Buffett talks an awful lot of sense, but, and this is what is so fascinating, it’s common sense.   Recently, the FT quoted one city analyst as saying, “If something is easy it probably means you have misunderstood it.”  Well that can be true – some things are complicated, and yet many successful businessmen will say things like “keep it simple.”   And it does sometimes feel as if the underlying cause of the credit crunch was, at heart, the analysts who made things too complicated. The failure of Long Term Capital Management, ten years ago, was surely because the maths behind its business model were so advanced that pragmatic business people didn’t understand it. Common sense can’t be applied to algorithms so advanced that it took the genius of Nobel prize winners to form them.   But then, that was its undoing.

Anyway, here are some of the latest pieces of wisdom from Warren Buffett, talking over the weekend at the AGM of Berkshire Hathaway, the company he has owned since the mid 1960s.

On oil, after conceding that part of the cause of the rising price of oil was the falling dollar, he told a CNN reporter,  “The possible surplus capacity in the world has narrowed to a very, very small margin.  If you go back 20 years ago, the world could have produced 20 per cent more oil than it was using at that time.   Now we are using 86 or 87 million barrels a day and we don’t have 96 million barrels a day of capacity, so we are very subject to geo political events, and we are going to be very tight for sometime.”

On ethanol: he was highly critical of this expensive, and apparently inefficient, alternative to oil, rightly saying its use was driving up price of food.  He went on to say, “If you can find other bio-fuels sources that don’t get used as an agriculture commodity like corn that would be useful.”

On employment he said, “If you go back a couple of hundred years when everyone was working on a farm, you would have said, if you bring along farm machinery so that horses are replaced where would all these people go?  The dynamism of capitalism finds  places.  Even look at the present situation – shoes, textiles and furniture are coming from abroad now.  It is very tough if you are in those industries, but more Americans are employed than ever before.  So we have an economy that finds ways to employ people, who would have guessed the software industry would have developed or even airplane industry, so you will see a different world in terms of how Americans are employed in 50 years from now, but they will be employed.”

And on the dangers inherent in recession: “The world is going to be a lot better in 20 or 40 years from now, but we will have a number of recessions in that time.    I think the current recession will be longer and deeper than people think – But if I hear about a business that makes sense I will buy it and I won’t give a thought on how it will do in the next quarter of  next year.”

And finally, here is something for you to mull over.

“We are happy to invest in businesses that earn their money in euros in France or Italy or sterling in the UK, because I don’t have a feeling that those currencies are likely to depreciate against the dollar,” said the sage.   Note that about sterling – he doesn’t think the pound will depreciate against the dollar.  In that one respect only, Mr Buffett’s comments go ever so slightly against common sense, after all, the UK and US economies have strong parallels, both suffer from too few exports and too many imports, both seem to struggle with a currency that is too high.        But the UK’s economic cycle seems to be lagging a year or so behind the US, and this will suggest a weaker pound later this year and next.  Only time will tell if Mr Buffett got that particular call about sterling right.