April 3, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

Credit is in the news again this morning, and this time they are asking “is the era of cheap credit over?”

The last few days have seen a raft of reports on this theme, and last night Bank of England monetary policy committee member, Paul Tucker, not to mention executive director for markets at the Bank, was scratching his head at the Institutional Money Market Funds Association annual dinner, and talked about a “serious puzzle.”

“There remains a risk,” he said, “that credit creation – the lubricant that the financial system provides to the real economy – will be further impaired.”

Time was of course that banks lent the money their depositors placed with them.   Mr Cash-rich put his money in his bank, and the bank in turn lent that money to Mr and Mrs Lots of ideas for creating wealth but not much cash.

The rate of interest was set by the demand and supply of money.    Banks needed to offer a sufficiently high interest rate to attract depositors.     They then made a mark up on this, and re-lent the money to businesses or consumers.  That mechanism is what used to form the market rate of interest. 

Central banks, on the other hand, are the lenders of last resort.    The rate of interest set by the Fed or Bank of England, for example, is set by different criteria.   

Arguablly, in an environment of developing technology, where productivity is rising fast, central banks themselves need to lend to banks in order to facilitate a greater supply of money to match the new level of potential wealth the advances in technology have brought.

But for many years now, perhaps since Mrs Thatcher was Prime Minister and Ronald Reagan was President in the US,  the credit markets have become far more complex.     Banks have borrowed from each other.  And as one bank lends to another, the credit provided itself becomes an asset.  It can then borrow money, using its assets, which itself might be money lent to other banks as its capital.

More recently, money has flowed in from abroad, from countries like Japan, where the rate of interest was very low, and no decent return was available to savers; OPEC countries, where oil revenue created excess savings; and China, where excess savings led to massive balance of payments surplus, meaning the coffers at Chinese banks were overflowing with money.

Put all this together and you can see why the money markets had so much credit.    As a result of this, at times the rate of interest set by markets was actually lower than the rate set by central banks.   Alan Greenspan called this a conundrum, but the real cause was the massive flows of money from abroad.

But now it has all changed.     Clearly US subprime has a lot to do with all this, but we are not so sure that is the only explanation.

Returning to Mr Tucker and his speech yesterday, he said, “Financial markets have swung from a prolonged period of underpricing risk to now plausibly overpricing risk on at least some products.”

He went on to say, “Banks around the world are carrying portfolios of term loans that are the legacy of the boom years. There is uncertainty – amongst banks’ management, shareholders and funders – about the degree of fundamental impairment in those portfolios. New loans are booked to the same balance sheets. And so many banks face a choice between, on the one hand, conserving capital and liquidity to support legacy portfolios; and, on the other hand, deploying capital and liquidity to write new business on what some see as the attractive terms and conditions now available.”

So the assets sitting in banks’ electronic vaults are not worth as much as they were.    As a result, banks have become reluctant to lend to each other, or to take on more debt.  

But, as the dollar falls, and with expectations that sterling will fall too, one assumes overseas lenders are becoming reluctant to put their cash on the Western money markets too.

Then we come to house prices.  If house prices continue to fall in the US, and start to fall in the UK, then it seems likely individual insolvency levels will rise, leading to more losses at banks, and a further tightening in credit.

As a result of all this, at the moment it seems to be almost irrelevant what the central banks do.    Sure, the Fed has slashed rates, the Bank of England has started lowering rates, but the banks need more savers, and to attract them, they need to offer higher interest rates, and in turn need to make more money on the money they lend out.

It seems that the rate of interest set by demand and the supply of money, has deviated from the rates set by central banks. 

Mr Tucker said, “For well over a century, throughout industrialised world there has in effect been something akin to a Social Contract between the banking system and the authorities. The banking system is permitted to profit from undertaking leveraged maturity transformation in the course of intermediating the liquid savings of depositors into illiquid loans to households, firms and others. In doing so, commercial banks provide liquidity insurance, whether via demand deposits or committed lines of credit. They can do this because their deposit liabilities are money, which puts them at the heart of the payments system and is what makes them special; banks are at the heart of a monetary economy. In return, the authorities respond with a combination of prudential supervision, to contain the risks that banks run; deposit insurance, to protect savers; and liquidity insurance from the central bank. ”

But over the last few years asset prices rose too high. Risk was wrongly priced.     These mistakes are now being corrected, and the central banks think that playing with interest rates might get the economy rolling, but actually the true problem is far deeper than that.

April 1, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

If there is one relationship you can be sure of, it is this one.     Crisis begat the call for tighter regulation.

Banks are being blamed for the current economic crisis, and now attention is focusing on how we can ensure similar mistakes are not made again.

Yesterday, the Bank of England’s governor Mervyn King was talking in Jerusalem.

“The recent challenges presented by the latest episode of financial turmoil suggest that much hard thought will need to be given to the structure and nature of banking regulation in the future,” he said.

Then he dropped the real bombshell. “In the longer-term, it seems extremely likely that banks and other ‘near’ banks, especially those that have been regarded as similar to banks in terms of their eligibility for financial assistance, will be called upon to hold more capital and a greater quantity of liquid assets than hitherto.”

And in uttering those words, Mr King was doing what others have done before him.   In the wake of one crisis he called for a radical overhaul – but in the process has created the danger of overreaction.

In the 1930s, banking regulation in the US has been blamed by some for making the depression of that era even worse.    The Sarbanes Oxley act passed after the collapse of Enron and WorldCom is a classic example of overreaction.  It was designed to try and stop fraud, in the process it created an intolerable strait-jacket for many US companies looking to float.

Now, in calling for new regulation, there is a very real danger we will go too far.    Just before the Northern Rock debacle, Alistair Darling called for a return to traditional banking, but surely it was non-traditional banking that helped create the boom of the last ten years, and helped provide funding for new burgeoning dynamic businesses.

In the US, Treasury Secretary Harry Paulson has also done it.   

There is nothing wrong per se with Mr Paulson’s plans, and in fairness to him he first revealed his intentions to look at new regulation before the credit crunch hit the front pages.  Among other things, Mr Paulson wants the Fed to be able to examine the books at hedge funds, insurance firms and brokers, and that is a good thing.

As a former CEO and chairman of Goldman Sachs, he was never going to reveal a plan that would crush the profitability of US banks – and in some respects he is calling for less regulation, although the Fed will be given more power.

But perhaps the fundamental problems lie too deep for regulation by the Fed and the Bank of England to have an effect.

At the moment, a lot of debate relates to what’s called moral hazard, the idea that banks must be punished for their mistakes.  Well, perhaps the problem is this:  Shareholders have been punished but bank managements have not.

In the last few weeks we have heard the arguments over and over again, and it is right. Management at banks are rewarded when things go wrong, but when things fail, their rewards are still pretty good anyway.

Yesterday, Northern Rock confirmed that its former chief executive Adam Applegarth will be paid £760,000, and his annual pension is being upped by £40,000 a year to £304,000.

But maybe there is another, even-deeper, problem too.

In the US, the Fed quite simply lowered interest by far, far too much.  Alan Greenspan promoted variable rate mortgages, and a move away from mortgages that have fixed terms over the long term.

In fairness to Gordon Brown, he is a fan of fixed rate mortgages, but in the UK, the Bank of England, too, is partially guilty.

Last year, this is what Lord George said:

“At the beginning of this decade… external demand was declining and related to that, business investment was declining… We only had two alternative ways of sustaining demand and keeping the economy moving forward – one was public spending and the other was consumption.

“We knew that we were having to stimulate consumer spending. We knew we had pushed it up to levels which couldn’t possibly be sustained into the medium and long term. But for the time being, if we had not done that, the UK economy would have gone into recession just as the United States did.”

Lord George added, “My legacy to the MPC, if you like, has been ’sort that out’.”

In other words, it seems that the real roots of the current crisis lie not so much with excessive wages for bankers, or mistakes by regulators, it was because short-term economic needs were put before longer-term needs.

It is vital those mistakes are not repeated.

March 17, 2008 | posted by Michael Baxter in credit crunch | comments (2) |

When the Northern Rock crisis first hit the headlines, and the UK suffered its first run on a bank since Queen Victoria was on the throne, US  Treasury Secretary Henry Paulson was in Britain.    “We look like a third-world country,” said some press reports. Mr Paulson himself looked bewildered,  as he stood beside Alistair Darling at a press conference and our chancellor tried to reassure us.  “What must he have thought?” they asked.”

Well, now, some 7 months on, it’s the turn of the US, and maybe all those critics of the way the government handled Northern Rock will wake up to the reality.  This is a mess, no doubt – but it’s a complicated mess, and much of the criticism levelled at the way the Northern Rock saga was handled, went way wide of the mark.

There are differences. Northern Rock was a High Street lender – its customers members of the public.  Bear Stearns is an investment bank,  and as such the US bank could not benefit directly from Fed money, instead Fed loans it received had to be via a conduit.

In the case of Northern Rock, the authorities tried to manage a takeover by Lloyds TSB behind the scenes, so that when the extent of Northern Rock’s exposure was revealed, the deal would have been done – and panic avoided.

They did of course fail, and the final outcome was one that no one seemed to want, just about everyone seemed worse off.

In the US, speed, but in the open, was the order of the day, and within two days of the announcement of  Bear Stearns’ bail out, then the saga had gone to the next stage, and  a buyout by JP Morgan Chase was announced.

The fifth-biggest investment bank in the US is costing its new owner $236 million, and yet a week ago, the bank was valued at $140bn.        So just like the shareholders in Northern Rock before them, the former owners of Bear Stearn have taken a massive hit.

But the Fed is taking a hit too, it is funding $30bn of Bear Stearns’ less-liquid assets – that may make its exposure to the bank seems less serious than the UK’s government exposure, but it seems the UK government is far more likely to get its money back.

The truth be told though, both the Fed and the Bank of England were on hidings to nothing.    They were sure to be dammed if they did, and damned if they didn’t.

But maybe if they had done nothing, the consequences would have been even more serious.      If the history of economic crisis has one lesson, it is this,  banking crises are about as serious as you can get.

Sweden, for example,  suffered a major banking crisis in 1991 – and the cost to the economy – 6 per cent of GDP; further back in 1987 it was Norway that was struck, and the cost – 8 per cent of GDP. But in 19977, it was Spain which felt the horror of a full-scale banking crisis – and the cost, 16 per cent of GDP. Examples of other major banking crises include France (1994), Germany (1977), Japan (1992), the US (1984), but top of the order comes the UK (1974, 1991 and 1995).

Both the Fed and the Bank of England have to ensure neither economy suffers similar jolts – and the price paid so far by avoiding such crisis is cheap.

But the question has to be, what next?

Bear Stearns was one of the first banks to suffer from subprime fallout, with two of its funds failing over a year ago – indeed it was their failure that first threw the possibility of subprime crisis into the full glare of the public spotlight.

It is tempting to say that the crisis then has come full circle – it started with Bear Stearns, and will end with the bank.  

The reality though, is that it seems far more likely the global credit crisis is only just beginning to get going. 

It seems the US is in recession, but most are saying it will be a shallow recession – but those predictions seem optimistic.    The US economic growth story of recent years has been built on credit – this credit in turn fed the global economy.   

The best-case scenario is that once the subprime debt has worked its way through the system, the economy will be back on course.

A more likely outcome, however, is that we are seeing the consequences of far deeper problems unravelling.

The US has relied upon foreign money to fund its credit boom.  US consumers spent too much, some foreigners – especially Chinese, Japanese and consumers from the oil exporting countries, saved too much.      This pushed the dollar up, and stopped the US balance of trade deficit suffocating the economy.

But the falling dollar, the rising price of gold and oil – both sit at new records at the time of writing – could be telling a far bigger story. 

Foreigners are no longer willing to fund a US spending binge. In the long term, this may well prove to be a good thing for the US, but it is naive to assume there won’t be an agonizing period of change first. 

As for the UK – it suffers from exactly the same underlying problems besetting the US – but alas, it has less of the strengths seen in the economy across the pond.