Bad bank Big risk

Constructing a Bad Bank to solve the Credit Crunch problem is too difficult in the current volatile situation. It would be quite wrong to force independent banks into one if they are not in receipt of taxpayer share capital.The main banks headquartered in the UK are too big to be taken on by the taxpayer. The taxpayer should not be expected to carry the burden of their potential losses on lending all round the world.
Some people think it is a relatively simple matter. They argue that too many bad loans are holding back the banks from lending more money. So why not, they argue, shunt all the bad loans off into a Bad bank which the government can own and work its way through, allowing the banks to start again with cleaned up balance sheets and loan books?

There are all too many obstacles in the way.
The first problem is that bad loans do not have a bad loan label on them, allowing easy identification. Some bad loans will be obvious – they are debts owed to the bank by companies or individuals who have already gone bust. The other bad loans are to people and companies who may go bust in the future or who may have trouble meeting the interest and capital payments.
The second problem is that there is not a given stock of bad loans, which once dealt with sorts the problem out. In this kind of fast developing recession the number of bad loans expands as the economy lurches downwards. Companies that can meet their payments today may be unable to next month. Individuals who can meet their mortage payments at the moment, may lose their jobs next month and then be unable to pay the interest.
The third problem is that the main UK banks are also big global banks. How would the UK authorities offer to take bad debts related to the UK in a way which did not leak out into other countries banked by the UK banks? If they could just buy up UK bad loans, how could they stop the benefits of doing this leaching abroad, making the whole task so expensive for UK taxpayers?
The fourth problem is how to value the assets or bad loans. Everyone involved now seems to understand valuing them is very problematic. If you cannot value them accurately then either the government pays too little, leaving the banks in a very weak position, or pays too much for the loans,leading to huge losses for taxpayers.

Let us look at some examples of these problems.

Loan One: to a man who has a drink problem and is a gambler. He fails to make his regular interest payments. The bank has to call in the loan. The bank manages to sell the house for more than the mortgage, so gets all the money back. (Ultimate value of loan £1 in the £)
Loan Two: to a steady well paid civil servant who has always made his payments and apparently has a secure job. He then gets involved in an acrimonious divorce, loses his job through bad conduct, fails to make the payments. The bank reposseses and sells the house for 75% of the mortgage. (Ultimate value of loan 75p in the £)
Loan Three: Loan to a company which is trading successfully in autosales. Demand halves, profit margins disappear as customers demand keener prices. The company fails to meet repayment schedule. The bank puts the company into receivership, and discovers it only gets back 20 p in the £
Loan Four Loan to a financial company which has bought financial futures. The bank believes it has full security and is told the future position is to reduce risk in the underlying financial business. The futures go horribly wrong, losing the company more than its capital. (Final value of loan zero)
Loan Five:Loan to another company that has geared positions in futures contracts 5 times the size of its balance sheets. Bank makes the company close them down over six months. Company does so and makes a profit. (Value of loan £1 in £1)

It is not easy spotting in advance which loan falls into which value band. Loan Two looked like a high quality one and Loan 5 looked very risky. Of course bankers spend their lives trying to evaluate these things. They look at the cash flow of a businesses or the income of individuals to see how likely it is they can pay the interest. They look at the value of the home or the business to see how they could get their money back if the client stopped paying the interest. In normal times their rules of thumb and their mathematical models work. In these extreme conditions they do not. Unlikely people and businesses go bust. Asset values collapse so quickly that banks are left without proper cover for their loans. That is why it it so difficult to sort out the true values of these loans and to make proper provision for them.

I was very critical of the government blundering in to buy shares in banks where it was obvious a lot more needed to be written off their loan books. The government should have tried to come to better views of the value of the loans before putting money in. This process is now happening because the banks need to produce end year figures and are having to be more realistic about how many loans will go wrong and how much they might get back.

The government needs to make the banks do this exercise for the year end. It needs to tell the banks they have to cut their costs and get themselves back into profitability quickly, as they need retained profit to strengthen their balance sheets. The government should be ready to lend against security, and offer sensibly priced guarantees both on deposits and lending, but they should not buy more shares, and should not yet buy bad loans. The situation is still too unstable, and we have no idea how many more bad loans will emerge in the hostile trading conditions of the first half of 2009

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21 Comments

  1. THE ESSEX BOYS
    Posted January 17, 2009 at 10:23 am | Permalink

    Without being unduly modest can you say if there’s anyone – please try to name names if so – in the government with JR’s understanding of and grip on these banking and financial problems please?

    Is there anyone in the BoE or the FSA for that matter?

    It’s frustrating for we taxpayers footing these enormous bills that the PM and Chancellor seem bereft of sound ideas and solid advisers who have experience in the commercial world.

  2. Posted January 17, 2009 at 10:54 am | Permalink

    John,

    You are absolutely correct that the root cause of the problem is that nobody knows what is a fair value for the asset underlying the loans. In a recessionary environment with falling commercial and residential property prices, share prices and no clear idea of what the value of a businesses trade is, it is not surprising that banks will not lend.

    One further complication to this is the extent of “off-balance sheet” assets and loans. These are usually single project vehicles or shareholdings in third companies held by SPV subsidiaries. I worked on the administration of Olympia & York, (developers of Canary Wharf), in the early 90s and their holdings were scattered through a birds nest of companies which made the task of unravelling just that one company a complete nightmare. I suspect the situation now is vastly worse.

    I wonder whether it is possible to force companies and banks to end “off-balance sheet” holdings? I’m not sure it can be done, but until a large proportion of the assets are in full view and the full scale of the – potential – losses are known, is there any prospect of the deflationary cycle being broken? Could we require all listed companies to publish an asset register which would do this as part of their annual returns?

    I’m not sure it can be done quickly enough in the current climate, but the 40% falls in Barclays and RBS shares this past week suggest that not knowing how bad it is, could in fact be worse than knowing.

  3. Posted January 17, 2009 at 11:32 am | Permalink

    I don’t see that extending assistance of a “bad bank” to “world” problems would in any way shape or form be either possible or affordable. Clearly if Brown is planning that then he might just as well give in for it is completely unachievable and fraught with nothing other than total bankruptcy for this nation.

    However, if such an idea is limited to UK instruments, ( if they can be separated which I’m not sure they can ), then patently this can be made affordable in the way I mentioned earlier. As for valuing those assets it is virtually a human impossibility as you rightly say. They would in fact have to be extracted from one another which defeats the object in itself of relieving banks from some if not all of the problem. ( That’s if it would be possible and even that is doubtful given that each single asset within the security would have to be identified as a profit or loss.)

    What’s the alternative ?
    TIME and recession which makes more losses for the banks.

    Yet if it is possible to rid the banks of some of those assets which may or may not be “toxic”, and give the banks time themselves to redeem them back from the bad bank over a reasonable time which allows the banks to build profit, then such a plan could work. That would have the benefit of permitting banks to lend again but on more prudent levels. In short another chance to do good from it whilst realising the losses over a substantial time frame which has the effect of stabilizing the economy, retaining jobs and homes and loans which happen to be comprised within those instruments. Thus limiting the risk of them falling further to become “real toxic assets”. If that happens then all banks will become nationalised simply because the assets in those banks will essentially be lost to the UK and to the taxpayers and to the treasury which eventually makes a profit from the assets and from the profits of banks and taxpayers but only if the economy has not fallen to pre-war levels which is likely to happen unless some sort of radical action is taken. This could be it therefore.
    “A Bankers Mortgage” to the taxpayer.

  4. Ian Jones
    Posted January 17, 2009 at 11:35 am | Permalink

    Main concerns have to be:

    1. So called “Good bank” Northern Rock being used to lend out newly printed money. Asset prices need to come back into line with the rest of the economy. Either asset prices fall or the price level in the ecnonomy rises or a mix of both. Asset prices cannot increase in price!!! Therefore the loans will be very risky!

    2. What is stopping HSBC and Barclays moving out of the UK to China if the Govt tries to force them to take part!

    3. Off Balance sheet items are far too big to bring back on!

    4. The Govt nationalises the remaining banks and thus takes on trillions in debt….

  5. Publius
    Posted January 17, 2009 at 11:38 am | Permalink

    It is reported today in The Telegraph, in an article that has all the hallmarks of undigested Downing Street spin, that the govt is thinking of using Northern Rock to “dramatically increase” lending to individuals and companies. Later in the same piece, it is reported that

    “Downing Street has been angered by the mounting evidence that there was widespread reckless lending by the high street banks that precipitated last year’s financial crisis. Mr Brown is understood to be concerned that up to 80 per cent of the bad debts at some banks were to foreign companies or individuals.”

    Now if your analysis on assessing the quality of debt is correct (and I’m sure it is), then how on earth is angry Downing Street, or its agents at Northern Rock, going to determine whom to throw all this new money at?

    I suspect there is no trite one-size-fits-all answer to this question, which is inconvenient, since a trite one-size-fits-all answer is precisely what Downing Street wants. Inasmuch as there is an answer, I suspect it requires a return to prudence and moderation and old-fashioned relationship banking practice.

  6. Alan Wheatley
    Posted January 17, 2009 at 11:53 am | Permalink

    Would not now be a good time to launch a new private UK bank? It would have the advantage of starting with a clean sheet and able to value the loans it makes in the light of current circumstances, and not have to make excessive provision for bad debts of unknown size.

    Sound businesses that can not get or extend their loan from their current bank would have a better alternative to try, with a better prospect of being able to continue in business.

    Existing banks would have to quickly sort out their own affairs or find they are loosing good business to a competitor.

    Those that fail to do so should be allowed to fail (assuming depositors are protected).

    If there is merit in a National bank that lends direct (as some propose), is there not an even better argument for a new private one.

    Of course, the money has to be available to capitalise the new private bank, but when has a lack of money ever been a bar to a good idea?

  7. Matt
    Posted January 17, 2009 at 12:06 pm | Permalink

    The difficulties that you’ve outlined in detecting which loans go bad apply equally to any taxpayer backed guarantee scheme.

    Extending guarantees on lending is I think fraught with problems.

    A business needs three basic things
    – Good management
    – Sound Business model
    – Sound balance sheet

    I think you need a minimum of two of the above to survive

    It’s a grey area, do you lend to a company merely to compensate for losses or to provide working capital?
    Most projections show a hockey stick, a few months of negative results and cash flow, then the inevitable pick up. A lot of companies that don’t have a prayer will be supported.

    There is no doubt that a lot of good well run companies in trouble, because their order book has fallen away, but there’s no use extending loans or guarantees for them to carry on building up stock.
    There is a huge risk that state intervention will just delay the evil day.

    The guarantee scheme may end up becoming the easy option, ahead of shareholders putting in more capital or providing PG’s or taking harsh decisions within the business… It’s often not too difficult to grow a business when the economy is going with you. A lot of managers will pick up a lot of experience in the downturn.

  8. Posted January 17, 2009 at 12:38 pm | Permalink

    I supported the first bail out because the government appeared to have cut a financially viable, even profitable deal in which the government ended up with a shreholding in all of the bank & the only losers were shareholders – which is how it is supposed to work. The banks are now complaining about what they signed up to & wanting government to releive them of more of only the useless “assets”.

    That is not how free enterprise works. Let banks which are bust fail, or more likely be taken over. The government should make sure that a receiver will have immediate access to money to cover the government depositers guarantee so that there would be no interruption of business & they should be setting up such procedures right now.

    We seem to be blundering into the Japanese situation where, to keep the banks going the entire economy was put into zero growth for 17 years. Even at abysmal UK growth rates losing that growth is equivalent to losing about 60% of GNP.

  9. Madasafish
    Posted January 17, 2009 at 1:39 pm | Permalink

    Personally I believe the discussion we are having is theoretical and on the lines of “how many angles can dance on a pinhead”.

    The banks I suspect are so insolvent – at this momemnt in time – that the entire UK GDP would not be enough to make them solvent.

    Why?

    Property for a start.

    Where will the bottom be? In commercial property down 50%?
    On domestix? down 30 to 50%.

    Unless we get inflation (which will make debts valueless) I can see largescale worldwide deflation for 5 years plus.

  10. Acorn
    Posted January 17, 2009 at 2:09 pm | Permalink

    Your scenario makes sense to me JR. The worrying bit is the position of the taxpayer who has a headless chicken for a stockbroker he has no control over, (Treasury and the BoE).

    I notice that the German government has had two bond auctions lately that were not fully covered; thirty percent were left on the auction table. Presumably to be sold off in local garage sales. (I wonder if there will ever be a “treasury bond factory outlet shop” at Bicester Village).

    It amazes me that UK bonds are still over-subscribed at auction. Perhaps buyers think Stirling will make a comeback. One thing is for sure; there will be a lot of government IOUs knocking around; hopefully we will not reach the state where the BoE is the only one buying Gordo’s treasury paper promises for cash. If that happens, best buy a wheel barrow to take the cash to Tesco.

    Oh, and up the insurance on your gold jewelry. It will be interesting to see what happens to the dollar / euro etc, when the Gulf states introduce their own floating currency later this year and oil starts trading in “Khaleeji”. The world will have another bloody central bank to bugger things up. At least this one will probably be built from 24 carat gold.

  11. Riochard Gray
    Posted January 17, 2009 at 4:39 pm | Permalink

    Would this not be securitsation on a grand scale. This is what banks have been up to. Bundling up loans/mortages etc and selling then on as an investment. The good and the bad. Nobody really new and as the down turn came along a lot of the mortages became bad. It would be a good scam to sell them onto us!

  12. David B
    Posted January 17, 2009 at 5:22 pm | Permalink

    Maybe your contributor above has the genesis of a good idea. Instead of a bad bank, why don’t we have a good bank?

    Now if it could pay depositors a sensible rate of return on their deposits, it could get lots of capital to lend. It could lend in sterling in the UK only, and thus keep away from currency risk and dodgy foreign mortgages. It could lend only say 75% on a valuation tops. It could keep away from buy to let or other bubble investments. Perhaps only investing in tangible assets. Its articles could expressly forbid involvement in financial instruments, and perhaps limit the salaries and benefits of senior staff – maybe relate them to say average wages, or a particular civil service grade.

    It would probably be best set up as a mutual society, so there wouldn’t be pressure from short term shareholders to maximise profits by trading in high risk areas.

    Sounds do-able eh? Maybe a bit like a well run building society perhaps. Remember them?

  13. mikestallard
    Posted January 17, 2009 at 5:49 pm | Permalink

    Thank you for a really clear explanation of what is going on. This is the first time I think I have understood it at all!
    The government are the very last people to go into serious banking. Why? First of all, they don’t have the money. Secondly they are not interested in profit and loss: they are interested in being re-elected. Thirdly, their vision is obscured by ancient doctrines about Trotskyism, Nationalisation and Capitalism. Fourthly, they know about as much about banking as I do about rocket science.
    When there was a minor, (Compared with the IRA, the atrocities in July were, yes, minor), terrorist attack in London, this very government used it as an excuse for introducing laws which so seriously threatened our liberties that Mr Davis had to resign.
    Now they plan to nationalise the banking system, arrogantly assuming that they have the nous to run it better than the experts.
    And, worse, the Telegraph of all papers is panicking! (Read the second Leader).

    PS. What is all this about a default of several billion pounds on a major bank by a Russian oligarch? This was in the Telegraph today.

  14. Monty
    Posted January 17, 2009 at 8:13 pm | Permalink

    The banks don’t seem to want to be banks anymore. They just want to feed off the money of their depositors. Mainly by charging us money for sequestering our money in their vaults.

  15. Brian
    Posted January 17, 2009 at 9:45 pm | Permalink

    Is it just me or are things getting worse?

    • mikestallard
      Posted January 18, 2009 at 8:48 pm | Permalink

      You ain’t seen nothin’ yet.

  16. APL
    Posted January 17, 2009 at 9:46 pm | Permalink

    By the way, lets not forget that at a time when bankers are coming under ever greater scrutiny with their remuneration packages,,,

    What are MPs doing? Hiding their own expense claims!

    You know, it’s like the Id database guys, if you have nothing to hide you have nothing to fear, so come on come clean.

    Let us see what you are all spending.

  17. Bazman
    Posted January 17, 2009 at 10:13 pm | Permalink

    Why is Redwood always the Bank Apologist?

    Reply: I am no apologist. I have made it clear I think they made bad errors – along with the Regulators. I favour cutting the banks down to size in the private sector, by making them live within their means.

  18. Posted January 18, 2009 at 1:09 am | Permalink

    well I don’t have any debt. Nor do I have a flash car, a massive TV or memories of holidays in the Seychelles. That’s an old-fashioned concept called living within your means.

    And I’m fed-up of being expected to bail out the indebted.

    While I have a lot of sympathy for those who HAD to buy property in the Brown bubble, I’m (blowed-ed) if I should be expected to bail out the rest of the feckless bastards.

    As a saver I’m not being heard right now, and I represent a large proportion of the elecorate.

    Time somebody dwelt on that.

    Mick.

    • alan jutson
      Posted January 18, 2009 at 7:30 pm | Permalink

      Exactly the position of most sensible people in the UK

      We try to live within our means (and have done so for years) only purchasing what we can afford, and we simply cannot believe how the feckless think that they should get sympathy.

      Of course bad luck plays its part in some instances, Health, Accidents, Redundancy etc but this is a small proportion of the whole.

      I am afraid that many good businesses will now go to the wall under the domino effect, and people who have been sensible with their finances will now suffer some of the fallout.

      My business does not work with an overdraft by choice.
      WHY.
      Because they are repayable on demand, and that is exactly what the Banks are doing at the moment to shore up their reserves

  19. Johnny Norfolk
    Posted January 18, 2009 at 8:30 am | Permalink

    We have a government and party that thinks they can control everything in life.
    If they carry on like this they will make things worse not better.

    They just do not understand the basics of economics.

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    John Redwood won a free place at Kent College, Canterbury, He graduated from Magdalen College Oxford, has a DPhil and is a fellow of All Souls College. A businessman by background, he has been a director of NM Rothschild merchant bank and chairman of a quoted industrial PLC.

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