Author: johnredwood

This morning the FSA takes the regulatory blame for Northern Rock and admits it made mistakes.
I think it is a case of mistaken identity. It was the Chancellor and the Bank of England that presided over the collapse of Northern Rock, not the FSA.
Remember what happened. In the summer of 2007 money markets dried up in an unprecedented way. Some of us went hoarse telling the Bank of England they needed to make more money available so the money markets could function.
Instead, in September, knowing Northern Rock could not borrow all it needed from the money markets, the Chancellor and the Governor of the Bank made speeches saying banks had lent too much and if they got into trouble it served them right. There would be no bail out.
There was then a run on Northern Rock, as small depositors sought to take their money out. (All this was obvious at the time – see the tab on Northern Rock for my contemporary comments on the Bank’s inaction and the Chancellor’s moral hazard speech).
Fortunately for Northern Rock, after huge damage had been done, the Chancellor and the Bank changed their minds and intervened to protect depositors.

I would not conclude from this that the FSA had got its stress testing wrong – or that the FSA needs more staff. I would conclude that both the Directors of Northern Rock and the FSA did their jobs in the belief that money markets would continue to function, and that the Chancellor would avoid comments that were damaging to regulated banks. These beliefs were not unreasonable. Northern Rock raised money in three main ways – from the money markets, from retail depositors and from securitisation. So do most banks, to differing degrees. As we have seen, other institutions can get into difficulties if money markets seize up, as with Bear Stearns.
What was wrong was that the Bank of England kept the markets so short of funds in August and September, and what was wrong was the speech and interviews of the Chancellor blaming the banks at the very point where a crisis of confidence was about to erupt.

The correct response to this crisis is not to appoint more staff at the FSA and let the FSA take the blame. The correct response is to strengthen the banking arm of the Bank of England, and reconnect the Bank more directly to the full working of the money markets, with a remit to keep the markets reasonably liquid. The Bank has as its main responsibility the setting of interest rates. In recent months the rates it has set have often become academic, as market rates have deviated from them under the pressure of the credit crunch. The Bank needs not only to set rates, but to enforce them.

The questions to be asked today are not about the FSA but about the Chancellor and the Bank.
Does the Chancellor now accept that his no bail out speech was a mistake?
Does the Bank now think it should have made more liquidity available to markets last summer?
What action is the Bank going to take now to ensure that the rates it sets are the rates the market follows?
Will the government restore the powers and duties in banking and money markets to the Bank of England that it took away in 1997?

There has been a lot of comment on the state of the economy, the Credit crunch and the banking problems over the week-end. It is time to re-examine the views of this blog, and the responses from many of you.

I have argued:

1. The US and the UK will avoid recession but will experience a slow down, sharp in some areas and sectors. Some are trying to talk us into recession, by claiming the US is already in one, but the numbers tell us otherwise. It is quite clear that the Fed, the Treasury Secretary and the President will do everything they can to avoid recession in the US.
2. Inflation will remain unpleasant for the first part of 2007, but in a year or so will have reduced. Most of you disagree strongly, believing the current inflation will persist, and if the authorities do too much by way of cutting rates and making money available will trigger a faster one. I see no evidence that inflation is passing from energy and commodities into wages. We instead seem to be entering a period when real wages will be squeezed, limiting the second round inflationary effects.
3. The authorities need to do more to make the markets more liquid to ease the banking problems. So far the Fed has been very active, doing all it can. The Bank of England seems to be reluctantly coming round to the same conclusion. The ECB is half way there, making cash available but not cutting interest rates. Many of you dislike the advice I am giving, but the authorities seem to be moving in the direction I think is right.
4. The banks will gradually be recapitalised by rights issues, new share issues, and money from the cash rich parts of the world – Asia and the commodity producers. This is gradually happening.
5. UK house prices will fall, along with commercial UK property prices and US house prices. Some think UK residential property price falls unlikely because we are building so few new houses whilst new household formation is greater. I still stick to this view, because the mortgage market is tightening substantially. I accept there is no need for Florida style falls as we do not have the same over building problem and did not have the same degree of excess in sub prime mortgages.

Today Anatole Kaletsky has written one of his thoughtful pieces. He states that the banking crisis is a liquidity crisis, not a solvency crisis. A liquidity crisis is when banks need more cash to pay out depositors and other creditors than they have readily available, and find it difficult to sell their other assets quickly enough to raise the cash. A solvency crisis is when banks do not have enough total assets to meet all their liabilities, so they need to raise substantial new capital.

I agree with him that Northern Rock and Bear Stearns both were liquidity crises – depositors and creditors lost confidence in the institutions and demanded more cash than the institutions could immediately lay their hands on without official help.
The one thing we have to remember, however, that is not in his article, is that a liquidity crisis if badly handled by the banks and the authorities can become a solvency crisis. If Institution A is experiencing a run on its cash, it needs to sell assets quickly to raise more money. This, in poor markets, can drive the price of these assets down to unusually low levels. All banks then have to mark down the value of their assets on their balance sheets, as even high quality assets can no longer be sold for good prices in such conditions. This can lead to some institutions no longer having sufficient assets to cover all their liabilities, so they need to raise more capital or they get into trouble.

This is why some of us recommend that the authorities should help the markets by intervening to keep the price of high quality financial assets up to realistic levels. If the Central Banks stand by and watch as well run institutions are forced to sell high quality assets for well below their normal value, they are allowing more serious problems to emerge in the banking system as a whole. It is in everyone’s interest that high quality mortgage debt, high quality bonds and corporate debt should sell at realistic prices, related to the current structure of interest rates. In a liquidity crisis the price of good quality assets can be driven down too far, putting pressure on well run financial institutions.

Today the Regulators start their search for the bear raiders who spread false rumours yesterday.
Meanwhile, the Bank of England should repeat that as the apex of our large and strong banking system, it will make enough liquidity available on a continuing basis so the markets function better and bear raiders have less chance to peddle their unpleasant trade. The authorities must use all their powers to protect decent institutions from false rumour and from artificially frozen markets.
The US authorities have responded postively and quickly. The Bank of England and the ECB are also important players. A strong united front from the Central Banks, facing the bears down and reassuring depositors by showing that they will do whatever it takes to support the many good banks there are in the system is what is now needed.
The UK government needs to act with and through the Bank of England. Ministers took the decision to throw so much resource into saving and nationalising Northern Rock, so they need to show the Bank of England that it by areement work with Treasury resources to keep the rest of the banking system liquid if needed. We do not want the authorities restricted in their actions because of the amount of Northern Rock support already on the books.

The oddest thing about this slowdown and credit crunch is the delayed reaction – or the lack of reaction – of the UK housing market. Shares have slumped. Commercial property prices have fallen substantially. Retailers have complained about the squeeze on their customers. Yet house prices are still slightly up on a year ago, and the last few months have seen only small declines in the national figures.

When I last wrote about this I ventured that high Stamp duty. Home Information Packs and higher mortgage and transaction costs were encouraging people to sit tight and not move. The market was short of supply, just at the point when otherwise it might have gone down. Fortunately unemployment has not been shooting up, and people have been able to meet their mortgage payments even though their budgets are under more pressure. There has been an uneasy equilibrium created by inertia and the new impediments to selling and buying.

We may still, however, be in a for a slow but painful decline in house prices. There is plenty of evidence that new buyers are finding it more difficult to obtain a mortgage. Gone are the deals offering total borrowings in excess of the house price, and gone are the days when you could get by without a deposit. US interest rates may be plunging, but UK general rates are much stickier, and banks and building societies are keen to rebuild margins by charging more for a mortgage relative to the general level of interest rates.

There are those who say they do not think lower interest rates will make any difference to the Credit Crunch – indeed that seems to be the fashionable position. They link this with fears about inflation in the UK getting out of control if any action is taken to cut rates. This is a strange misunderstanding of the position.

Lowering the general level of interest rates could be crucial to avoiding the slowdown of the housing market becoming something worse – a price crash. As part of the Credit Crunch is the banks’ unwillingness to accept mortgages as good assets when lending to each other, anything that makes it more likely more of the outstanding mortgages can be serviced and repaid by their owners would be good news. Surely more people will be able to afford the mortgage if the mortgage rate comes down, than if it stays up or even goes higher? In the USA the authorities have grasped it. They are fighting the battle of the bulge of the sub prime. If too many sub prime mortgage holders give up on the mortgage, then the losses will multiply through the banking system and more credit will be destroyed. The UK may not have had such an extreme version of sub prime lending as the USA, but similar dynamics apply in our housing market.

If the UK house price slide gathers pace, then more people will be in negative equity. Once the house is worth less than the mortgage, more people are inclined to give up on it. If more people lose their jobs, more will struggle to pay the high mortgage bills they currently face.

Meanwhile, it is difficult to see how we can become alarmed by inflation against the current background. The public sector is at last taking a tougher line on public sector wages. There is no evidence of inflationary pressures building up on private sector pay, as the market for goods and services is still competitive enough to make passing on big cost increases difficult. Private sector bonuses, especially in the financial sector, will be well down, deflating total remuneration. We have a few more months of bad figures to live through from the impact of raw materials prices and energy. The authorities need to be fighting against too sharp a slowdown from the Credit Crunch, rather than fearing an inflation that seems unlikely to get out of control.

A quick haggle, a visit to the lawyers, and a bank is bought and rescued over a week-end in New York. That’s the way to do it. It makes the UK’s attempted private sector rescue of Northern Rock look ham fisted, long winded and ultimately unsuccessful in comparison. The US authorities have once again acted decisively, with vigour and purpose, to prevent the banking collapse getting out of control.

This week we can expect further interest rate cuts in the US following on the 25pt reduction in the discount rate announced overnight. All this US activity is producing two main lines of criticism of the US authorities which we need to consider.

The first is the criticism that inflation is not under control, so cutting interest rates in premature and dangerous. It is difficult to hold both this view, and the view that the US is now in recession or is about to go into recession. The Fed clearly fears the forces that are restraining activity and cutting jobs more than it fears the inflationary forces that are evident and left over from the easy credit days that have now gone. Whilst I remain sceptical about the claim that the US is now in recession, it does seem that the impact of the housing crash and the drying up of credit means the threats to activity levels are more important than the threats of further price increases. I back the Fed’s judgement that their main enemy today is too little credit and activity, not too much.

The second common criticism is that by cutting so far so fast, and by using so much of its financial fire power at this stage, the Fed will have nothing left if it fails to work. This is an even more bizarre argument. It is saying if you use your umbrella in the wet and the wind today you may damage it, so it will not work next time. If you take that view everytime the weather’s bad what is the use of the umbrella? The Fed has good reason to suppose this is just the kind of crisis it has to respond to strongly by cutting interest rates and putting liquidity into markets. If they get it right they will make a relapse less likely. If they do not try with what they have there will be a very serious banking crisis.

Since last August I have been commenting on how different the approach of the US authorities is to the approach of the UK authorities. It has taken just four days to rescue the assets and what remains of the business of Bear Stearns. More than six months have passed and we are still a long way from finding a private sector rescuer for Northern Rock. The Treasury and the Bank now have much less flexibility to deal with any other financial catastrophe, because their balance sheets are stretched by taking on the Rock. Meanwhile the Fed is well on the way to laying off its problems with the Bear.

The budget looked insignificant and irrelevant the day it was announced. It looks absurd this morning.

The near collapse of the 5th largest investment bank in the US and the rapid action taken by the US authorities to avert a crash in the wider mortgage and banking markets matters to us as well as to Americans. We are all in this together. If major US institutions run out of money or stop trading, London based financial institutions will take some of the hit.

Those who think this is just a worry to highly paid people in finance who have good times for too long should also think again. If the banks run out of money, in the end we all run out of money. Many businesses and individuals need access to borrowing to keep trading, to buy homes, to buy new equipment. Borrowing will be getting even scarcer if the authorities do not sort out the banking problems.

We still have very different attitudes either side of the Atlantic. In the US, the President, the Head of the Federal Reserve Board, and the Treasury Secretary are all of one mind. This is a serious crisis in the mortgage and banking areas, and everything has to be done to prevent a collapse. We have seen big cuts in interest rates already – we should expect more. We have seen big sums offered to markets to buy up good quality paper that the market no longer trusts – we should expect more when needed. We have now seen direct lending to a bank in trouble, and should expect similar support if market bear raiders try it on with another institution.

In the UK we have had lectures from the Chancellor and the Bank Governor that the banks have been guilty of bad lending and there will be no bail outs. We had a steely performance last summer, until the Northern Rock problems got out of control, when they announced a comprehensive bail out for one mortgage bank, leading to its eventual nationalisation. In the last week the Bank of England did join in concerted central bank operations to make more money available to distressed markets, but it was on a modest scale, suggesting a friendly intent but a lack of conviction in what they were doing. It may also show that after Northern Rock, where UK handling has led them to take on more liability than I think they need have done, they are short of fire power.

The problem remains at base a simple one. We all know that banks have made too many loans, and that some of those loans will turn out to be bad ones where the borrowers will be unable to repay the money. The trouble is no-one knows just how many loans will turn out to be bad, and which of the banks has too many of them. Whilst banks are increasing their provisions against bad debts in the future, and raising new capital to strengthen their balance sheets, fear stalks the markets. People are now worrying that perfectly good loans and mortgages will turn out to be worthless. Investors are dumping investments in good loans as well as bad, driving the value of all a bank’s loans down.

That is why there is a serious threat to the world banking system. Banks only work because most people trust them, and most depositors are happy to leave their money in their accounts knowing they can get their money out when they want it because not everyone will want their money at the same time.. They work because they can play a numbers game, knowing they will do well if say only 1 in 100 loans goes bad, and still survive if 4 in a 100 go wrong. If depositors no longer believe they can get their money out, and if investors believe large numbers of usually good loans will go wrong, the system breaks down. The authorities prime duty is to make sure we never reach such a self defeating set of attitudes. It is after all in the end our own ability to save and spend, to make payments and earn interest that is at stake here. The US authorities once again did the right thing this week. They have shown they understand the gravity of the threat to the system, and showed they are resolute in defending people’s money. Next week they are likely to continue their good and essential work to reassure markets, and therefore move to underpin everyone’s bank account.

Listening to the deafening silence of the Chancellor this week, I was left asking myself “Doesn’t he know there is a credit crunch?”. Yes, he said he understood there were storms in the world economy, but then he raised a children’s umbrella and plodded on. He should show some urgency in tackling the overspending and overborrowing in the UK public sector. He should produce a statement on how the Bank of England’s powers in money markets will be urgently restored, learning the hard lessons of the combined failure to avert the Northern Rock crisis last summer. Behind the scenes, instead of playing silly politics with drink and green issues, he should be devoting his sole attention to international collaboration, to make sure the world authorities get ahead and remain ahead of the pack of bears seeking to make money out of bringing down other financial institutions and financial products.

The world system does need to cut its over borrowed state, but in an orderly way at a sustainable rate.

Inflation is too much money chasing too few goods. Today inflation in the UK and the US is being driven higher by increases in the prices of energy, raw materials and basic foodstuffs, and in the UK by the costs of government. Much of the international inflation comes from excess liquidity in the oil exporting economies and from the demands of Asian economies which have built up large surpluses through successful exporting. The US and UK economies have bigger problems from the way credit has dried up, leading to job losses in the US and a sharp slowdown in the UK economic forecasts.

This makes high interest rates in the US and UK economies an inappropriate response to the inflation – something the US authorities have understood. There is clearly no excess liquidity in the US or UK private sectors. Asset prices on both sides of the Atlantic are falling. US house prices, shares and commercial property are either in freefall or are showing signs of distress. UK commercial property has fallen sharply, UK shares are down and most residential property prices are now static at best.If we had too much domestic liquidity you would expect some or all of these values to be rising, not falling.

Energy prices have risen partly because the emerging economies have need more and more of the limited supply, partly because the dollar and the pound have been weak currencies, and partly because despite global warming theory it has been a very cold winter in many parts of the northern hemisphere where much of the effective demand for energy resides. Food prices, especially grains, have soared. This is partly because the Asian customers want more and better food, but partly because the weather has been so bad affecting crop yields and partly because some global warming theorists have favoured using grains for fuel, diverting them from food.

The big pools of liquidity built up in Asia, Russia and the other commodity producing areas have helped power the prices of precious metals and other commodities, both to fuel demand for industrial products, and to satisfy new holders and hoarders of them.

The UK’s inflation rate has been increased by the inefficiency of the public sector, and the liberal use of higher charges and taxes to tackle what is more truly a problem of spending badly.

The correct response to the commodity price inflation in the west should be to ignore it, all the time there is no transmission from the higher metals, energy and food prices to wages and asset prices. So far there is some sign that some of the extra costs are being passed on by business, but no sign that either the US or the UK is about to have a worrying round of wage inflation. Passing the price increases on just shifts more of the pain from companies to the individuals who buy the products. It looks as if this inflation is going to lead to a reduction in the spending power of consumers in the UK, as neither the government nor the business sector are willing to take the hit. Indeed, the government is keen to divert attention from its own role in the inflation, by calling in parts of the private business world for punishment talks when their prices have gone up, as it is currently doing with the energy suppliers.

In the UK everything points to the need to cut the costs of government, not by doing less in the services that matter but by doing things better where they need doing. I set out in yesterday’s blog the need to cut UK government borrowing as part of our response to the present economic crisis. Today the message is reinforced by the inflation figures. The government has done the right thing in at last telling the public sector – including MPs – that this year’s pay rise has to be below inflation. It needs to do much more to get value for all the spending it is committing.

Today’s gales may be the last fling of an unpredictable winter in the UK. The parallel squalls on the markets need the authorities to realise they have a serious problem and get to grips with it if they wish to create calmer conditions.

Under this government you don’t get much for £1 billion these days. You can soon blow a £100 million on fees for advice on a financial matter, and can get through many times that on a centralised computer contract or good pay rises all round for public sector workers. I expect the political classes will soon be looking for a new unit to make it sound more reasonable.

So I have come up with a modest proposal. Why not account in “rocks”. We can’t be quite sure how much a rock is, but it is probably around £110 billion. It breaks down into 2 Granites, a smaller unit of account which works well offshore.

Recasting public spending, the total spend comes out at around 5 rocks. The Health Service is a snip at just 1 rock, whilst you can have all the armed services for a year for well under a granite and keep them mainly working offshore.

Total stated public debt is only 5 rocks. Even adding in unfunded pension liabilities, borrowings by a nationalised bank and railway, PFI and PPP you still come up with a very easy sounding 12 rocks of total public sector liabilities.

This could well catch on, and make it easier for the government to carry on spending as if we had all the money in the world.

(Based on a speech given to a dinner in the Great Room of the Grosvenor House Hotel on Tuesday night of this week)

I have posted the full transcript of the one hour debate we were allowed on Thursday on Northern Rock, because it illustrates just how damaged Parliament has been by the constant use of timetable motions that are unrealistic.

The Lords passed three amendments to Labour’s bank nationalisation Bill. One wanted the Freedom of Information Act to apply to Northern Rock, just as it applies to the rest of the public sector. One wanted a proper audit report on what we are buying, and a third wanted more detail on the competition arrangements. All three were perfectly reasonable requests. They did not seek to prevent the nationalisation of Northern Rock or some other bank. They were well within the spirit of the decision of the Commons to press ahead with nationalisation, taken a couple of days before.

It was clear these amendments would need a few hours of debate. Each one raised very different issues, worthy of a separate debate. Because the government decided to drive it all through in one hour, they ”grouped” all these amendments together, along with some government amendments. The Opposition offered to sit through the night, as urgency was part of the government’s agenda, even though we could not see the need for the urgency. Alternatively the House could have met on Friday again to discuss Northern Rock, and Friday’s business could have been transferred to a day next week. The government refused to co-operate.

As a result we had one hour. The Chief Secretary to the Treasury occupied half of this with her comments. She took a number of interventions. We needed to intervene for two reasons – firstly because she was not explaining her position clearly and convincingly, and secondly because we knew there would not be time for us to make speeches so several of us chose to make one of our points in this less satisfactory way. The Shadow Spokesman kept his remarks much shorter. This allowed Sir Stuart Bell to speak, and the Lib Dem Spokesman got a few minutes at the end. No Conservative backbencher could make a full speech, No Lib Dem backbencher, and only one Labour backbencher. The front benches had no time to return to the debate to deal with points raised by other MPs.

The Conservative government used timetable motions sparingly. We did so if the Opposition had spent many hours on the first clause or amendment to a Bill, and showed every sign of wishing to delay and prevaricate as much as possible. Most Bills went through with time unlimited, so the Opposition could choose what they wished to talk about, how many of them wished to speak, and for how long. It was a much more democratic way, and ensured that all important amendments and clauses were debated. The government benefited from this, because there are times when Parliament – and those who brief us – made important points that led to a modification or improvement of a measure.

Thursday’s performance reminded me just how much Parliament has lost by ruthless timetabling. There were good issues to discuss. Some of us had things to say. The government had not made its case satisfactorily on why we were to be denied access to information on Northern Rock, and why we were buying it without a proper audit report on what we were buying. The lack of time to discuss it was unreasonable.

There will be a cost to the taxpayer. Rushing into this purchase without proper consideration is likely to mean bigger losses and problems for taxpayers ahead. The Lords unfortunately did not sustain their pressure on the 3 points. The Lib Dems decided they agreed sufficiently with the Bill that they did not want to prolong the dispute even for a few more hours. Once they gave in there was no point the Conservative peers continuing, as they did not have the votes.

Sensible Ministers welcome Parliamentary debate, and listen to commonsense points made by others. Ministers who rush legislation through often live to regret it. The nationalisation of Northern Rock is not the answer, but the beginning of a whole series of new and difficult questions for the government. As Parliament was not able to ask them all and have them cleared up satisfactorily, they will now be determined by events. Events can be much rougher for Ministers to handle.

One day we will find out if Northern Rock is now going to be run down, or if there is a way for a nationalised bank to compete fairly and grow its business. One day we will find out if people are going to be sacked and if so how many. One day we will find out what the true profits and losses have been in recent months. One day we will discover how much cash taxpayers have had to put in, and one day we will find out the full extent of the financial arrangements put in place for the public servants at the top of this company. As so much of this is forbidden fruit at the moment for Parliament, the media will find it so much more tempting to pick it.