Author: johnredwood

Mr Darling is already in a big hole, thanks to his misjudgements over monetary policy last August and September, the run on Northern Rock, the botched proposals on capital gains tax and the U turn on Non Doms. Now, the man in the hole has decided to more than double its size!

There are ten reasons why nationalising Northern Rock is a bad idea.

1. It more than doubles the amount of money the taxpayer has at risk,from a little over £50 billion to more than £100 billion
2. It means any bad loan Northern Rock owns, the taxpayer will own.
3. It means the taxpayer is now liable for any redundancy payments if Northern Rock has to slim its staff numbers.
4. The taxpayer may have to defend against writs from angry shareholders if the compensation terms are not sufficient.
5. The taxpayer becomes responsible for the pensions deficit for staff
6. The taxpayer has to pay compensation to shareholders at a time when public borrowing is already excessive
7. The Chancellor will have to explain mortgage foreclosures, staff redundancies and other bad news to Parliament each time it happens
8. The amount of total government borrowing will increase as a result of the big increase in the amount of money at risk, and the cash needs of the business.
9. The taxpayer will have to pay any losses, meet any write downs of assets and pay for all capital expenditure of the business.
10. The government and taxpayer may be accused of undercutting other viable financial businesses competing against this bank dependent on public money if they are not careful with their guarantees, subsidies and pricing.

What due diligence will the Chancellor do if any before committing the taxpayer to all these liabilities? What law suits if any is he anticipating from shareholders? What will be the cost of compensation to shareholders? What will his policy be on remuneration for his new state employees and how will that fit in with other public sector remuneration?

Tomorrow we need a statement from the Chancellor. There will be all too many questions, but I fear this botched nationalisation will not come with many convincing answers.

The Bank of England yesterday bowed to the inevitable and warned us that we will become worse off this year. Many people already feel worse off, after the huge increases in food and energy costs that we have experienced in recent months. There was no apology for leaving credit too loose a couple of years ago, and no public recognition that the Bank had kept conditions too tight last summer and autumn as the bakdrop to the Northern Rock crisis. There was no revision to the absurd line just before the Northern Rock crisis struck that banks had been foolish in their lending and there would be no bail outs!

The Bank is right that they are boxed in – boxed in by government spending that is too high, by a public sector whose productivity is too low, by past credit excess and rising prices, and by the more recent Credit crunch which is having a big impact on property. The Bank is partly boxed in by governemnt mistakes – the government should have reined back more on wasteful spending earlier, and cut public borrowing – and partly by its own erratic performance on money growth.

We now have a boom and bust approach to credit creation – boom in 2003-6, bust in 2007. We have had boom and boom in public spending. Now we see the government fighting to get to grips with the problem of over spending.

I am glad the Conservative leadership has responded to those of us who have asked that we should not match all of Labour’s spending plans in the future. We should keep all the teachers, nurses, doctors, police and armed services personnel, for they only cost under one quarter of publilc spending. We should not keep all the quangos, regional governments, ID cards, computerisation schemes, advertising budgets and management consultancy contracts. They do not represent value for money and they are squeezing the public needlessly.

I welcome the government’s decision to place the Northern Rock debt on the government’s own balance sheet. It always belonged there, as the Bank of England is wholly owned by the Treasury on behalf of taxpayers.
It is there as a reminder of the importance of getting this money back as quickly as possible. It does not help the government’s fianancial standing, given the high level of new borrowing being undertaken.

Today I learn that the Chancellor has become a mortgage salesman again. He is lecturing us to take long term mortgages at fixed rates. Has no-one reminded him that his government has made mortgage selling a regulated activity? I doubt if the Chancellor has bothered to fix himself up with the necessary regulatory approvals to start selling the fixed rate proposition so actively.

Is he aware that mortgage salesmen need to know their client? Does he grasp at all that long term fixed rate mortgages may work out dearer for some people? They do not make much sense if you plan to move on and repay the mortgage in a relatively short time period. The relative cost of floating rate and fixed rate mortgages can vary sharply as interest rates change. In a period of falling interest rates – which many think we are now in – locking yourself into a fixed rate mortgage may not be a good idea.

I hasten to add I am not a regulated mortgage salesman either, so anyone needing a new or different mortgage should go to a professional to seek advice geared to their own circumstances. This site general views and comments, but avoids individual advice on savings, borrowings and investments as these do require professional (and regulated) advice based on knowledge of the individual’s circumstances.

I find it extraordinary that our Chancellor is making this further foray into the world of lending and borrowing, after his last disastrous one just before the run on Northern Rock. Regular readers of this site will recall that I was very critical of his famous speech about how lending institutions had behaved irresponsibly, and would not in the UK be bailed out. His resolution to avoid helping the banks lasted but a few hectic days, before he bowed to the need to guarantee all deposits in all banks under pressure in UK jurisdiction!

He should also remember that as the taxpayer’s representative and principal bank manager to Northern Rock he is no longer above the fray on mortgage bank products. I just hope he has remembered to ask the management of Northern Rock to make sure they have plenty of the types of mortgages he favours available for their customers, before journalists come asking difficult questions about that.

On second thoughts, isn’t the government’s close involvement with a mortgage bank another very good reason why the Chancellor should have said nothing about mortgages to avoid any conflict of interest?

The main reason he seems to be offering us his thoughts is fear. He is afraid there will be a sharp fall in house prices. He does not seem to understand that it is in a way government policy to try to bring house prices down, as they are constantly telling us housing is not affordable and needs to become more affordable. He hopes that if more people take out fixed rate mortgages, more people will be able to pay the mortgage through difficult times. The only thing to be said about that is, at least he realises he is presiding over tricky times. Maybe spending a bit more time thinking about how to unstick them would be a better way to proceed. Lower interest rates will help. Lower interest rates make fixed rates a worse deal!

I was asked to write a piece on what the government should do next in the Northern Rock refinancing saga. Those most closely involved – the company, shareholders, the Bank of England and the government – will need to take professional advice on the legal, tax and investment complexities they have dug themselves into. The general position however, remains much simpler than those who clamour for nationalisation suppose. The government as main lender has all the power it needs to protect taxpayers, whcih should be its prime aim. I sent the following to the Guardian:

The government seems to have been mesmerised by shareholder power. I don’t know why. The truth of the position is simple. Northern Rock needs access to large sums of public money to keep its business going. There is no other source for this money in the short term. The government can therefore set out its terms.

It is wise to seek agreement with shareholders and the mortgage Bank, but foolish to underestimate the power in the government’s position. The taxpayer wants the government and the Bank of England to do a good deal, which saves the bank and ensures the taxpayer will get early repayment of the large sums with interest. The taxpayer should also be rewarded with stock warrants or options to give the taxpayer some share in success, if the rescue works well and the shares recover.

The rumoured decision to demand the end of the guarantee in three years rather than the originally floated five years changes the nature of the task any owner of Northern Rock faces. It means they need to generate more cash more quickly, or to be sure they can raise private finance more quickly. Assuming the government changed the terms on offer like this, it should ensure all potential bidders know, and each bidder has to be given a chance to change their bid in the light of the new circumstances. Presumably the government realises if they press for a shorter repayment period it will increase the pressure on management to cut costs, and may result in a smaller business. This does not mean it is wrong, as the taxpayer does want to know the money will be repaid sooner rather than later.

In order to decide between the competing bids, the shareholder representatives have to satisfy themselves they are recommending the best bid in the circumstances to improve shareholder value and give the business the best chance of future prosperity. It is not for the government to decide which bidder, but it is for the government to make its terms as Bank manager clear to all bidders. Given the scale of lending to the company the government has an effective veto on any bidder, as the government could decide (only if there were good reason) that a particular bidder did not satisfy the government that it was likely to be able to repay the loans in good time.

From the beginning the government has failed to tell us how much it has lent, what interest rate it will charge, when it will b e repaid and how much security it has taken for the loans. These are all elementary parts of good banking. Let us hope these necessary arrangements were made to protect the taxpayers’ interests. Now there is the chance of shareholders putting more money in, or a of a new plan by management to develop and finance the bank, the company needs to make a decision. To do so it needs to be sure how much money it can borrow for how long on what terms from the government. That will then help determine how quickly the business will have to be reduced in size to repay borrowings, and how much scope there is to try and trade their way out of cash shortage.

The Fed duly cut interest rates by another 50 basis points, taking them down to just 3%. We see recession fighting in full cry in the USA, where the Central Bank and the administration are uniting to pull the US economy out of its sharp slowdown.

Lower interest rates will ease some of the tensions in the housing market, allowing some people to carry on servicing mortgages which might have been too dear for them at higher rates. It makes it easier for all those businesses operating on borrowed money. It will also encourage a lower dollar, pricing US exporters back into world markets, and curbing the US appetite for imported products.

Meanwhile, on this side of the Atlantic, the authorities remain hesitant and divided over whether to carry on fighting inflation, or to see the Credit Crunch as the new enemy. UK rates are too high for comfort. Inflation will remain unpleasant this winter but will start to correct later in the year.

Yesterday the government published its review of the regulatory arrangements for banks in the wake of the Northern Rock crisis. They made suggestions and proposals in five areas:

1.” Strengthening the financial system” by introducing better risk management of banks and better supervision and rating of securitisation of loans.
2. “Reducing the likelihood of banks failing” by asking for more information and changing the arrangements for providing liquidity to banks.
3. “Reducing the impact of failing banks” by introducing a “Special resolution regime” by allowing the authorities to take action with a failing bank to achieve a rescue or orderly run off
4.”Effective compensation arrangements” including faster and bigger payments.
5. “Strengthening the Bank of England and improving coordination between authorities”.

The proposals combine the sensible with the foolish, mixing some important lessons learned with the sound of stable doors banging shut after the horse has gone.

I would suggest the government listens carefully to informed opinion before implementing these changes.

1. It is important to take action to improve the deposit protection regime, without requiring a large up front cash payment from existing banks at a time when they are struggling to re-establish strong balance sheets after the losses made on securitised loans.
2. The government should make the Bank more independent and stronger to deal with failing banks in the future. This requires transferring day by day banking supervision to the Bank of England, and transferring the necessary staff or recruiting the necessary staff with banking expertise to be able to do the job.
3. The “Special resolution regime” could give near nationalisation powers to the authorities without the need to compensate existing shareholders. These powers were not needed in previous rescues, as the Bank of England has a powerful position as only lender to a bank in trouble. It is difficult to see why they need all these extra powers. The one thing that does need clearing up is the legal power of the UK authorities to arrange rescues quickly and in private under current EU market regulation.
4. It is a moot point whether the Bank of England needs new legislation to clarify its powers and role, when it always used to be able to undertake these matters before many of its powers were taken away in the 1997-8 reorganisation. The availability of skilled and experienced staff in a banking and bank rescue is a more relevant consideration, given the removal of banking supervision from the Bank ten years ago.

As always, there is a danger of the authorities fighting the last war. There is no immediate prospect of another run on a bank. The current difficulties are those of a range of banks strapped for enough capital and cash, and a new aversion to risk as banks reveal losses on some of the paper they hold in the securitised and syndicated loans area. A sensible supervisor would be asking how can the regulatory burden be eased prudently at a time when banks have to recapitalise themselves. There is a danger that further capital adequacy and regulatory tightening, coupled with demands for up front levies for a compensation fund, will make it even more difficult to get the banks and the markets bank to balanced conditions, allowing a reasonable amount of credit to be advanced at sensible prices.

I will respond in more detail to the many individual consultation questions in the government document when I have had more time to consider all the detailed queries.

The Chancellor has promised a statement next week to try to sort out the regulatory mess that characterised the Northern Rock debacle.

What he needs to do is the following:

1. Ensure the Bank of England is more than just a monthly tea party for a group of academic economists sitting round talking about interest rates. The Bank needs to be given the power to direct and deal in government debt (currently with the Treasury).

2.The Bank needs to be a hands on operator in the money markets, so it does not allow in future the markets to become as illiquid as they were in August and September 2007, nor as loose as they were a year or more earlier. The Monetary Policy Committee became entirely academic last year when market rates diverged from MPS rates by up to 100 basis points. If the Bank is to set interest rates, it has to have all the powers and knowledge to operate successfully in money markets, to enforce the rates the MPC recommends.

2. Transfer banking supervision from the FSA to the Bank to allow the bank to operate properly in markets.This would ensure the Bank saw the main positions of the big banks daily, and understood the minute by minute pressures in money markets better.

3. Press for amendment of the EU MAD Directive to allow the Bank to organise rescues for ailing financial institutions in private and rapidly if needed.

4. Renegotiate Basel II to strike a better balance between off balance sheet and on balance sheet items, and to avoid Basel II becoming a further tightening of the capital rules at a time when banks are already finding it difficult to lend through balance sheet pressures.

5. Announce that the UK will not support any more EU regulations of financial services – there are too many new ones that have not yet bedded down, and we need a period of reflection and implementation to see how they will work.Some will need amendment or repeal, as they are too proscriptive and will drive busienss offshore from the EU.

6. Review the operation of the Rating agencies with other overseas jurisdictions, to see if they can operate more cautiously in future.

The sub prime crisis, a run on a UK mortgage bank, and now the loss of $7 billion dollars through rogue trades at Soc Gen: and still they say regulation works!

I accept that financial services businesses can be different. Where they take money from people, on the promise they will repay it at some date in the future, people need reassurance that the promise will be kept. In most other businesses the business takes the risk and supplies the good and service before the customer pays.

It makes sense to have deposit protection, and it should make sense to have some additional checks and requirements to reduce the risk that a business will steal people’s money, or will fail to keep enough capital to pay for losses and mistakes and still be able to give people their money back when they want it or are entitled to it.

This proposition has led to a vast regulatory industry, where clever regulators try to interfere in ever more details of the banks’ lives in the belief that this will prevent mistakes being made. As the last few months have shown, it does not work.

We need to ask how did the world regulators get it all so wrong, and what changes do we need to reduce risks in the future?

The biggest problem is the so-called sub prime crisis, which is in practise a world crisis, not just a US one, and is not confined to mortgages alone. It is a securitisation and off balance sheet crisis – too many banks packaged up too many loans born of the easy money conditions the authorities encouraged, and spread them around the system. The Regulators through their Basel I requirements positively encouraged this, asking for less capital if you securitised your lending and pushed it off your own balance sheet. This crisis should be called the Basel regulatory crisis, rather than the sub prime crisis.

The solution is for monetary authorities to be more careful about making money too easy – not that this is an immediate problem in the middle of the Credit crunch! They also need to revise rules over capital requirements, without lurching to a position where too much banking capital is required, intensifying the Credit Crunch. The whole thing is complicated by the move to Basel II, which needs urgent review in the light of current circumstances.

The run on Northern Rock was an unfortunate event for London. I do not agree with the MPs who say the FSA got it all wrong. As I understand it, the FSA was warning about the problems of Northern Rock well before the run on the bank began. The failure was a system failure, which owed a lot to the failure of the monetary authorities to keep money markets liquid, and to the dithering of the Chancellor who was meant to hold the ring and make the decisions in areas of overlap between the Bank and the FSA.

The UK government should decide that in future the Bank of England will get back its old powers to regulate banks and to run the government’s debt financing programme, so it once again sees the whole range of business going through the money markets. The Bank should have prime responsibility for banking the commercial banks, ensuring adequate liquidity in markets and avoiding any future run on a bank. They always used to be able to do this before Brown’s botched reforms.

The Soc Gen debacle is difficult to believe. Most banks make dealers deal in open dealing rooms where colleagues can hear what they are up to. I thought most require two signatures on larger deals, most have real time reporting through a common system, and anyone needing cash to pay margin or settle transactions would need someone else to certify or check the requirement. As the trader apparently acted without other authority he must have found ways to circumvent the checks in the system. The regulator presumably was completely unaware that such a thing was happening.

I do not think Regulators can stop a Soc Gen event. Only better internal controls and procedures in a bank can do that. The fact that Regulators cannot should make more people suspicious of the cry that what we need is more regulation. In this case what we needed was better bank management.

Three cheers for the Fed. One cheer for each 25 basis point cuts in interest rates announced as an emergency measure yesterday. It did the trick, limiting the savage market decline, and turning round the Asian markets which had been in freefall the previous day.

The US authorities have made it clear to the markets that they are going to stop a recession if it is in their power to do so. They have made aggressive moves in reducing interest rates. This will help a great deal. It means that many mortgage holders and companies in debt will now be able to afford their interest payments and repayments, improving the quality of the loan assets on the balance sheets of the banks and those held in securitised form. It means that all those financial companies that have borrowed so much to sustain the easy credit of earlier years will also have some relief on the amounts they have to pay in interest. The whole financial structure in the US is a little less unstable as a result of this development.

As I argued yesterday, two conditions need to be fulfilled for recovery to get underway. The first is lower interest rates. The second is the recapitalisation of the banks, so they have the stronger balance sheets they are going to need to lend people and companies more money again. This process can happen by the passage of time, as they trade profitably. It can be speeded up by cutting or cancelling dividend payments, or by raising new money from shareholders.

The gyrations of world markets in the last few days shows that the Indian, Chinese and Japanese markets are still very influenced by perceptions of the state of the US economy. All three are important exporters to the USA and are influenced to some extent by US conditions. The internal strength of the Indian and Chinese economies is becoming more obvious, but it is not thought sufficient to offset the full blown US recession which some market participants feared.

The Governor of the Bank of Englands remarks showed how far behind the plot the UK now is. The worse circumstances of the UK economy as a result of recent policy are now dragging it down relative to the US and the Asian giants. As the Governor pointed out, we have a bad inflation problem this winter. The governments own borrowing requirement was far too large before Northern Rock hit, only to be made far worse by the Northern Rock debacle. The big build up in UK public spending and borrowing, and the poor productivity of the enlarged public sector, all limit the UKs room for manoeuvre, at a time when the UK too needs lower interest rates to relive pressure on its financial system. The government is trying to control public spending at last by clumsy interventions on public sector pay, but still lacks a grip on large projects and staff numbers.

A recession can be averted in the US. The UK will experience a sharp slowdown, which will be made worse if the Chancellor presses on with plans to increase capital gains tax on entrepreneurs and with damaging plans to tax non doms too much.

Traffic Blackbook Review

The collapse of Stock markets around the world should come as no surprise. As readers of this blog will know, the years of easy credit were decisively ended last August when the financial community woke up to the reality of the securitised loans crisis, aided by the Central Banks at last in tighten mode after years of sloppy credit.

A credit crunch means there is little new credit available at a time when too many people and companies are desperate to sell assets to raise the cash they need. Investors with cash suddenly decide they want to hold more cash. Investors who have been investing on borrowed money have to rein back their activities and pay down debt. Banks that were able to lend people money and then package the loan up as security to sell to someone else suddenly find there are no buyers for these packages. As a result asset prices crash.

A credit crunch ends when two conditions are met. The Authorities have to signal they want easier credit by lowering interest rates, so high borrowings become affordable again. Banks have to sort their balance sheets out so they have the capacity to lend more. It is this latter condition which may take some time to get right this time round, because so many banks have been involved in syndicated credits and in trying to put their loans off balance sheet in structured vehicles. The sooner the banks sort out what all these investments are worth, write them down, and raise the new capital they are going to need to be able to carry on their business, the better.

The weakness of banks is not solely a US phenomenon, and the so called sub prime crisis is not just a US or a property related difficulty. This is a crisis in the global banking system, where there are worries about the Bank of China as well as about the European and US commercial banks. They have to contract their balance sheets as they value their loans more realistically, and then many of them will need new capital ??whether by cutting dividend payments and keeping more of their profits, or raising new money directly by selling new shares to shareholders. Doubtless the worlds regulators, led no doubt by the UK authorities, will make it even more difficult to by tightening the rules on capital adequacy at exactly the wrong point of the cycle.

The worlds economies are in different conditions to meet this sudden lurch from easy money to tight money. The Italian and Spanish economies are going to be made to suffer for their membership of the Euro, with interest rates and money growth dictated from Frankfort leading to painful adjustments in their domestic economies. The US economy is so far mainly suffering in the real estate and banking sectors, with some signs of a good export led recovery emerging in other sectors from the lower dollar. The UK economy is badly placed, thanks to the very high public deficit and poor productivity performance of the much bloated public sector. The bungled approach to money markets and banking which uniquely gave London the only run on a bank does not help either. If the Chancellor follows this up by taxing the rich out of London then we will have a major residential property price collapse to add to the current woes. The Indian and Chinese economies may find exporting to the US and the West more difficult, but they have the cushion of rapidly growing domestic demand and China has the huge foreign exchange reserves its successful exporting has built up in recent years.

We have seen a sharp contraction in real estate in the US, in Spain, and in commercial property in the UK. We are now seeing a sharp fall in share prices, as investors adjust to the new reality that banks and property companies will find it difficult to maintain earnings, and as the growth rate of the worlds main economies slows.

There remains plenty to worry about. Some are still worrying about the price rises that are coming through this winter as a result of the years of easy money. Others are worried looking forward, fearing a recession in the US and elsewhere. I still think a full blown US recession unlikely, and do not see an inflation problem looking out a year, but recognise that these fears will remain real to many unless and until my two conditions are met for a recovery.

There will be growing pressure on the US, UK and European authorities to lower interest rates, and lower rates will help. There also needs to be a concerted drive to clean up banksbalance sheets and establish some kind of a market in all of these securitised loans that characterised the years of easy money. Once we can know what is left on banks balance sheets, markets can get on with the necessary task of recapitalising the banks so more normal credit conditions can be recreated.

PS: The Fed’s move today to cut interest rates by 75 basis points, taking them down in one go from 4.25% to 3.5% is a good start.