Author: johnredwood

The BBC today offered two visions of the future for Northern Rock. The first is nationalisation, with the Lib Dems recommending compulsory purchase of the Rock, apparently for nothing, wiping out all the shareholders. The second was another Treasury guarantee, this time to small long term shareholders so they do not lose out if things get worse from here.

Both of these ideas are absurb. The taxpayer already has too large a commitment to Northern Rock, and should not be asked to take on a bigger one. It is not the taxpayers job to own and run a mortgage bank. Nor can the taxpayer decide to subsidise one group of shareholders amongst the wider list of shareholders. The compulsory nationalisation of the bank with no compensation to sharteholders would probably trigger law suits from them claiming their shares still had value. The subsidy to some shareholders might trigger law suits from the others claiming the division was arbitrary and unfair.

The Lib Dem acting Leader has pursued a persistent campaign against the outgoing management of Northern Rock in a way which makes offering impartial advice difficult, and has displayed a lack of knowledge of legal obligations and how banking works. That presumably is why the BBC have him on so often on this subject. His advice would put the taxpayer at risk of legal actions by shareholders and leave the taxpayer with larger problems of how to manage the whole mortgage bank.

People ask what could be done? What should the Conservative position be? I think that is obvious, bearing in mind I would not have started from here, as I recommended pre-emptive action long before the bank experienced the run.

What the Chancellor should do with the Bank of England is treat this lending to Northern Rock as if it were a commercial loan. They must agree with Northern Rock the duration and interest payments, with a schedule of repayments. They must take sufficient security to guraantee that in no forseeable circumstance can the taxpayer lose money, and then force the mortgage bank to manage its way out of the debt to the agreed timetable. If they cannot agree a sensible timetable then they have to impose one which they think the bank should be able to meet. Above all they must have enough security to ensure no taxpayer loss. Then they need to agree all that with Brussels, which may be the most difficult part of the obvious remedy. I assume they got Brussels agreement in the first place to temporary assistance – they now need to define how long is temporary.

The Chancellor has to be careful not to create a false market in Northern Rock shares.

The amount and duration of government lending to the mortgage bank is fundamental to valuing the shares. If this funding is to be there for as long as Northern Rock wants, the company will have one value. If the funding is to be phased down it has another value. If it is to disappear rapidly it has yet another value. In circumstances where the funding is withdrawn quickly the value of the bank then rests on what private sector funding is available at what terms. The differences between these values will be large.

In such circumstances it is vital to avoid a disorderly market in the shares that the government makes a statement tomorrow saying:

1. How much money has been lent to Northerhn Rock so far via the Bank of England?
2. How much more might be lent under the guarantees in place?
3. What time limit if any there is on this arrangement?
4. What if any agreement is there over repayment schedules?
5. Is this funding available to any buyer of Northern Rock, or only to the independent company that first asked for assistance?
6. If funding is available to a buyer of Northern Rock, what will be the requirements concerning repayment by them?

The markets need this information so people can value the shares sensibly. Parliament needs it so we can do our job protecting the taxpayers’ interests. I fear a false market in the shares unless we are told what the government’s position is on these and related matters.

The government has to be very careful in how it handles the Northern Rock situation. This morning on the Today programme there was a call for them to nationalise Northern Rock, offering no compensation to shareholders. That is not an attractive proposition for either taxpayers or the remaining shareholders. It could fall foul of the government’s general duty to be fair to the shareholders of a company it is lending money to and of EU competition rules if they then give the bank favoured access to funding. The shareholders would think they had been robbed, as the market currently ascribes a value to their shares. Taxpayers would be on the hook for the long haul, with a new owner with no expertise at running a mortgage bank and all the problems of nationalised industry control.

The problem has arisen because of the actions of the government so far. The current share price of Northern Rock is based on the continuation of loans from the Bank of England and the deposit protection put in place by the government. Those who think the shares have value must believe either the Bank of England will continue to lend the money for as long as necessary, or that there will be a private sector rescue which will ascribe value to the shares (which also probably requires some continuation of government/Bank of England support). In other words, in the immediate future the value of the shares is heavily influenced by what the government and the Bank do over the financing of Northern Rock. If Northern Rock were capable of refinancing its Bank of England loans in the private sector market it would resumably do so.

If the Bank of England is too generous in its loans and guarantees to Northern Rock, then a private buyer may well emerge who can make money out of the situation, benefitting from the taxpayer support. If the Bank is too severe in removing funding from the mortgage bank before there is a suitable alternative available then it retriggers the problems it has been trying to avert.

So what are the government’s options from here?

The first is the completion of a sale to the private sector that the shareholders accept. The government does have to set out what its position is on how much money will be lent to Northern Rock under new ownership for how long. Presumably the government’s interest in a sale is to reduce both the quantity and duration of the loans it makes to Northern Rock. The Chancellor should make an early statement so we the public and Parliament know, as well as presumably making some statement in the Sale Memorandum drawn up on behalf of Northern Rock shareholders. If a buyer can be found who has the balance sheet strength or the access to funding to repay all the current public loans, that would be ideal.

The second is to agree a schedule of repayments and lending reductions with the new Board of an independent Northern Rock, as they have to believe they can trade themselves out of their problems, and can gradually replace public sector loans with normal market borrowings.

The third is to impose a date for the repayment of some or all of the loans, and leave it to the Board of Northern Rock to decide how they are going to meet this, with or without a takeover or new partners.

It is difficult getting accurate information about this on the media. The BBC this morning told us that the Board of Northern Rock had resigned, and this meant a deal must be imminent otherwise Northern Rock was left without a board. Yet the Times says this morning that two new Non executive Directors joined the Chairman on the Board whilst Mr Applegarth, the outgoing CEO, had agreed to stay on for a further two months to help with the sale process. The Times on this occasion sounds more reliable than the BBC. That news is compatible with the view that there is no immediate deal but that serious negotiations are underway with a view to sell the bank. The deal will still need shareholder approval.

From the taxpayers point of view, we need to to be told why so much of our money has now been committed and how the Chancellor expects to get it back and when.

The immediate questions for him are:

1. Where did the ??25 billion advanced so far by the Bank of England come from?
2. What guarantees/ comfort letter has been issued by the Treasury to the Bank of England to enable it to take on so large a commitment in relation to its own size?
3. How long is the money going to be available to the Northern Rock?
4. How does the government envisage it being repaid?
5. When will there be a loan agreement which we the taxpayers can see, with the security, covenants and repayment schedules that one would expect in a large commercial loan?

It is high time Parliament was told more about this huge taxpayer commitment, now bigger than the annual defence budget.

The Chancellor is ever keen to claim a Tory “black hole” in the Opposition figures for any odd billion needed for a tax cut or a spending improvement. Yesterday when I asked him about the ??23 billion “hole” in his own figures he was unable to answer.When I asked Peter Hain at the end of the debate the government still did not know. Ministers had failed to use the hours of the debate to get properly briefed on this important subject – yet they raised Northern Rock themselves in the Chancellor’s opening remarks.

The Chancellor authorised the Bank of England to make ??23 billion (so far) available to Northern Rock. The Bank of England is a company wholly owned by the Treasury on behalf of taxpayers. It is a relatively small bank, with total equity of just ??1.8 billion, and a total balance sheet of around ??40 billion before the Northern Rock crisis.

I asked the simple question, where did the ??23 billion come from? Which account? How will it be accounted for in the government’s reports to Parliament and the nation?

The answer has to be that the public sector has borrowed the money to lend to Northern Rock. I appreciate they believe they will be repaid it as some point – maybe some of it not for several years according to latest leaks – but in the meantime it is money spent. As the public sector overall has been spending more than it raises in taxes, and as it is heavily in debt, the most likely source of the cash is borrowing. Buying a mortgage portfolio should have the same effect on public spending and borrowing as buying property or vehicles or any other public asset.

It appears from the Banking returns of the Bank of England that there has been some reduction of the other assets on the Bank’s balance sheet to make some room for the Northern Rock loan which helps. But it also appears that the Bank has increased its overall borrowings to help finance this loan, which means public borrowing as a whole has increased. We should be told how we are paying for this special finance. We should be told what guarantees the Treasury has offered the Bank of England to enable it to take such a large loan onto its books, distorting prudent management of risk at the Bank of England.We should expect the Chancellor to know how it was done, as he authorised it. We should expect him to tell us, as he is always urging the commercial banks to be more open about their assets and liabilities. As this is our money at risk we have a right to know. I will go on asking these questions until we get an answer.

Today in the Commons it was the Chancellor’s turn to show he has gained his diploma in Tory bashing from the Ed Balls academy.

Apparently the failure to build Crossrail during the last fifteen years is all down to the Conservatives who were in power for five of the fifteen years. Meanwhile we are told that every policy difference between Conservative and Labour is the cause of a “black hole” in the figures.

Can you create a black hole by saving all that money from abolishing ID cards, or slimming down regional government and quangoes, or cutting the regulatory bureaucracy? And how does that mythical black hole compare with the gaping black hole in this government’s figures, filled by borrowing through the government debt market, borrowing through PFI and PPP, and by offering guarantees to others that are not recorded on the government’s own balance sheet? Ever since Gordon divorced Prudence, this government has run up collosal debts, whilst criticising others for being masters of black holes. This Chancellor has added massively to contingent liabilities by offering ??23 billion of loans to Northern Rock and offering to guarantee the deposits of any bank in trouble.

When in a black hole of his own, the Chancellor should stop digging.

The Chancellor’s contribution to understanding the credit crunch has been lamentable. So far he has told us it is an American problem based on bad mortgage lending in a far away country; that Northern Rock is a one off problem in a mortgage bank which has a good mortgage book; that he wants more transparency about off balance sheet financing; that he thinks banks should not be bailed out for the mistakes they have made with poor loans, and believes there should be a re-pricing of risk.

Let’s look at this in relation to his own actions:

1. Whilst lecturing banks on the need to tighten up lending because there would be no bail outs, he has offered a gurantee on all the deposits in any bank subject to financial problems in the market. Such an offer is without precedent.
2. He has through the Bank of England lent ??23 billion to Northern Rock. Recent sale documents for Northern Rock suggest taxpayers will still be lending ??6 billion to them in 2010.
3. Despite his wish for more transparency and less off balance sheet lending and borrowing, he does not put the full details of the government’s PFI/PPP borrowings onto the government balance sheet, and continues to encourage off balance sheet borrowings by government.
4. He has failed to sort out the muddled responsibilities between Treasury, the Bank and the FSA over banking regulation and money market operations.

What is wrong with his analysis?

1. This is not just a US problem. The Credit crunch in the UK will raise the mortgage failure rate here. The world banking system has bought and sold loans between banks from different countries, so it is a global problem.
2. This is not just a mortgage problem. In the UK there will be the need to write down some loans in the private equity, property and business areas as well as some mortgages. People today in the city are finding it difficult to value a range of differing debt instruments, and the property that is often the security for loans.
3. The US banks have started reporting to the market how much they think they have lost in the credit crunch so far. The UK banks do not report for a while, and are probably pondering how to value some of their assets in this volatile and constrained market. There is no sign that Darling’s call for greater transparency has resulted in any changes to reporting or reporting requirements, so why did he call for it?

Mr Darling should take better advice and understand the nature of the coming problems the banking system, the property sector and financial markets face. Property share prices are anticipating a double figure percentage fall in commercial property values in the UK. Housebuilding shares are warning that the housing market is going to be damaged. Some early indications suggest that other forms of debt are going to be marked down by a significant amount.

Mr Darling should start looking forward, and understand his overall responsbility not just for banking regulaiton but for the money and credit markets, as they are heavily influenced by what government and Bank does day to day by way of market operations, and month by month in terms of supplying cash and issuing government bonds. He cannot duck his involvement or responsibility, so he had better start learning how to carry it out. So far his record is poor and full of contradictions. The City’s reputation requires skillful handling by Treaury, Bank and FSA. Over the last 10 years financial and business services in London have been the stellar performers within the UK economy. Mr Darling still needs them to do well.

The danger for him is he allows the crunch to go on for too long, and forces an extreme re-pricing of risk which weakens credit creating institutions too much. If balance sheets are weakened too far by big write downs, then the banking system will be unable to deliver sufficient credit to the market. That will mean fewer jobs, fewer new homes and all that goes with it.

I understand why many of you are worried by inflation – food prices are leaping up, and the government has just increased the price of petrol sharply through the duty increase and the ad valorem tax increase on the back of the increase in oil prices. It is quite likely our inflation rate on the government/Bank’s measure of CPI will go back above the target of 2% in the next couple of months. If you add mortages in to the full RPI the figure is much worse, given the rate rises we have experienced. There is a real squeeze on disposable income. People may try to have a good Christmas and New Year at the shops, but that will just lead to slower sales thereafter.

The Bank, the MPC and the government should be focusing on the medium term picture – there is nothing they can do to stop the food price inflation in the pipeline, and they seem unwilling to solve the petrol inflation problem by cutting the tax rate as they want to pocket the extra money. I remain of the view that inflation is not the problem over the next couple of years – the problem is deflation from the credit crunch.

We now see that UK commercial property prices have fallen and may well fall more. Experts are arguing over whether they have fallen a few percent or whether it is already by more than 10% in many districts. Residential property prices are falling in most parts of the country outside the expensive districts of central London, where foreign demand seems to be keeping the market lively and detached from the rest of the country.

For the first time for several years the government is keeping public sector wage increases down – save for the top officials and managers who escape the squeeze. THere is no sign of a priivate sector wage lift off either.

Evidence is coming in from the banks that they now want to show more cash on their balance sheets, and are far more reluctant to lend. This will have an impact on retail spending patterns as people find it more difficult to obtain unsecured loans. The slow down in the volume of housing transactions will also reduce spending, as substantial big ticket and housing related expenditure occurs when people move, when a larger mortgage helps.

Keeping the pound high against the dollar by keeping money markets tight is extering downward pressure on manufacturers’ selling prices as they have to try to stay competitive against US exporters.

The Bankl and the MPC should not be misled by short term strength in inflation into making the credit crunch worse. If the government wanted to help they should cut the tax rate on petrol now, to control the short term increase in the CPI. Then the Bank could cut interest rates, lwoering RPI inlfaiton in the process and starting to relax the squeeze.

The authorities have to decide how far they want property and other asset prices to fall before they think they have done enough to make their point. If I were them I would not leave it too late. The US faces a bigger inflation threat than we do owing to the big fall in the dollar, but they decided on two cuts in interest rates to try to stop their residential property price collapse spreading and worsening, with the risk that it could tip the whole economy into recession if the authorities stood idly by.