Monday, 19 January 2009

Oh dear, how much this time?

Seconds out, round two, ding-ding. The battle of the banks moves into another phase. Last year the government handed over £37billion to help stabilise them but now a different problem has arisen, or to be more exact the same problem for a different reason. Last time there was a threat of imminent collapse through the banks being under-capitalised, now the threat is imminent collapse because of ... good question, because of what exactly?

It seems to me there is only one thing that can cause the collapse of a bank and that is an obligation to pay money when they don't have enough money to do so. We saw that problem when there was a run on Northern Rock. At the moment there does not appear to be a threat of imminent claims for payment which cannot be met, the perceived threat seems to be longer term. Our old friend Mr Toxic Loan is back in the headlines again.

I waffled on about him back in the summer, but a brief re-cap might be helpful to those who were listening with insufficient assiduity. If a bank makes a loan of £100,000 to allow someone to buy a house it expects to be repaid by the borrower over twenty or more years. Because too many loans were made without sufficient evidence of the borrower's likely ability to repay, many people borrowed money they simply could not afford. That brings the value of the house into the picture because serious default by the borrower leads to the bank seizing the house and having to sell it to recoup its losses. Too many banks lent too high a proportion of the perceived market value of houses and those properties are now worth less than the balance owed. To make things worse a massive merry-go-round operated by which banks and other financial institutions bought and sold the right to receive the income from these bad loans and a right to share in the proceeds if the houses had to be repossessed and sold. Thousands of loans were bundled up into batches and sold as a job lot, then re-sold in whole or in part over and over again. All sorts of people invested their money in funds which depend on these bundles of loans to provide a profit.

The current problem is that no one knows how much of each bundle comprises bad loans. They might have bought identical interests in two apparently identical bundles, one of which is going to be substantially loss-making and one of which is going to be substantially profitable. There are so many individual transactions involved that you simply cannot look at one bundle and try to assess the viability of each loan involved. Even if you tried it would take many months and a lot of guesswork. The only practical way of approaching the problem is to take a stab at the total value of loans made without checking the borrower's means, take a stab at the total value today of the properties used as security for those loans, assume the levels of default will be at the high end of historical averages and calculate what percentage of current worldwide outstanding loans this represents. It's little more that a wild guess and everyone knows it. All the financial institutions with fingers in this rancid pie are being treated like pin-less hand grenades.

As and when the bad loans go into default two consequences follow. First there is no income from the borrower, so a bank that advanced £100,000 expecting a return of 5% a year suddenly has no return on that investment. Secondly, the amount recovered on sale of the house might be less than the amount advanced. So, having invested £100,000 the bank might receive only £80,000 leaving it to dip into its capital to keep its books square. And, of course, there are knock-on effects. Because the bank was receiving income of £5,000 while the borrower was making the repayments it used that anticipated income as cash-flow from which to make further loans to other people. When the source of income dries-up so does a source of funds with which to make new loans, thereby causing a reduction in the bank's ability to do new business and, with it, a likely reduction in next year's income and that for some years to come.

One little discussed aspect of the credit-crunch is the startling effect increased defaults can have on the ability of a bank to lend in the future. Not only is there a shortage of income which would have been available to advance elsewhere, but the need to keep their capital reserves at a safe level means that they have to use income from performing loans to top-up their capital when a defaulting loan results in a capital loss. In the example I gave, the shortfall of £20,000 reduces the bank's capital by that amount so they have to use the equivalent of one year's income from four similar loans just to put cash back in the safe. And so the shrinkage of available funds to lend carries on until such time as the balance of its investments is steady again.

There is no magic way out of this problem. The defaulting loans will cause losses which will have to be paid somehow. If you want the banks to continue lending as though they did not suffer a drop in income, you have to relax the capital requirements. If you want to retain the capital requirements, you have to accept that they have less income from which to make new loans. Less income from which to make new loans means a lower total value of new loans, which means less money sloshing about in peoples pockets and less spending. Less spending means shops, importers, manufacturers and service industries have less income, which means less spending by the people involved in those businesses, and so the cycle progresses. This is the difficulty facing the government when deciding what to do next.

They know they have to insist on banks being properly capitalised because one effect of the government regulators relaxing capital requirements in the past was the massive expansion of bad lending. But they also want to take such steps as they can to prevent the vicious cycle of recession accelerating out of control. Their chosen course appears to be to reduce banks' overheads and give insurance against existing customers' defaults.

Part of the bail-out last summer resulted in injections of capital on which the banks have to pay interest at, I believe, up to 12%. Inevitably this means the banks have to use income from customers who do pay them in order to service that debt, thereby reducing the amount of cash the banks have available to lend. The government appears to be prepared to change the basis of that capital injection by taking a larger shareholding in return for dropping the requirement that interest is paid on the money injected. In other words they will reduce the banks' overheads by reducing the government's income from the banks. This could be a good deal for taxpayers provided the additional shares taken by the government increase substantially in value once the banks are doing additional business and the government then sells the shares at a stonking profit sometime in the not too distant. It might work. The one thing it should do is increase the amount of money banks have available to lend, thereby increasing their chance of returning to trading profitability. That of itself will help the public finances.

Insurance against the risk of default on existing loans is a far more difficult issue. The banks will have to pay a premium for that insurance. How, I wonder, will these additional overheads stand against the reduced overheads caused by removing the need for them to pay 12% on last summer's capital injection? We will see the details shortly, but it is a tricky balancing exercise. As I understand it, this part of the new plan will not increase the banks' ability to lend in the short term because it will not give them any more cash. What it will do is help to repair their capital position when loans default so that they do not need to use as much of their own income to restore their reserves of capital, instead the taxpayer will chip-in. To my mind the crucial question is what method, if any, will be included to allow the taxpayer to recover this money in the future. If there is no such mechanism, this scheme will amount to a potentially massive gift to the banks and an equally massive burden on future taxpayers. In fact it will be an even more massive burden on future taxpayers because the government is borrowing the money and laundering it through an inefficient bureaucracy. This measure is potentially far more expensive than any benefit it could produce.

I have commented before on the failures of regulation which allowed the banks to get themselves in such a mess and on the abject failure of the banks and their shareholders to do what they should have done to prevent the current problem arising. But we are where we are and the issue today is what, if anything, should be done about it. To my mind the one thing that should be at the forefront of government policy is that future losses as a result of past bad business cannot be avoided. They will surface, if not today or tomorrow then next week, next month or next year.

Simply transferring those losses to the taxpayer is not only bad for the economy generally - because higher taxes to pay for them will stifle the creation of wealth for a long time to come - it is particularly bad for those at the bottom of the economic pile. They are always hit hardest by increased tax because (i) there are more of them (so £1 from each is worth a lot more to the Treasury than £10 from each wealthy person), (ii) a higher proportion of their income is spent on taxed purchases and (iii) it is easier and cheaper to collect it from them than from those with the means to find legitimate ways to reduce their tax bill.

One option the government should not leave out of account is allowing the banks in the worst positions to fold. If they do fold, the loss will fall on those owed money by the banks. Mr and Mrs Ordinary will have their savings protected up to £50,000 per bank and that will be a loss borne by the taxpayer. Beyond that, shareholders who have gambled on bank shares producing either an income or capital growth will find they put their chips on black rather than red. So be it, that is the chance they took knowing they were gambling. Other financial institutions will take a hit when there is no money to repay them, just as The Amalgamated Plasterboard Company Ltd takes a hit when Fred Bloggs the builder goes bankrupt before paying their invoice. These risks are spread all over the world, British banks do not only have British investors.

I fear the insurance idea has a fundamental flaw. It guarantees that a proportion of losses will remain at home when otherwise they would be spread around the globe. Say a loss is made of £1million and 80% of the bank's shares are owned by Brits. That loss will cost the British shareholders £800,000 and £200,000 will be borne elsewhere. It might not mean an immediate loss to anyone, but it will reduce the bank's capital which will have to be reimbursed from future income thereby reducing the profitability of the business and, in turn, both the income and capital value of the shares. If the taxpayer has to carry as little as 1% of the loss (£10,000) the shareholders bear £990,000, split £792,000 to the Brits and £198,000 to Johnny Foreigner. The total UK loss is increased to £802,000 (£792,000 to the shareholders and £10,000 to the taxpayer) and our friends overseas get a gift of £2,000 from our taxes. Of course we are not talking about losses of £1million but about potential losses of hundreds of billions. Voluntarily sucking a greater proportion of that into the UK's debit column doesn't seem a very sound way to bolster this country's finances.

If, as I suspect, the real fear is that things are so bad that one or more banks will fold without a cushion against the effect of Mr Toxic Loan's halitosis, taking a measure that will increase the proportion of loss retained in the UK seems extremely risky. Could the scheme make the difference between folding and remaining in business? No one can tell because the potential losses are so massive and where they will fall so unpredictable. I have a nasty feeling about this one.

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