The bailout begins

The UK taxpayer is being prepared for a major banking sector bailout. It is going to be expensive. When it happens, it will make most of us a lot worse off, some people will make a fortune, and everyone responsible for this financial mess will get away with it.

Today, Mervyn King told parliament:

"We are discussing with the banks how a longer-term resolution of the problem might be reached. It is too soon to say where those discussions will lead, but two principles would underlie any central bank role.

First, the risk of losses on their lending should remain with banks’ shareholders. The banks neither need nor want the taxpayer to insure them against these losses.

Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets."

At first sight, King appears to be ruling out any taxpayer bailout. Read it more closely and he saying nothing of the sort. King doesn't say that bad debts should stay with the banks. He merely talks about the "risk of losses". Actual losses could easily end up in the public sector.

Mervyn also talks about the taxpayers "insuring against losses". He doesn't rule out any burden sharing of losses. with the bulk of losses falling on the British public. However, I am splitting hairs here. In a few days, Mervyn's lawyer-like assurances will be forgotten.

The rest of his comments point towards a bailout. A longer term solution means shifting the deadwood from bank balance sheets. How will this happen? Let me sketch it out how the Bank of England will end up pushing these losses onto the public sector.

Stage one - The banks replace bad assets with high quality government paper

Although this crisis has been characterized as one where banks are short of liquidity, the Bank of England has not actually injected any new money into the banking system. So far, the BoE injected high quality assets into the banking system and received low quality debts in return.

The bank of England balance sheet is already taking in huge amounts of commercial bank assets in return for high quality government paper. The BoE is already holding ₤32 billion of Northern Rock debt. More recently, the Boe has transfered another ₤20 billion of high quality assets to commecial banks through repo operations. This asset injection is designed to shore up bank profitability and strengthening their balance sheets.

Stage two - the Bank of England runs out of assets

Although the BoE owns a lot of government paper, it doesn't own enough to prop up the entire UK banking system. Soon, it will run out of governmetn debt and it will start buying weak commercial bank assets in return for cash. As it does, the BoE's balance sheet will increase dramatically. On the assets side, it will hold rubbish, on the liabilities side, it will owe high powered money.

Stage three - the Bank of England balance sheet will deteriorate

As the BoE accepts the toxic debt, its balance sheet will gradually become "non-performing". At some point, the BoE will ask the government for a recapitalization. The government will say yes, and give the BoE a big pile of new public sector debt. In return, the Bank of England will hand over the toxic bank assets it accumulated in stages one and two.

Stage four - Government sets up a debt recovery agency

The government will transfer its newly acquired bank assets at a heavy discount to a special agency that will have the task of recovering value. The agency will be privatized and it will ruthlessly go after the debtors that underpin the diseased bank assets. The shareholders of this agency will make a fortune. Outstanding losses will remain with the public sector.

Stage five - Everyone forgets the banking crisis ever happened.

With the bank balance sheets rehabilitated, and the Bank of England focusing on monetary policy, everyone will conspire to forget the crisis ever happened. The banks responsible for this mess will offload their losses, while those who were supposed to supervise the sector work to put the issue to sleep.

The residue of the crisis will sit on the books of the government, where public sector debt levels will have increased. For years to come, the UK taxpayer will bear the cost in public sector interest payments.

Stage six - The banks start it all over again

Six or seven years from now, the banks will relax lending standards, estate agents will pump up the market with talk about housing shortages, and the British public will again start speculating on two bedroom flats in Leeds.

Naturally, the UK will learn nothing from the great banking crash of 2007-9.