Today, George Osbourne was on Breakfast TV, offering Tory support for the brown bank bailout. It was deeply depressing viewing. Osbourne first claimed it was his idea all along and that the government should have moved sooner.
However, my jaw dropped when Osbourne described the bail out as a nothing more than a cash injection. I do not want to be rude and say that Osbourne is talking rubbish, but a government bond is not cash. It is a debt instrument. People holding government debt expect to receive an interest payment. As soon as the banks get hold of this new debt, they will have their hands out demanding payment from the treasury
Since the treasury will be writing out cheques to the banks, how much will this bail out cost? So far, everyone, and that includes Brown and Darling as well as Osbourne, have been suspiciously quiet. In the absence of any hard information, it might be worth trying to imagine how banks will access this facility. While it will not answer the question of costs directly, it will point out that the question is important and needs an answer.
Up to now, the Bank of England used auctions to pass on their long term repos to cash-strapped banks. With this kind of operation, there are three possible outcomes. First, banks are making money; the return on the repos their receive from the BoE is higher than the return on the assets they give. Second, the rates of return are equal. Finally, the banks are losing money because the return on their mortgage backed securities is higher than the debt they receive from the BoE.
The first answer is the most likely. This bailout will cost the taxpayer cash. Since the BoE is receiving less than it pays, it will be booking losses. Eventually, the BoE will have to pass these losses onto the taxpayer.
The second outcome is extremely unlikely. The two assets being swapped have different risk profiles that would inevitably be priced into the final result from the auction.
The final answer is the most worrying. It is possible that the desperate banks need cash so badly that they are prepared to swap their illiquid assets for higher quality assets with a lower return. However, in the long run, banks will continue to make losses. Moreover, the reason for their difficulties will remain unresolved; bank balance sheets are full of high risk, soon-to-default mortgage loans.
Whatever answer we reach on this question, it is obvious that this scheme is ill-conceived. What ever assurances the UK public might receive in the coming days, the likelihood is that a huge bill is heading their way. Over time, this bill will be settled through higher taxes and lower public spending. So what is it going to be? More money for the NHS or for cash strapped banks. Did you even need to ask?