Thursday, 17 April 2008

Debt is not cash

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?


Ben said...

when the banks get these government bonds, they can start lending again. New mortgage credit will restart the housing bubble and the game is back on.

Problem solved, dear girl.

Anonymous said...

"More money for the NHS or for cash strapped banks"?

The answer is 'cash strapped banks' - this is disaster capitalism in action.

Over the next few years there will be increasing privatisation of with the usual specious reasoning about efficiency but the real reason will be corporate welfare.

Anonymous said...

Giving the money to the NHS is hardly a good thing. One thing that should be clear from the whole taxpayer bailout / moral hazard going on now is that it's not just the big bad banks that take advantage of it.

When we dump cash into the NHS we get the same problems. They are encouraged to mismanage because then the taxpayer bails them out too, except usually with full popular support. Guaranteeing a market means we get inflated prices, and NHS prices have run out of control.

Why argue about disintermediation in markets (i.e. originate and distribute) for banks but not the NHS. The NHS, like all welfar systems, separates the payer (taxpayers), administrators (NHS bureaucrats, doctors) and beneficiary (patients, staff). You'd expect precisely the same sort of malincentive problems there as you do will Investment Bank senior managers and rogue traders.

Only we're not supposed to say the parasites who milk the NHS are scumbags. Even though they are.

Follow the principles that you very correctly apply to banking to the welfare state and you'd soon see how many socialist fantasies fall apart.


Anonymous said...

Nick: "When we dump cash into the NHS we get the same problems."

Of course you are exactly right. But people think because the NHS is supposedly run for a good cause them all that cash has been spent wisely, of course it hasn't and the overall health provision is worse for ten years of misallocation of resources.

It has been a long time since the NHS was run for the benefit of the patients.

Nick: "Why argue about disintermediation in markets [..] for banks but not the NHS"

I fear it is because, it is much more fashionable to blame the nasty capitalists, even if many of them are not real capitalists. than it is to look a little further up the chain of responsibility and put the blame where it squarely belongs. In my opinion first with that nice Mr Greenspan, and then with our nice Mr Brown.

Anonymous said...


Did you see there's a new book out called "Greenspan's Bubbles". Just got mine from Amazon yesterday. It spends a long time comparing what he said publically to Congress with the exact opposite that he said in the FOMC meetings a week earlier (FOMC minutes are released five years after they are useful).


Anonymous said...


This is going to sound naive but, if the BofE have a government bond with a face value of £100k that pays 5% per annum surely it cannot be too difficult to find a mortgage backed security that pays similar (5K p/a). If the MBS fails then in theory the liability should rest with the bank and so they owe the BofE the original
£100k and any interst lost in the meantime. Is this being hopelessly optimistic?


Anonymous said...


People would never have bought MBS if they offered the same rate as a treasury. The whole point of the higher rates is the risk premium. The whole reason for the spectacular growth in MBS was the credit ratings assigned to them seemed to suggest the premium was a free lunch and the risk wasn't there.

For an MBS to have a 5% yield it would have to have a much lower par value than the treasury, and thus the collateral isn't there to secure the swap.


Alice Cook said...


Perhaps I should have entitled the post "more questions than answers". So far, I have heard very few people suggest that a massive asset swap might actually cost money. Moreover, I can see plenty of ways how it can cost serious amounts of taxpayers resources. Nick's recent post points to an obvious and dangerous aspect of this scheme.

I keep coming back to the question why would a bank swap a high yield asset for a lower yield govt treasury bond. The answer must be that the MBS is somehow impaired.


Anonymous said...

BTW, I think I got that last paragraph of my last post twisted a bit. Perhaps an example makes it clearer.

Security A is a Treasury with a par value of £100 and a coupon of 5%. Assume you buy it for par, you get £5 interest per year. Realistically no default risk.

Security B is a junk bond with a par value of £100 and a coupon of 8%. You buy it for par, get £8 a year and have plenty of default risk.

Security C is a MBS with a par value of £100 and a coupon of 8%. You buy it for par, get £8 a year but Moodys have rated it AA so you figure there's no default risk.

Pretty obvious that people want to buy Security C. Now why on earth would a bank want to swap Security C for security A? Could it be that they figure Moodys got it wrong?

It's a general rule of investing that people only sell you the stuff they don't want.

If Security C really did have a default-adjusted real return of 5% they'd just keep it.

If they really thought an offsetting credit default swap was going to pay up, they'd just keep it.