Sunday, 6 April 2008

Who is going to pay? You are going to pay.

As the credit crisis becomes more entrenched, an unholy alliance of unpopular politicians and desperate bankers are setting up the UK taxpayer for an unprecedented financial sector bailout. Today's Observer reports:

“Intense discussions involving the Treasury, the Bank of England and the UK banks are going on over how this blockage (i.e. the credit crunch) might be cleared. One possibility is that the authorities might either purchase or guarantee assets to put a floor under their prices, the theory being that it might encourage investors, who are staying out of the market because they fear prices might fall even further, to wade back in.”

Yes, it is as bad as it looks. The government, the Bank of England and the commercial banks are working towards a massive public sector intervention to secure banking sector profits. The taxpayer is about to be presented with a massive bill for all those long years of irresponsible monetary policy, lax lending standards, and failed financial sector supervision. The chickens are coming home. Balance sheets are deteriorating, and the banks want the public sector to come in and clean up the mess.

The very idea of a bailout based on the principle of purchasing degenerated bank assets or trying to put a floor under prices is so outrageous that it should leave all decent people speechless. For ten years, UK banks cooked up an unprecedented rise in asset prices, while the Bank of England and the FSA were willing accomplices. As credit flowed into the housing market, prices exploded, and although all the warning signs of a bubble were evident 5 years ago, nobody did anything to put a stop to this lunacy. Interest rates stayed low, the FSA allowed banks to run riot with minimal risk management, while the government happily took in huge amounts of housing-related tax revenues.

Now, the bubble is crashing faster than anyone ever thought. Everyone now sees a terrible danger just ahead of us. A chain of events is now underway that could lead to an unprecedented financial sector meltdown. The housing bubble has gone too far, and many borrowers now find it difficult to service their loans. The banks know that defaults are about to rise catastrophically, and they would prefer to hold whatever cash they have on their own balance sheets. Furthermore, no one wants to lend to another bank because of a genuine fear of another Northern Rock style failure. Mortgage volumes have collapsed, and demand for housing has been flushed away.

The situation is about to get really nasty. As demand collapses, house prices can only go one way. Since the market is top full of speculators, falling prices will lead to panic. As speculators dump their unwanted houses onto the market, the crash escalates further. The shock then hits the real economy. Tumbling prices will make home owners less wealthy, and when everyone realizes that they are not as asset rich as they previously thought, consumption will fall back. Economic growth will slow, unemployment will rise and eventually the default rate on all those mortgages will begin to rise. Then it will be time to say hello to a systemic banking crisis.

Since everyone sees what is coming, there is a natural desire to dodge the oncoming freight train that is about to hit the UK economy. However, when politicians are involved, we can always count on the short-term fix to dominate the long-term solution.

Brown, and Darling have surveyed the scene. Both understand that economic policy under New Labour was been built on three pillars; house price inflation, easy consumer credit, and public sector expenditure. Last August, two of the three pillars came crashing down; and if the UK slips into a recession, tax revenues will decline, taking the third pillar with it.

Understandably, Brown and Darling want the good times back. They have concluded that if only banks began to lend to each other, the crash could be avoided. For Brown and Darling, the solution lies with more credit to households. If only there were more mortgages, house prices will stabilize. No one will feel poorer, consumption will remain high and the recession will be avoided. This all points to the government buying up compromised bank assets.

Of course, this ignores the underlying source of our difficulties. People are overloaded with debt. A rising default rate is inevitable, and any foolish scheme that props up the housing market will only delay a housing crash. It will not prevent it.

So, if a guarantee on housing market assets is not the solution then what should the bank of England and government do right now. After all, the threat of a banking crisis is very real and something needs to be done.

The first thing we need to understand is that this crisis is a distributional question. There are huge losses out there, and it is simply a question of who will pay. Will the taxpayer end up with the bill or will it be the banks, their shareholders, and homeowners.

Naturally, the banks and their shareholders are looking to pass the cost onto taxpayer. The banks would also like to limit the losses for homeowners who previously enjoyed huge capital gains. It is not that they care about homeowners per se. Rather; banks regard the long-term welfare of homeowners as intimately linked to their own well being. Banks need solvent borrowers, and a housing crash will destroy the net worth of many homeowners. This huge loss of housing equity will reduce the value of the collateral holding up bank balance sheets. Besides, an army of upside-down homeowners gives the bank a powerful ally to pressure the government towards accepting a taxpayer-financed bailout.

There is another, fairer solution that would push the losses back onto the banks and and homeowning speculators. The government should pass emergency legislation that requires all banks to keep an absolute minimum of two percent capital. Any bank falling below that level will be automatically nationalized and all shareholder capital will be wiped out. This will give the banks a strong incentive to maintain capital levels and avoid pushing their losses onto the public sector. The two percent capital requirement will also give the government a buffer to limit public sector losses.

The legislation would also tighten up the requirements on who could manage a bank or take a position on a bank board. Any director connected with a failed bank would automatically banned from holding a similar position for 15 years. Again, the idea is to align incentives for managers to discourage excessive risk taking.

The government should also create a bank resolution agency that will manage any nationalized banks. The agency would break up all failed banks and sell off their assets. This new agency would rapidly clean up bank balance sheets and quickly stabilize the financial system.

Unfortunately, there is likely to be losses. Nevertheless, the magnitude of those losses will almost certainly be lower than any half-baked purchase and guarantee scheme that the banks are now pushing on a desperately unpopular government.


Anonymous said...
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Anonymous said...

I have the feeling I'm going to get monumentally shafted by all this. However, I do seriously have to ask myself, what does the UK government do with all this tax money anyway? It simply gets frittered away on hair brained schemes with little or no benefit to the average working person. If the money does go to clear up this mess, whilst deeply immoral, is no more so than any other waste of UK taxpayers money. Taxpayers' money SHOULD be treated with respect like its a scarce resource, but the reverse has been true for so long that its all to easy to become conditioned by it.

Non-homeowners have seen at the sharp end of government policy for the last 10 years now and there's going to be no let up just yet. The banks will receive all the help they can get because as you rightly point out, they have been the driving force behind the miracle economy.

(BTW "Furthermore, no one wants to borrow to another bank" I think you mean lend!)


Jobo said...

Two percent is hardly a buffer worth mentioning. Sweden handled its banking crisis much as you describe, only that the limit was 8%. Despite this, the state was stuck with a bill of SEK 35B out of a total lending loss of SEK 120B.

Anonymous said...


While I agree Brown and Darling are incompetent and dishonest enough to try this, there's a good chance wiser heads will prevail for the following reasons:

1) Higher tax rates = popular revolt, brain drain, less overall tax revenue. If it somehow gets pulled off, all the rest of the business sector will be against it because it will kill consumers

2) Higher government borrowing = credit concerns, inflation concerns = rocketing long term interest rates = crippling interest burden on current public sector borrowing

There's alot thats anti-democratic about having a lightly regulated global financial market. One of the good things is that a few bond traders could quickly squash this sort of dumb government proposal.

There's no getting around that fact there's losses, but there's also no getting around that pushing the costs on to the taxpayer will also wreck the economy. It'll be interesting to see if the narrow sectional interests can still push it through but look how much trouble they are having in the US trying the same thing.

It's no done deal.


markbaldy said...

Darling and Brown are akin to Laurel and Hardy... these people are a joke.
They insult my intelligence when they say the UK economy is strong and that they support "Britain's hard working families"... it is these poor suckers that are being shafted to pay for the total mismanagement of public money.
I see a time in the not too distant future when the smart folk will have deserted the UK and the remainder will comprise of people on benefits and the rest working from hand to mouth till they drop - forget retirement, the kitty will be empty.
Teflon Tony got out at just the right time didn't he !

Alice Cook said...


I agree a 2 percent takeover threashold doesn't give much of a buffer, but it does align incentives to ensure that banks will want to keep away from the government and a bailout.

As you said in your comments, the Swedish government did end up carrying a loss. I expect the same thing here.


Alice Cook said...


I can only agree with you. There are no easy options.