Tuesday, 5 August 2008

The cycle of failure and self interest

Eleven months ago, as the run on Northern Rock began, the UK public was repeatedly assured that the bank was solvent. Today, we find out that the bank ran up losses of £585 million during the first six months of this year. Today, the authorities acknowledged that Northern Rock is bankrupt. They didn't say it explicitly, but their ghastly numbers left everyone in no doubt about the true financial position of this horrific bank.

If this was all, it would be bad enough. However, the Treasury also announced that it was going to convert £3.4 billion of debt and preference shares into ordinary equity to shore up the balance sheet. Added to this, we also found out that the wreck still owes the Bank of England £17.5 billion. These are not small numbers. The recapitalization is about 0.2 percent of GDP. The outstanding debt is about 1.3 percent of GDP.

How could one medium sized regional bank with a bank network of just 70 branches create such large losses? How did the taxpayer end up paying out so much money on such a marginal bank? Should we point the finger at the Treasury? Was the government respoonsible? Did the Bank of England fail to act? Certainly, all three are partly culpable, but their mistakes pale into insignificance compared to the FSA. Here is where the problems started.

Gordon Brown made a grave mistake separating financial supervision from the the Bank of England. The old system worked well for years and within one week of becoming Chancellor, he destroyed it. Nevertheless, he charged the newly formed FSA with the responsibility of overseeing the UK banking sector. Overall, the job description was clear; prevent banking crises.

Instead, the FSA feel asleep. They developed the disastrous doctrine of "light touch" supervision, which amounted to letting the banks do what ever they wanted. So when Northern Rock came out with its 125 percent LTV mortgage last spring, the FSA did nothing. It remained silent as Northern Rock went on a mad growth spurt, extending implausible mortgages to anyone who wanted one.

As a consequence of the FSA's appalling record, the UK is now facing the prospect of a systemic banking crisis. Northern Rock was not an isolated incident. A large part of the UK banking system is close to insolvency. Attempts to recapitalize it through new rights issues was a fiasco. Arrears are rising rapidly, and losses are mounting at an shocking rate.

Make no mistake, today's announcement was a taxpayer bailout. Moreover, Northern Rock wasn't the only bank creaking under the weight of stupid lending decisinos. Other banks will fail before this mess is finally sorted out, and the taxpayer will have to pay much more than £3.4 billion. Banking crises are always expensive and we have only just begun to pay.

Nevertheless, it would be some consolation if something positive came out of this experience. If only we could be reassured that in future banks would be properly regulated, and that this crazy cycle of housing boom and bust could be finally exorcised.

However, there is little prospect of this happening. Already, we see some newspapers talking up the next bubble. Banks are pressurizing the BoE and the government to guarantee mortgage debt. The whole focus of policy is on resurecting mortgage lending rather than sorting out the distortions that generate these damaging speculative cycles.

Vested interests have too much to gain from housing speculation. Once this mess is cleared up, the UK will be ready for the next housing bubble and we will start generating the same mess all over again.


Anonymous said...

All UK builders are up 10-20% today, and some of the worst hit (Barrat, TW) are up over 100% versus their july lows.


Grim, Alice. What do you think will happen?

Anonymous said...

Look on the bright side. The commodity bubble just burst so we can forget much of that inflation talk.

If ever there was a good time to be in instant-access cash, now is it.


Alice Cook said...


I don't think inflation comes and goes so easily.

I hope you are right, but I fear you will be disappointed.

Anonymous said...

Don't fret, Alice. It will be twenty years before there is another property bubble in the UK. Look how long it took from the last collapse in the late 80s: the market didn't bottom until late '92,and the bubble didn't really take off until 1997. The bubble psychology is evaporating, even if prices take a bit longer to decline substantially (but they will, they will).

Anonymous said...

Spot on Alice, my sentiments exactly, if I did not know better I would've thought you were copying my ideas!?!

I am now 90% convinced that no significant lessons will be learned from this episode. The Chancellor was on the Today program on Radio 4 and was constantly making the point that the credit crunch has affected all countries equally. Not once was he asked why the govt. via the FSA allowed the crazy securitization / mortgage lending boom to get so out of control, thus making the UK particularly susceptible. With the media being this slow / stupid, there is just no chance we will ever get proper mortgage regulation. Especially as Cameron's Tory government in waiting is only interested in further de-regulation.

Anyway, spiffing blog, keep it up



Alice Cook said...


Thanks for the kind words. I have given up on the media ever asking Darling et al a sensible question. Most journalists can't frame a question much beyond "so your poll ratings are down, what are you going to do about it".


Anonymous said...

Have all countries suffered equally?

I don't think they have actually.

Mark Wadsworth said...

Yup. This is the bust, followed by a period of low stable property prices, with the next boom pencilled in for about ten year's time.

What are you going to do? Cash in at the bottom, or campaign for Land Value Tax to put and end to it? (or as in my case, both)

Patrick Crozier said...

Rather than hope that governments will get regulation right why not just let banks go bust?

john miller said...

Alice, excellent stuff. You're right about the meedja. Darling said on the Today programme that there was no need to redfine the remit of the BoE because it was there to support Government policies.

What a wonderful moment for Naughty James to say "What, the Bank that you made independent?"

Sadly, they moved on to discussing where Darling bought his tie from...