In a discussion with an old friend yesterday, he asserted that the cause of today's financial mess was the sub-prime market in the US. It is not an uncommon perception, after all it is one that Gordon Brown has been quick and determined to impress upon us all.
Just a Minute
The estimated cost so far of the global banking bail out is £4.5 trillion and rising. If I am not mistaken, the total cost of the daft sub-prime lending was a mere fraction of that figure. So why is it costing so much?
The fact is that that sub-prime was only part of what was a systemic failure by the financial industry. The current financial mess was caused by a scam that started from a simple idea that built in a long term time bomb just as soon as the whizz kids got their greedy hands on it. The trouble with the financial markets is that it is a closed shop - no-one ever questioned what was happening even in Government and we even acted to give them more freedom to do what they wanted and maintain self regulation effectively putting them beyond the law. Even as we wallow in the mire, the calls for heads to role have already subsided - banking will carry on as normal. In fact the global bail out will not only ensure that, we actually depend on it.
How Did It All Go So Wrong
Let's be clear - Northern Rock, HBOS, Bradford & Bingley, Barnsley Building Society all had little to do with sub-prime. Their mortgage base was almost exclusively in the UK. So how were they caught up in this mess and why does Brown tell us sub-prime caused their failure?
Banks are special companies and different to businesses generally they have a liquidity test they must pass daily. Some genius came up with the idea that because lending was cheap, all you had to do was borrow money from other banks at the inter-bank lending rate (LIBOR) and then lend the money out at a slightly higher rate and make your profit on the marginal difference which over 25 years could be a lot of money. Better still, because you now have people borrowing from you and owing you interest on an asset they have mortgaged, you have 'security' to borrow more money to lend out which allow you to borrow more. So why worry about how much capital you have in your bank or amounts of deposits? You can securitise your next loan on your last one.
Better still, why not lump together all the debts you have and sell them as a lump? Sell them to interested other parties like investment banks who can wrap them up in other debts and sell them on at a nice little profit and commission to another company who will lend them money to lend to someone else and buy more debt. Pretty soon everyone was at it. It was a no fail scam. The more money to loan, the more you can lend which means the more you can loan.
In order to make it more interesting and lucrative, any old debt was lobbed in. And the packages were traded and traded amongst each other so that pretty soon all connection to the original assets that were lent against were lost. Quite literally, no-one knew who actually owned which original debt as it it been repackaged traded many, many times and at each trade someone had made some marginal profit which meant the price of the packaged debt had lost all connection to worth of the asset and the interest it could yield.
Everybody Was Happy
Money was plentiful - it was a no fail scam as the value of underlying assets were rising. In Britain alone, average house prices rose a whopping 160% in just 10 years and the boom forced up pockets of Europe as Brits bought second and even third homes abroad plus buy-to lets so we could share in the bonanza. General spending was high as everyone leveraged the increase in their equity by remortgaging which was another debt to be sold. Incredible deals were offered to 'churn' mortgages as competition to lend money and make more 'profit' even on mortgages that lasted only for the duration of fixed rate deals. At the height of the fiasco, Northern Rock and others offered mortgages of 125% of the value of the purchase price and took account of several times the annual income of the purchaser. It made no sense whichever way you calculated it from our side but at the Banks it made plenty of sense as it was another 'asset-backed security' against which they could borrow more money......to lend more again. Any business was good business.
A House of Cards
Sub-prime was like a bucket of icy water on a slumbering drunk. It exposed the key issue. What if the original purchaser of the original debt could no longer pay their interest payments? And because of that, they have their home repossessed. And, because specific mutuals in local areas sold to many people on the same basis, the problem was experienced by many more. Pretty soon whole sections of communities had their homes repossessed and the local property prices crashed as no-one wanted to buy these repossessed homes.
What sub-prime did was merely illustrate the madness of the system. The problem then struck everyone - after all those exotic and derivative trades of packaged and repackaged asset-based debts who now actually owned those original debts and what they were they actually worth?
It wasn't the fear that Northern Rock, HBOS or B&B had loaned money to sub-prime borrowers in the US, that killed them. It was their business model, because what happened next was that all Banks suddenly stopped lending to one another for fear of the others owning some of those worthless assets. So complex was the problem based on such a simple concept, that the inter-bank lending rate rocketed and immediately meant that in order to fund their businesses, Banks would have to make large losses. But worse still - Banks simply stopped lending until the madness could be sorted out.
Without a ready supply of borrowing, Banks who had used the model of borrowing to lend rather than leveraging their deposits simply went bust. On paper few of these companies had actually done much wrong in lending to customers. They had had gone wrong in their own business model.
It meant, as every Bank bought and sold each others debt many times over in a revolving scam of epic proportions and at each trade more money was skimmed off, that one minor hiccup in the lending system caused by the exposure of its folly, would bring an entire House of Cards down.
Government Hubris
You can blame the Banks and the Regulators. But we had seen this sort of idiocy before in companies like Enron. Governments had stepped in and brought about new Corporate Governance rules like Sarbannes-Oxley. But Banks had conveniently waved a collective two fingers at it all as they self-regulated. They wrote their own rules and kept outsiders out.
Besides why would Governments act? GDP was rising quickly, inflation remained low as the cheap money drove spending to enormous heights and tax receipts were flourishing on all the extra VAT, Stamp Duties and jobs being created by the 'Virtual Boom' which lasted a good 10 years.
The warning signs were there. At the peak 49% of all new mortgages sold were re-mortgages. Average earnings per household were actually decreasing in real terms and more worrying the rate of savings were going negative to earnings and a long term pension crisis was looming.
Britons had quite literally mortgaged their future to fund the present.
Gordon Brown had his stable economy underpinned by this false boom and anyone who had a brain cell spotted that at some point there would be a hole in the finances - it was the safest bet since Red Rum. But Brown had a problem - he had to keep it going in order to keep the finances looking good - spoil that and the whole New Labour scam would be exposed. They had spent beyond all sensible proportions and over 1 in every 4 jobs in Britain was in the Public Sector. If the good times stopped, Britain was virtually ruined. Everything depended on house prices continuing t rise and its why a succession of Politicians, academics and experts were wheeled out on TV programs to say that we could not be affected by economic downturn in other countries or sub-prime because our economy was good because of our housing market. We tried to talk ourselves out of it. But there was no escaping the inevitable.
The Bail Out
Brown has been lauded for his decisive actions and the fact he has protected depositors. The £400 billion British bail out follows the rescue of Northern Rock and B&B. The Government waived competition laws to allow Lloyds TSB to buy the failing HBOS, only to have to lend Lloyds money to do so - how idiotic is that? RBS, with a massive £161 bn funding gap, is now 60% owned by the taxpayer. The money lent by the Government for the bail out is being borrowed and the collateral used to secure that borrowing is future tax receipts. This borrowing is then being given to the Banks to loan money to us so that we can kick start the housing market to refuel the boom and stave off recession (the one Brown told us would never hit us).
In other words we are paying for the interest on that borrowing to lend back to ourselves. So the scam has started again only this time we pay for it.
Britain had built its economy over the last 10 years on a false housing market - asset values could not continue to rise at that rate and only a minor adjustment in prices would hit us hard. But far worse would be if lending stopped generally and this is what Brown could not afford to happen. What Britons have described as decisive was indeed the actions of a desperate man. As Alastair Darling muttered doom messages to the press, Brown must have taken him to a dark room and slapped him with a damp kipper to snap him out of it. Mortgage Britain and we can convince them we are brave and honourable men.
Meanwhile, the IMF, OECD and Ernst & Young have clearly stated Britain is far too dependent on the housing market and that borrowing has been too high generally for at least the last 5 years. For that reason alone, Britain will fare far worse in this recession we denied for so long than most others.
By the end of this year, Britain will be borrowing over half of its GDP which itself is decreasing. Tax revenues which will pay for that borrowing are set to fall sharply in the same period which means we will have borrow more. Sub-prime did not cause this mess it was just an inevitable consequence of a financial scam worth $535 trillion - many think that zero-sum accounting means that the money cannot be lost. Maybe not but we will be the ones who pay for it.
Brown has borrowed massively in order to restart the housing boom, like a gambler who does not know when to quit and thinks the roll of a ball on a roulette table will save him. The odds at such a table on a single number are 35 to 1.
I really hope our odds are better than that.
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