How is the Mortgage Industry In The UK Holding Up?

Thank you for your question Graham, sorry for the delay in reply.

As I see it, there is a fundamental problem in what Gordon Brown wants and is expecting to get from the major UK banks, and the causes that have brought this particular problem about.

A lot of the cheap lending that took place across the US, UK and mainland Europe was based on lending backed by assets. When it turned out those assets were based on Fannie Mae and Freddie Mac style repackaged subprime mortgage products that had been converted into CDO’s, not only did their value get wiped out, as the reality of this type of lending caught up with the banks, all the products associated with them (like Credit Default Swaps) also reversed from safe money-making assets into bad insurance policies that had to be paid out.

Now it can be said that moves have been made to stem these losses through government share purchases, the creation of a liquidity scheme to replace the private interbank lending that died when reality hit, and the moves to allow banks to swap bad assets for good Treasury bonds.

However, even though this is all well and good for the banks, and may just about keep them afloat (even RBS) it does not change the fact that all the industries that had created assets which backed the lending between 1999 and 2007 have now dissappeared. These assets that were part of what is being called the ’shadow banking sector’ made all this lending possible to home owners in the UK, and now it’s gone and is unlikley ever to come back, so too is the lending that made its way to UK home buyers.

So, although the Labour government keep playing the information game and convincing everyone that by saving the banks they can now order them to turn the lending tap back on, the potential profits from CDO’s (Consolidated Debt Obligations) and CDS’s (Credit Default Swaps) have gone, and the net book value that also allowed billions in lending to take place has also gone, there will be no immendiate return to what we’ve been used to in the past 8 years in terms of the high volume of lending.

It seems that this should be apparent to any policy makers looking at what has caused such destruction to the UK banking sector. Even though we see record losses posted (like the £20 billion by RBS in January) the Labour government, the Treasury and the FSA are still not allowed to mention this elephant in the room; the decimated CDO and CDS markets. In their twisted logic it probably has something to do with ’speak no evil, see no evil, and the situation will eventually go away as the market picks up’.

Fact is, that’s wrong. I don’t think any financial firm anywhere in the world, whether its banks or others, will allow subprime mortgages back into the game, so all we’ve got to look forward to is lending based on deposits which was the original core of real old style lending.

What is the longstanding affect from this disappearence of sufficient lending by UK banks? Well we’ve seen the first installment – the collapse in UK house prices. This unfortunatley is only the first wave of consequences.

Still to come we have the record repossession rates from Q3 & Q4 of 2009, and Q1 & Q2 of 2010 as the unemployment caused by struggling UK businesses combines with the real collapse in mortgage payments from people who have lost their income. This will further hurt the banks and restrict lending, and also see house prices dive further as banks swamp the auction houses with repossessed properties.

We’ll then start to hear talk of a bottom to the falls in house prices as its decided that house prices can’t fall any further and all the pain must surely have been dealt by now. Unfortunatley however that is only the end of the second wave of negative consequences.

The real end of days situation that marks the start of the third wave is when all the Labour governments’ economy-breaking spending pledges to help UK banks come back to haunt us. The first signs of problems are already on us, the price of UK bonds have collapsed. This is because as we make more promises of cash to banks with money we don’t already have, bond holders know we’ll be looking to sell about £800 billion new government backed gilts (bonds everywhere else).

The more you sell the more worried the market gets that you won’t meet the payments, so the price of them falls. Then there’s the fact that the new bonds will pay out less as the Bank of England have a very low interest rate, so the returns aren’t worth the risk, pushing prices down further. This then means that the government will need to sell more of them to raise the £800 billion it needs to fund its promises, further weakening our ability to pay the returns. At this point we’d expect to see the UK credit rating drop from ‘triple A’ as many people are  currently discussing.

How does this affect wave three of the housing market? Well, this will cause our currency to collapse and alongside the perpetually stupid idea of ‘Quantative Easing’ (printing money) which will cause a spike in inflation, we’ll see the Bank of England need to raise interest rates to counter these two problems. For UK homeowners this will mark the most devastating part of this economic collapse, because those who have hung on so far will see rising prices again and higher interest rates. As fixed rate deals are harder to get,  as banks have restricted lending, the index linked tracker mortgages and the variable rate customers will have swollen in volume and they’ll be hit by a higher mortgage cost. This will cause a new wave of defaults and reposessions, and result in a further drop in already depressed housing prices.

So overall how is the UK housing market holding up? Unfortunatley they haven’t even seen how bad or how far this depression will go, most have no idea what negative equity is or how it will bankrupt them when they get repossessed, and with 3 million unemployed by Q4 2009, they’ll wonder why no one ever warned them that a situation like this could occur.

As bad as things are at the minute, and as much as stupid people are seeing the ‘green shoots of recovery’ to entice more misguided purchases to take place, the mortgage industry is about to get a whole lot worse, and not stop getting worse for a long time to come.

At least that is how I see it. For rays of sunshine you have to be looking underground like all the UK policy makers are doing, with their heads buried firmly in the sand!

The UK Economy and the Pre-Budget Report

The Chancellor of the Exchequer’s Pre-Budget report was November’s big eye-opener as to how you can regurgitate 1970’s policies to deal with current problems in an old way.

The current problems are a recession, a housing market collapse, a bunch of private corporations on the brink of insolvency and ready to go into either bankruptcy or administration, a restriction of credit to small businesses and mortgage customers, deflation (supposedly), collapsing currency, collapsed interbank lending, collapsing stock market, collapsed commercial paper market, collapsing retail sales and unemployment rising to nearly 2 million. This is only the core list of problems, of which there are many more.

To deal with these problems the Chancellor plans to increase borrowing up to £118 Billion by 2010 through the issuing of more bonds (UK gilts), dropping VAT from 17.5% to 15% (worth £2.5 billion), making the 10p tax solution permanent (resulting in more money for the low paid), the part nationalisation of many UK banks (58% holding of RBS at a £2.5 billion loss 28/11/08) in a holding company called ‘UK Financial Investments Limited’ and the encouraging of the (Independent) Bank of England to cut Interest Rates to 2%.

The chancellor is reportedly working with the Business Secretary Lord Mandelson on drawing up a list of potential companies that can expect state aid to avoid the financial difficulties their reliance on customers with credit has caused.

Taken together this is very similar to the state intervention of the 1970’s where ‘Beer and Sandwiches’ with the Prime Minister resulted in state aid for strategically important industries such as British Coal and British Leyland, with the only real difference being that unions wanted big pay increases, where as the rescued businesses of today want modest % pay increases for workers, and big bonuses for top management.

While we may have dispensed with throwing state aid at corporations that don’t have shareholders (for the last 25 years), the new Labour government have in recent months turned to using every last bit of cash the country has to prop up inefficient businesses that can’t survive even the first 12 months of a downturn in the economy.

Aside from the conflict caused by rewarding shareholders with state aid (when they have invested in lame duck companies that should be allowed to go out of business) the Labour government has allowed itself to get dragged into cow-towing to CEO’s of reckless companies like Royal Bank of Scotland (RBS), because they are too big to fail. This was the same argument used back in the 1970’s for failing businesses like British Leyland, and smacks of the same failure today that was overcome through privatisation during the 1980’s.

The moral hazard of allowing a business to know it is too strategic to fail allows it to ‘name its price’ in state aid, to call the shots on pay, as happened with ‘beer and sandwiches’, and treat the government like dirt in the end, because the government have already stated they will do whatever is wanted. Majority ownership of RBS by the government is meant to head this problem off, but in the end the moral hazard of providing a consequence-free environment means RBS will eventually take advantage of this situation.

RBS can even throw the dog a bone and promise a headline catching 6 month moratorium on mortgage customers in arrears, to make it seem that the government is helping steer this corporation into doing the right thing by customers. I have concerns however about what RBS will extract as the price for this favour.

Getting back to the problem of borrowing £118 Billion to encourage spending in the economy, is that it’s a blatant ’spend your way out of trouble’ manoeuvre. I would like to believe it represents the government stimulating a recovery in the economy by latching onto an upturn in sentiment, and will help businesses and consumers pull themselves out of a recession.

The problem with this approach is that they aren’t looking to pick the economy up off the bottom, and help those surviving businesses that have run efficient operations to get the ball rolling and kick off a long overdue upswing. Instead they are trying to force the market to find an artificial bottom, they are trying to interfere in the natural deleveraging process, and they are trying to restart the credit boom without having paid the piper for the last 10 years of excesses.

This is foolish in the extreme. Labour tried throwing good money after bad in the 1970’s and using a Keynesian market intervention approach, Alistair Darling and Gordon Brown hope to spend enough money fast enough to manipulate the natural cycle of the economy, and bring it back out of recession.

It won’t work. It has never worked. In the 1970’s we proved it definitely won’t work if you do it with borrowed money, and even Keynes agrees with that point as he stated only surpluses should be applied to a recovery package. As we have no surpluses and seek to borrow £118 billion to manipulate the markets, we can expect the same IMF bailout that occurred in 1976 when finances were in better shape than they are right now.

The Shadow Chancellor George Osborne recently said “All Labour Chancellors eventually run out of money, and this one will be no different”. By the time we find out he’s right and the Labour party have spent our money trying to engineer a recovery that was never going to work while the whole world economy went into recession, it will be too late to reclaim the good money we’ve thrown at the bad losses.

The really stupid part of Labours approach is the ‘what’s counted as National debt and what’s not’ approach they’ve taken. The dud assets they’ve purchased in bankrupt companies should be marked down as part of the National debt, but they haven’t been. Instead they are noted as investments by the Government, and so are kept off the National debt. That way you can spend £37 billion bailing out banks and not have it double the National debt overnight.

The problem with this approach is that it matches the failed approach taken by these banks in the first place, who used Structured Investment Vehicles (SIV’s) as separate ‘off balance sheet companies’ to issue commercial paper and invest in Credit Default Swaps and Consolidated Debt Obligation’s (CDO’s). When Zoe Cruz at Morgan Stanley finally had to bring her £25 billion SIV back onto the books, because it was in trouble (July 2007), it marked the start of the banking crisis and gave us our first look at how these banks were hiding their real liabilities.

So to now find the Chancellor of the Exchequer allowing the Treasury to run the public finances in the same way as has just caused the collapse of the banking system, by keeping our real debts hidden and misrepresenting the UK’s real liabilities, is a complete disgrace.

The Chancellor of the Exchequer, Alistair Darling, has used the same argument in public to justify this action as the now failed banks used before the losses started to appear. The banks back then said these SIV’s were viable asset management businesses that were holding assets that had market value. When it turned out that Credit Default Swaps and CDO’s were worthless pieces of paper which actually caused heavy losses not annual returns, they went crying back to their originators (the banks) and appeared as losses on balance sheets.

Eventually the National debt will have to absorb the most of the £37 billion lost from these bad investments as the banks share prices fail to recover quickly, and in the meantime rack up billions of pounds of extra losses, due to the massive quarterly losses these business are still making. Eventually the Labour Government will have to accept these bank shares as worth far less than they paid for them, just like the banks themselves had to with SIV’s, CDS’s and CDO’s.

At that point our economy’s credit-worthiness will be downgraded, the value of our bonds will collapse, our currency will go into free fall, and if the Government haven’t already raised the £500 billion they need to pay for all the spending they’re planning, they will find no one willing to fund their manic spending spree. At that point the IMF will be called in as lender of last resort, and we’ll all want to lynch Gordon Brown and Alistair Darling for investing in worthless businesses that will have brought our country to the brink of collapse like Harold Wilson, James Callaghan and Dennis Healey did before them in the mid to late 1970’s.

After An October To Remember What Next, Inflation or Deflation?

October has been another month of great change, starting with the US Congress finally passing the $700 Billion bail-out of US banks and now with a week to go, we have the Governor of the Bank of England (pre-empting the publishing of data) announcing in a dinner speech that the UK economy is now officially in recession.

During October we’ve witnessed the collapse of the Icelandic banking system and the bankruptcy of their government, the £37 Billion investment by the UK government into shares of RBS, Lloyd’s TSB and HBOS as part of a wider £500 Billion UK bail-out package; and similar actions by the rest of Europe to recapitalise the western baking system with taxpayers money.

To fund the UK governments spending spree we’ve seen UK borrowing for the first 9 months of the year reach £37.5 Billion and we now look well set to break £60 Billion national debt for the year. We’ve also seen the CPI measure of inflation reach 5.2%, well above the Bank of England’s target of 2%, and we have also seen the BoE lower interest rates down to 4.5%.

The results from these events on the UK are as follows, in Iceland UK councils, police forces, universities and private individuals have seen nearly £1 Billion pound of investments disappear into the black hole of bankruptcy, with only the first £50,000 worth of investment looking likely to comeback out. This means huge losses for UK investors and institutions, and the rather humbling acceptance by the Icelandic government that they are unable to financially rescue their banks or wider economy, and will probably default on payments themselves.

The bail-out of the UK banks by Gordon Brown’s Labour government was carried out through crisis talks at 10 Downing street, held with the CEO’s of the UK high-street banks, and put together a deal which would see an immediate £37 Billion investment in shares, a £250 Billion lending guarantee to kick start interbank lending which has dried up and been replaced by the BoE. The final £213 Billion would be used to purchase the ‘Toxic’ debts that are still on the balance sheets of UK banks, and are preventing this crisis from ending.

For the banks part of this package they are to end the ridiculous bonuses to employees that have seen this collapse occur in the first place, a moratorium is to be placed on the payment of dividends while using tax payers money, and the senior executives of the banks involved are to leave without taking their golden parachute payouts (severance pay).

Moving beyond the distractions of leading UK banks, I would like to deal with the real problem that is at hand, the now apparent UK recession. I have heard many commentators such as DeAnne Julius (former MPC member) or Anatole Kaletsky (Writing for the Times) suggest that we need to lower interest rates, and more aggressively that the 0.5% cut that the BoE did this week.

Both commentators suggest that a rate cut would help fix the lack of credit availability and lower the current borrowing costs between banks, known as LIBOR. This would then help stimulate the UK economy and help prevent a prolonged recession. The difference between the commentators is the acceptance by DeAnne Julius that this policy will cause long term damage, where as Anatole finishes his article by suggesting that a drop in interest rates would help lower the trading value of the pound and help stimulate export sales, further boosting the economy.

I however take a very different view on the current situation and the results of interest rate changes. I think inflation will not fall but instead will increase. This is because although prices of commodities have started to fall now that a global recession is taking hold, I don’t see these price drops being passed onto UK consumers.

After a difficult 12 months in which most companies have see their gross profits squeezed to almost nothing, the chance to buy in at a lower price while holding a higher sales price will help off-set some of the missing revenue of the last 12 months. The banks have already started to make this a reality with the latest round of interest rate cuts by the BoE not being passed onto consumers, but quickly being passed onto savers. This will maximise the banks revenues out of both savers and borrowers, but at the same time demonstrates how the current assumption, that we will experience a period of deflation, is not going to happen.

Further evidence of the UK’s inability to price downwards can be seen in the latest data coming out from the Farming industry, as despite a global fall in the price of dairy goods has already begun, the UK market has actually seen price rises.

Secondly, As Alice Cook from UKBubble fame is regularly pointing out, there is still a massive disconnect between interest rate movements and the resulting movement in the LIBOR rate. The lowering of rates is in fact making the gap more pronounced and as LIBOR refuses to budge, the gap shows how the mechanisms that make interest rate moves so effective, have now gone, and demonstrate the weakness of the Bank of England in effecting the key market area of lending rates.

This now means that the area most affected by interest rates is not lending or borrowing, but is in fact savings. As returns for savers are cut by the banks, two negative responses will occur. Firstly cash will leave UK banks for foreign banks, as they offer better returns, further damaging the capital base of struggling UK banks. Secondly, and Most importantly however will be the collapse in our currency, the Pound, on the international markets.

Unlike Anatole Kaletsky I see this as damaging the UK economy because we don’t export manufactured goods any more, and since the credit crunch started we don’t export that many financial products either. We currently have a balance of payment problem where we import £7.5 Billion per year more in goods than we export. This means that although the gap may narrow due to changes in purchasing behaviour, unlike the rest of the world where prices of food are falling, our collapsing currency will actually see our prices rise, as our imports become more expensive.

The third reason why we will see inflation not deflation is that for the last 12 months we have seen inflation increase well beyond the 2% target set by the UK Government and Bank of England. This prolonged period of high inflation has now translated into higher wage demands. My primary evidence for this (apart from it being obvious) is that my own employer agreed 18 months ago to provide a pay increase at the rate of either 2.5% (near the CPI target) or at the current level of the Retail Price Index. When this agreement was originally struck RPI was below 2.5%, so not a problem. Now however RPI stands at 5.0%, and it has been confirmed that I will very soon be getting a backdated pay increase of 5.0%. As I doubt that my company are alone, and as I’m aware that most Financial city jobs also track the RPI for pay increases, this is a clear demonstration that the wage price spiral has now begun.

Taken together, price reductions not reaching customers, a falling currency and the start of wage related inflation indicates that prices will be increasing, not decreasing. Further more, a higher national debt level and plans to massively increase government spending in the economy with that borrowed money, sound like the old inflation generating Keynesian policies that failed during the 1970’s, of ’spend your way out of trouble’. The added problem of reduced interest rates, and a disregard for inflation mean that any benefit that is derived from reducing interest rates today, will not only fail to arrive in time to help, it will undoubtedly be at the expense of double digit inflation tomorrow.

DeAnne Julius knows this, when asked in her interview about the impact of current government moves to spend £37 Billion with borrowed money, she didn’t deny it would have a serious negative (upward) impact on inflation further down the line. Gordon Brown knows this, which is why he had 2 big rules – only spend to invest & his golden 40% borrowing rule. This was because spending to stimulate demand caused hyper inflation in the 1970’s leading to the ‘Winter of discontent’ in 1979, where we had double digit inflation and interest rates.

In my estimation this is where we are headed again, double digit inflation & interest rates. As inflation isn’t dealt with because the government and ‘Leading Economists’ (who didn’t see the credit crunch coming) now claim we will experience deflation; what we’ll end up with is rampant inflation and then the inevitable move by the Bank of England, an increase in interest rates to deal with this problem. At that point we’ll have the 1979 problem of high inflation and high interest rates, huge government borrowing and crippling interest payments on the new bonds (gilts), issued to pay for the increased government spending. All we then need is increased public taxation to replace the declining revenues of businesses, and we’ll have the full set (Although this at least has not yet been announced).

The affects of 8% (or higher) interest rates on anyone who has fallen into negative equity (estimated to be 2-3 million homes) will be horrendous as the majority will be repossessed and bankrupted, and we’ll be back to 1990 again, with keys being posted back through estate agents letter boxes. As both the government and Bank of England know that a failure to control inflation will cause this, I would disagree with DeAnne Julius, Alistair Darling (Chancellor), Merv King (BoE), Anatole Kaletsky and the whole dam world by the look of it, that lowering interest rates is the right thing to do, or that inflation will be lowered by falling commodity prices.

Should Part of The £37 Billion Bail-Out Go To Shareholders

I came across this question on UK Bubble and had to join in the comments, here’s what I put:

‘Banks using part of the £37 Billion of tax payers money to pay dividends is a slap in the face to everyone who hasn’t got shares in these banks.

If the government had tried to sell this difficult to swallow spending spree, on the basis that it would go straight into shareholders pockets, everyone from parliament to the tabloids would have ripped them apart.

I doubt the rest of Europe would have signed up to similar arrangements if they had to explain this to their electorates, but the most galling aspect of this latest bank whimpering is that they’ve played along with the whole non payment plan right up until they had the cash in their pockets, and now they announce that the rules change.

I would have thought that with reality catching up with highly paid liars, they might have bought a clue and cut the crap, but they can’t be grateful for a rescue that no other companies on earth would get, oh no, they have to have their cake and then dish it out to shareholders too.

Given how long this change of heart took it seems very likely they had no intentions of stopping shareholder payments, but just paid lip service to the idiots in Downing street long enough to get their hands on our tax pounds.

This is quite frankly outrageous, how dare they slap tax payers in the face like this, so soon after we kept them afloat. We should have let them all go to the wall and see how the shareholders feel about that lack of a dividend.’

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To deal with the main reason why the banks want to keep paying shareholder payments, they think that posting no dividends will drive the value of their businesses down further, making them less attractive to investors and less competitive in the wider market. A reduced business value would also make raising short term loans against the value of their businesses more difficult, which increases the risk of a shortfall in meeting debt payments, increasing the risk of bankruptcy.

The truth is that they should be viewed as less attractive assets by the wider market. They are bankrupt businesses that are limited in what they can offer shareholders, and their market price should reflect that. In fact the market price of their shares should reflect the reality that they are bankrupt, and hit its true value. The government has done them a favour in keeping them running, and this has distorted their true value.

For greedy selfish banks this distortion isn’t enough, they want the markets to treat them as the strong viable businesses they thought they were, so they want to further distort the markets’ perception of their true value, by posting the dividends that most businesses are now going to struggle to post in the current economic climate.

The fact is that they aren’t viable – they should not be valued as businesses that are so strong they can keep posting dividends no matter how difficult the economic climate becomes. They should be forced to learn that lying to themselves about how great they are is what has got them into this mess in the first place, and tax payers should not be dragged into helping them perpetuate this myth.

It seems that no matter how bad thing get they cannot break their natural instincts to claim value exists in an asset, when it quite clearly doesn’t. The taxpayers and UK government should be helping banks to start dealing with reality, instead of helping them to find new ways of distorting the true position of their businesses. They are like junkies that are trying to get right back on the smack, we have a moral obligation to say ‘NO’ and force them to exist in their true form as poor investments, until they can make their way back up with hard work and prudent policies.

The term ‘Enough is Enough’ is all I want to hear from the UK government, and a forcible rehabilitation program, without any easy rides, is the only prescription the Chancellor Alistair Darling should have on offer.

$700 Billion Bail-Out of the US Economy

It’s hard to know what to make of this proposition – yes, it’s needed, yes, it’s wanted in some quarters, but in the end it is government intervention in the markets, which means it’s not capitalism.

This is the big problem for the $700 billion Federal Reserve bail-out of Wall Street; that 133 Republicans & 95 Democrats are so into the ideals of capitalism, they are willing to ride this collapse all the way through to a depression.

The key problem for capitalists is that, with the government being the chief regulator of the economy, it will cause a massive conflict of interests when the same people who will have to audit every company in the market, then have to manage their assets against the very companies they are regulating.

They will have an unequalled access to the accounts of their competitors, and are then meant to make a profit for the taxpayers whose money they are managing, but without using the knowledge they have gained through regulation. This ‘Chinese walls’ situation is so unrealistic that it has long been decided that for governments to be effective in regulation, and seen as being impartial, they should never join the market as a player.

Another sticking point in this rescue package for both Democrats & Republicans in Congress is that they have an election coming up in November, and none of them want to be insisting to their constituents that they shoulder the hurt from the state of the economy, while Wall Street gets all the money their constituents are told they can’t have, because of the damage it would cause.

To make matters worse, it seems that Morgan Stanley after being one of the chief contibutors to this market collapse would get a $1 Billion contract to manage and distribute the $700 Billion rescue package. Having made huge personal sums of wealth getting the US economy into this mess, Morgan Stanley are then going to get paid more tax-payers money to save their own arses. A situation that beggers belief is the only term that comes to mind. How can they be trusted with anyones cash after being a leading culprit of this disaster in the first place?

On top of that, both Henry Paulson and Morgan Stanley are going to have one of the strongest positions of patronage ever witnessed. As everyone has to come to them for help, they will effectively become untouchable, as no companies will want to risk their own slice of this $700 billion bail-out pie by critisising either one of these players in the coming months. The terms of Henry Paulson’s original deal were so stacked in his favour (such as no oversight, no limits, no checks and a free hand to spend this cash) these terms alone were enough to outrage Congress and wider America.

Not only has Paulson overseen this whole mess, now he wants unpresedented power to spend as he sees fit. Even the American tax-payers can tell that being in charge of a mess like this should mean you get the sack, not the patronage to spend $700 billion helping out your mates on Wall Street, while the rest of Americans lose their homes, jobs and savings.

The Banking Collapse

On the 7th of September Fannie Mae and Freddie Mac moved out of private ownership and were de-facto nationalised through a process the US Treasury calls ‘Conservatorship‘. This means that the US Government has now guaranteed a $5.3 Trillion companys debts and taken them on as part of the national debt. Furthermore any new trading of mortgage-backed bonds by Freddie & Fannie will also need to be backed by the government.

This action started the Credit Default slide that Alex Ritson warned about back in July; that the failure of Freddie & Fannie would constitute as a default. This meant that all other companies involved with Freddie & Fannie would come under pressure from 2 possible sources. Either they would have to lose vauable cash paying out on any default swaps that deliver returns with the collapse of Freddie & Frannie, or they would have to devalue any mortgage backed assets, that were backed by Freddie & Fannie.

This then created a problem, as not only did banks and insurers find they had no cash left after making default payments, the devaluation of their MBS (Mortgage Backed Securities) meant that many companies overall market vaue was significantly reduced. This then means that when Lehman Bros., AIG, Merryll Lynch and HBOS most need to raise cash against the value of their businesses, that overall value has come down so much that they can’t get any more money from the markets.

Unfortunately for Lehman Bros. the consequences of not being involved with the commercial (home/personal loans) banking sector meant that they were exposed to the markets (and practices such as ‘Short Selling’ of banking stocks) without any money to fight anyone off, and most significantly with no government support as a safety net. The stock markets anywhere in the world treat weakness as a chance to make easy money, and where there’s easy money there’s always a broker.

On 15th September Lehman Bros. filed for Chapter 11 bankruptcy protection, which means thay are bankrupt. The combination of a falling stock price because of their inability to soak up anymore bad debt, the downward pressure of ‘Short Selling’, and the need of humans to flee a potential sinking ship, even if this reaction will make going down a certainty, meant that Lehman Bros. lost too much value and went bankrupt.

This finally reminded the financial system that it was a financial system (and not the fun end of a US government department) and the markets underwent the sort of correction that has been long overdue. Stocks went from 11421.99 to 10, 917.51 with a 4.42% loss, based on the fact that Lehman Bros. failure proved that failure itself was still possible. The great collapse would now begin. All stocks would fall, all companies relying on revenue and credit from the markets would eventually go into bankruptcy, and the cascade effect of bad debt would sweep the whole system.

With the the primary quake having now gone off with the collapse of Freddie, Frannie and Lehman Bros., next to hit were the aftershocks from the realisation that the constant growth from credit-fueled trading was over. Subsequently Merryll Lynch was purchased by The Bank of America, and the collapse took place of a well hidden keystone of the western financial system; AIG (American International group).

The $85 Billion rescue of AIG by the US Treasury on the 17th September 2008, which gave the US Treasury 79.9% overall control of the company, was a recognition by the US government that while it could live with the failure of Lehman Bros, some market players are ‘too strategic to go down’.

AIG holding everyone else’s loan protection policies (Credit Default Swaps), combined with so many financial companies now being reliant on AIG backed assets for market value, meant that the US government could not allow AIG to fail and devalue $400 Billion of assets held by other key market players.

AIG had one key failing in its revenue stream – it went mad on selling credit default swaps. It had sold this defacto insurance on so many US mortgage assets held by the wider market that its own failure would put the whole stock market at risk of collapse. This prompted the US Treasury to look at AIG in a different way to Lehman Bros, with the subsequent bailout of AIG delivered at a cost to the US Government of $85 Billion.

Next to go was Merrill Lynch, purchased by The Bank of America to aviod becoming the next Lehman Bros, and was joined with the takeover of HBOS (the UK’s largest mortgage lender) by LLoyds TSB for the same reason. Barclay’s decided to join The Bank of America in aquiring new assets, with its purchase of the US investment arm of Lehman Bros.

In both cases these rescuing banks themselves have been under pressure for resources recently, but seem to have played the psychology of the situation and made good on the idea that the best way to convince investors you’re not in trouble is to play it cool and flash the cash. It does begger belief that, once again, there are companies seemingly looking to spend their way out of trouble, but it may well work, and will undoubtedly secure them the backing of both the US Federal Reserve and the Bank of England.

This left only two investment banks, Morgan Stanley and Goldman Sachs. After the shares of both of these companies started to come under pressure on Friday 19th September, they organised over the weekend to change their banking status with the Federal Reserve from investment banks to become Bank Holding Companies. Not only did this mean that the banking crisis has discovered a problem in the housing market, the business model of investment banks had failed, starting with the collapse of Bear Stearns in March, and ending with the status switch of Morgan Stanley and Goldman Sachs.

As recognition of how the traders who ’short sell’ stock have contributed to the collapse in stock prices of most of the banks on the FTSE 100 & Dow Jones stock exchanges, on Monday the 22nd of September the UK’s FSA (Financial Service Authority) banned the practice of ’short selling’ until 16th January 2009.

‘Short Selling’ is so controversial because the traders borrow stocks in a target company (like Lehman Bros.) and then dump that stock onto the market. This causes the stock price to fall, at which point they then reacquire at the lower price the stocks they borrowed, and pocket the difference. They therefore make money when stock prices fall, and then pay no regard to the damage this causes as it reduces the market capitalisation of the the banks, building societies & insurance companies affected.

It’s at this point we can now consider what the US Treasury’s spending spree will cost. Although it may seem like a bottomless pit of finance, especially as oil is traded in your currency, but there is a limit set by Congress and the US Treasury has spent more than the US people ever expected they would need to borrow.

Billions of dollars now seem like small sums compared to the total of $11.3 Trillion, which is what Henry Paulson has just asked Congress to lift the national borrowing limit to, as a way to cover the cost of his new $700 billion bail-out plan, on top of the purchases of Freddie, Fannie & AIG.

The problem with all of this borrowing is that on the government books it will cause the dollar to crash as the value of the US economy is reassessed by the markets. This devaluation will see inflation rise as America’s love of imported goods ensures that they either end up spending more on imports to recieve the same volumes of goods as they did last month, or they get less for their dollar. Either prices go up or consumption goes down and jobs with them, a real lose-lose situation, with possibly both happening at the same time.

To counter this collapse in the dollar and rapid influx of inflation into the economy, and to maintain the US Treasury’s long standing committment to a strong dollar, Interest Rates will have to be lifted. Lifting interest rates will strengthen deposits in the banking sector as a whole because the rates of interest offered will now be stronger than the returns offered on the stock markets.

As this switch will be into very low risk saving accounts it will seem very attractive to large organisations like pension funds and mutuals. The overall effect will be to make less money available to the markets and more held as savings, and so reducing consumption, especially that based on borrowing, and allow inflation to fall back to the 2% target level.

The problem with this solution is that while you’re waiting for inflation to start to decrease you have both high inflation, high interest rates and a low dollar. With reducing consumption you will have economic contraction in GDP and more companies will repost reduced profits and lose share value. This may then cause the start of the next wave of businesses coming under pressure over liquidity linked to their market capitalisation.

There is no mistaking however, this $11.3 Trillion debt the US Treasury and Federal Reserve have presided over will cost the US economy dearly. During this housing crash the lift in interest rates alone will take some absorbing. This then will be disturbingly combined with the affects of the gold rush in housing (from November 2005) coming back to haunt the US housing market, as huge numbers of home owners come to the end of their 3 year fixed rate introductory offer mortgages in November 2008.

The subsequent surge in prices due to a high base interest rate will cause a new round of mortgage defaults, and almost guarantee that all the toxic assets the US Treasury purchase through their rescue package will be proven to be as worthless as the rating agencies had made out, causing them to be offloaded in the first place.

It seems that there’s no escaping the fact that the bad debts are going to hurt someone, and the US bail-out will ensure that it’s the American tax-payers that suffer most with the prospects of a recession becoming a depression before the economy hits bottom and GDP growth once again returns, along with rising house prices.

Reality Bypass

The current UK Government is suffering from a serious case of ‘We can’t face reality’. The situation is dire because the Chancellor of the Exchequer, Alistair Darling, is predicting economic growth of 1.75% – 2.25% for this year and next, when all around him are finally getting nearer the mark, such as the IMF who are predicting 1.4% economic growth for 2008 and 1.1% economic growth for 2009, and the CBI (Confederation of British Industry) now predicting 0.4% economic growth for 2009.

This is very bad because if the UK Treasury can’t come to terms with the reality of a collapsing economy, they can’t set policy to deal with next years lack of money. No reality = no policy.

The situation will be a minimum inflation of 5%, lower tax receipts from the financial sector, housing sector (Stamp Duty) and retail sector; interest rates that are on the rise (or they should be if the BoE have any sense) and a rapid increase in unemployment which will increase government spending on benefits. This squeeze on incomes and increase in outgoings will leave the government with the same choices that we’ve had in the past.

1. Raise Government borrowing
2. Raise taxation
3. Cut public spending

Option 1 is out because the 10p tax debacle has already put us way past the safe borrowing limit that indicates a net outgoing of revenues on interest payments that will restrict economic growth.

Option 2 was tried in the late 1970’s under a Keynesian structure of tax and spend, which never works, because increased government spending when inflation is on the rise only fuels further inflation and, on top of our current high borrowing levels would result in both double digit inflation and interest rates, such as those in 1979.

Option 3 is just like Margaret Thatcher’s early 1980’s approach, rolling back the state and cutting government spending. However as the above analysis shows, we are entering a period of low government tax revenues and higher government spending on unemployment benefit, which would only leave spending cuts in other government departments such as the Department for Health (with spending up from £35 Billion in 1997 to £90 Billion in 2007), to achieve a reduction in government spending. Cutting 3,000 hospital beds while cutting back on Local Government services will be as popular today as it was during the 1980’s.

The big problem with option 3 however is it will cost too many votes in the run up to the next general election in 18 months time, and for an already very unpopular Prime Minister (Gordon Brown), this would finish him off as Prime Minister and the Labour Party as the UK Government. Besides, as Alistair Darling’s comments show, the current Labour Government doesn’t have the stones to deal with reality, let alone present a potential cure to mitigate against the coming problems, that would then cost them the next General Election.

As a result of all this we are left with infuriating persistence by the Treasury that they are right about GDP growth, and pretty much everyone else is wrong – me included.

This current problem at the Treasury is confounded by the worst offender of all, the chief turd-polisher herself, Housing Minister Caroline Flint, who in the middle of a housing collapse keeps coming up with wonderful statements to prove how this housing crisis isn’t actually a problem at all.

When speaking on Radio 4’s Today program on 10th July she made the following housing market comments:

“In terms of consumers we’ve seen a modest fall in house prices” - This comment comes 3 weeks before UK house prices showed their biggest annual fall since the Nationwide began its housing survey in 1991. The 8.1% annual decline came after house prices dropped by 1.7% in July, the building society said.

“We’ve seen an increase in repossessions, but nowhere near the sort of repossessions we saw years ago” - Home repossessions have risen by 48% in the past year. There were 18,900 repossessions in the six months to June (2008), up from 12,800 in the same period last year. While this is still not as big as the 75,540 repossessions seen in 1991, we have not yet even entered recession in 2008, while the 1991 figure was taken at the bottom of the last housing market crash during a bad and deep recession. As things stand at the moment the 75,540 mark could well be broken as unemployment rockets out of control.

“In some cases flats were necessary for first time buyers” - (1 month later) A fall in flat prices has become a key factor in the slowdown of the housing market, UK government figures show.

“And most of those people being taken to court hold onto their homes if they are given the right advice”. (5 weeks later) Last week the regulator (FSA) warned it would take action against lenders who were too aggressive to customers in arrears. But the Council of Mortgage Lenders (CML) said the FSA was wrong to suggest the whole industry was at fault. The FSA replied that potential problems with repossession policies were found with all types of lender. “There were issues discovered across the piece with all lenders which is why the warning was addressed to the whole market place,” said an FSA spokeswoman.

Between the lack of reality from the Chancellor and the Treasury, and the ridiculous comments from the Housing Minister Caroline Flint, Merv King at the Bank of England will have his work cut out bringing these two down to earth.

The US Treasury Have Thrown Good Money After Bad

It’s so obvious this would be the end result of the US Governments decision to provide a $167 Billion stimulus package, it’s hardly worth saying, yet I just can’t help but cover the point.

President Bush in May and June provided the US economy with his teams solution to a huge credit binge lasting years; he went on a credit binge and threw some cash at the economy. This ’spend your way out of trouble’ idea was poor at best, and today we find that it has in fact failed. It has failed because the problems that have brought about the looming recession have not been dealt with, and as the latest retail data shows, it has had a marginal affect on the economy. Not only has that mild effect worn off very quickly, it had no follow-through with either more cash or a resolution to the underlying economic problems.

It must therefore be seen for what it is, a crude economic stunt with only political benefits and as my title suggests, it has ended up throwing good money after bad.

In generating extra borrowing it has in fact weakened the US economy, but ,worse still, it has wasted some of the precious money that was still available to the US Treasury. With nearly all the major Dow Jones companies now declaring losses (AIG being today’s latest) and failing to generate profits that the US government loves to tax, the limited resources that the US Government had at its disposal should have been better spent, rather than being wasted on a politically motivated forlorn hope.

It is now assured that in a period of declining US Government revenues, this one- off stunt was a definite waste of money.

Financial Crisis

To start this months post I would first like to make a mention of a great blog I read every week that I consider to be well worth a look;

It’s written by Alice Cook and is called UK Bubble

The second artice I would like to recommend is from Alex Ritson (14/07/08), a reporter with the BBC’s Newsnight program. The contents of his article are so powerful and awe-inspiring that this is one situation that would never be allowed to play out. Titled ‘The US Economy’s Next Bad Thing?‘ it is essential viewing.

Even the most conservative of approaches to market intervention would still be put aside to prevent this meltdown from taking place. The scary part is that this is not some doomsday scenario, but is in fact a very real situation that will take some skillful and careful economic management from all western governments to avoid it becoming the worst economic collapse ever.

To prevent the situation identified by Alex in the above article, no bank will be allowed to fail, especially the two most precarious of giants, Freddie Mac and Fannie Mae. If you wanted to know what the gun being held to the US Treasury’s head looks like, the Credit Default Swap market is that gun. The US Treasury looks like being handed a choice between nationalising Freddie & Fannie and taking the US national debt from around $3 Trillion to $9 Trillion, or allowing them to collapse and starting the cascade effect of Credit Default Swaps being paid out by the banks that issued them.

The problem is that these banks can’t cover the payments they are meant to make and will therefore collapse. The big problem with banks collapsing is that these Credit Default Swaps are in fact insurance policies, and, to ensure they will never have to be paid out by any bank, they secured most of them on the safest assets they could find – big banks mortgage products.

When the two biggest banks in the market fail, and all the policies are paid out by the surrounding banks, then those banks paying out may also collapse. Then, the next wave of CDS’s (Credit Default Swaps) pay out on the next set of banks to fail, and, before you know it, you’ve got a cascade effect going right though the system ripping $62 Trillion out of banking.

In the UK the exposure of British banks to this problem was mentioned in Alex’s article as being unknown due to it being hidden amongst a package of credit derivatives. Notably however, the two banks that have recently been inexplicably trying to raise shareholder finance, Barclay’s and RBS, have the biggest exposure of any UK banks at £2.5 & £2.4 Trillion respectively. Is it any wonder then that they are desperately trying to raise their capital holdings?

One further notable problem connected to Fannie & Freddie is the fact that one of the biggest takers of their sub-prime related bonds are the Chinese government. If, in avoiding a Credit Default Swap situation, the US government does have to nationalise Freddie & Fannie and bankrupt its investors, this will wipe out any holdings by China.

This would really represent a Bush administration encouraging China into investing in the US economy, only to find that the US government has taken their cash and run. It’s not like the US government will have much choice, but that will still be a hard pill for the Chinese to swallow, and may discourage them from fueling any similar fires in US housing in future.

Housing & Economy Update

As the latest housing data is released showing a 64% decline in the number of mortgages completed last month, as compared to this time last year, It seems something significant is happening in the housing market and wider economy. This news combines with the inflation rate of 3.3% and the £550 million write off by Taylor Wimpey from UK losses to reveal a housing market with problems today and far worse to come.

As inflation increases the Bank of England will look again to raise interest rates above the 5% they are currently. As this happens the lenders will increase the deals they have on offer to higher levels and this is when everyone will notice that a high rate deal on a house of average price £179 ,000 – £184,00 will, in conjunction with an average 10% deposit + fees + stamp duty, result in an impossibly high start up cost combined with a huge monthly payment.

The problems of Taylor Wimpey show how the business side of this market is already suffering and now even the biggest of players is having to look for a buyout or share capital. As new business drys up and the prices of houses start to fall, all the land that Taylor Wimpey have bought for new housing projects not only stands empty, but starts to look over priced and gets re-evaluated, netting Taylor Wimpey a huge loss. Taylor Wimpey are not the only ones who are going to get caught ‘holding the baby’ with huge inventories of land; eventually the rapid decline in the price of property will result in a less well-financed business getting caught out. The shared problem now being market capitalisation dropping by 75%, meaning they can’t raise funds for new projects or lending to offset their losses.

The cyle of problems now has a lot of key pieces, as construction companies lay workers off and estate agents go too, the jobs situation will put families with mortgages in financial peril as repossessions have previously ensued in this situation. The fundamentals that I keep hearing are all fine at the moment, are not fine at all, its just the lag on the effect that is still feeding through the system. The fundamentals being the rate of employment, the rate of inflation and the rate of interest.

The real problems however will begin when the inflationary spiral tries its best to start. The fundamentals followers’ claim that there’s no inflationary spiral at the moment, so when the current fuel increases have fed through the system, the rate of inflation will fall back and everything will go back to normal, interest rates can be lowered and the housing market can recover in the nick of time.

The Governer of the Bank of England, to his credit, has not chased the housing crash like The Federal Reserve in the US have, and the current Interest Rate of 5% will make his best scenario a possibility, and a rate cutting intervention in those circumstances would make him a total superstar of economics (and rightly so). I think however, what has been overlooked is the current increase in gas and oil prices increasing the price of food and transport with them, and this will lead to inflation that may have its limit, but is enough to trigger wage-led inflation that will add to the food price increases at the point of sale and IS going to be the trigger of an inflationary spiral. That may mean that Interest rates have to go above 6% and take longer to come back down, which would then lead to a recession. It will be a close thing in the UK but some good work by The Governor of the Bank of England (in spite of some of the short-sighted retail advisers on the Monetary Policy Committee) has at least given the UK a fighting chance.

The US however have not got with the program, and having lurched after the housing crash now have Interest Rates of 2%, which are too low to fend off the inflation that has built up from high energy costs. They are starting from too low down to manage this problem properly and will end up chasing interest rates all the way back up over 4% (and probably higher), and whatever ground they may think they’ve gained from lowering them suddently in 2008 will be lost as those just hanging on finally go under and start the next phase of housing crash in the USA.

For the same reason as in the UK, they will experience fuel led inflation leading to wage led inflation, leading to higher prices at the shops and starting the inflationary spiral. The best thing the Federal Reserve could do at the moment is cut their losses and start the inflation fight right now, but instead of making the hard call like the UK and EU made to stay on top of inflation and, in effect, be proactive in the right area at the right time, the Federal Reserve are now holding Interest Rates and watching to see what happens before they will make the hard call to lift Interest Rates. By the time they have data on the start of an inflationary spiral it will already be too late to get on top of it quickly. This then means that instead of taking on a recession, the Fed are waiting to buildup a bad recession, and will take this on instead. I feel they either lack the courage to make a move or have some Presidential legacy to protect instead, consequences be damed.