House Prices

Rob Williams has an excellent article on the Compass website today:

The great property bubble has been, and continues to be, a disaster. Wealth hasn’t been created, it’s simply been redistributed, and to those who are already well off. It’s siphoned away money that could have been invested in more productive parts of the economy.

For short term electoral reasons, the government would like house prices to rise. For the sakes of the millions priced out of a decent home and for the sake of a balanced economy based on sustainable investment, we must hope they don’t.

I fully agree:

Thatcher revolutionised the housing market through the ‘right to buy scheme’. Britain is now close to being the ‘property owning democracy’ of which she spoke. Given that 70% of voters are now owner occupiers it is no surprise that governments, of all colours, will aim to give these people what they want. But this is not what centre-left politics should be about. We need to create a new housing market, where prices rise in line with earnings, where people think of their home as a place to live not a source of cash and where tenants (whether private, social or council) are not seen as lesser beings than owners. This will mean building a lot more homes, replenishing the social and council stock and probably being more prescriptive with banks as regards their lending policies. It is hard for any government to say to 70% of its electors, we don’t want the value of your assets to rise so quickly, but, for a centre-left government, it is necessary.

Jenkins & the wrong kind of stimulus

Vino notes Simon Jenkins article in yesterday’s Guardian.

Jenkins is full of praise for ‘cash-for-clunkers’ style packages to support car sales in Germany and the US and criticises the Government’s smaller scale actions here. He calls for the programme to be extended to other goods.

However as Vino notes:

Furthermore, I think British manufacturing no longer products many of the household goods we buy. They are made in China and elsewhere. We would need to boost our manufacturing capacity before we could meet our domestic demand for consumer goods. Otherwise, the demand for more consumer products would lead to increasing imports.

He’s quite correct.

In 2006 Germany produced 5.4mn cars and the US 4.4mn. The UK only produced 1.4mn.

The pattern is similar with other consumer oriented goods. The UK’s comparative strengths (services, pharmaceuticals, advanced manufacturing, creative industries, etc) are not that easy to stimulate through consumer spending.

Any stimulus of the type Jenkins advocates would increae consumption but also increase imports (which subtract from GDP). The net impact would probably be a marhinally higher GDP but much higher government debt.

Focusing on consumption ignores the crucial point – investment. Increasing investment not only raises GDP in the short run, it helps long run growth and helps rebalance the economy.

The Future of Northern Rock: The Maths Adds Up

The Guardian today reports that:

A tug of war has begun at the top of the government over the future of Northern Rock as senior figures argue that the Treasury’s planned sell-off should be stopped so that the ailing bank can instead be turned into a building society owned by its customers.

The move would mean forgoing a potential £11bn windfall for taxpayers but some cabinet ministers and No 10 officials believe this option is preferable to selling the bank to a rival or refloating on the stock market since it would leave the bank less prone to instability and financial risk.

However, there are concerns within the Treasury, which needs to reduce public debt and claw back some of the £25bn of taxpayer money which was used to bail out the bank in 2008.

The final decision will be taken by ministers but they want to win the support of UKFI, the company set up to run the nationalised banks after last year’s crash. Senior government sources believe there is a convincing case that taxpayers would benefit in the long term if a remutualised Northern Rock were able to help less well-off customers get low-interest loans.

I’m quite fond of the idea of Northern Rock returning to its roots and becoming a mutual.

Mutuals are not a panacea. The collapse of Dunfermline Building Society shows that. But they do, when well run, tend to perform the core retail task of offering savings accounts and making mortgages well as they don’t need to generate an excess return for shareholders – Nationwide is a great example. In the case of Northern Rock the numbers stack up well.  

It’s difficult to say at this stage  exactly what a re-mutualised Northern Rock would look like but the first half 2009 results provide some clues. The current plan is to split into a ‘good bank’ and ‘bad bank’ – similar to what happened to Bradford & Bingley (with the ‘good’ bit then being sold to Santander).

Northern Rock currently has (as of June) £88.7bn of assets, including £62bn of mortgages. Buy to let loans make of  £5.6bn of the total. Although bad debt charges were £600mn in the first half, £300mn of that came from unsecured personal loans and another £60mn from BTL loans.

Even so, some of the mortgage book is not great (remember their 130% loan-to-value ‘Together’ loan?). The overall LTV for the mortgage book is 74%. Whilst LTVs over 100% represented 39% of the total book.

Loans with an LTV above 100% are obviously more risky (if the borrower defaults the collateral (house) won’t cover the losses), but most people will not default. As of June, 3.92% of the mortgage book was in arrears.

It seems fair (and very conservative indeed) to assume that 80% of the loan book is fine. So let’s imagine that the ‘good bank’ that would be remutalised can take £40bn of the mortgage book (only 65% of the book and the highest quality).

In simplified terms it then needs to ‘fund’ that £40bn of assets (obviously it will have some other assets too – cash, branches, etc). My ideal solution would be to transfer all deposits (£20bn) and covered bonds (£10bn) to the new mutual.  The remaining gap of £10bn would be plugged by transferring across £10bn of the £30bn of securitised bonds. This would not involve issuing any new securitised debt, just shifting some outstanding bonds.

This would leave NR with a loan to deposits ratio of 200%. Which is high, but could be brought down over time assuming it attracts savers.  The first priority of the new NR would be to reduce dependence on securitised debt.

Crucially it would have to fund all new lending through new deposits and would have to have no reliance on overnight and other short term funding. This is all achieved in the structure outlined above and so avoids the problems that led to the downfall.

How much value could this new NR offer customers? Actually quite a lot.

The running costs of Northern Rock (excluding exception items) were £107mn in the first half of 2009. Annualising that we get a running cost of about £250mn (with some leg room). And remember building societies don’t have to generate a ‘profit’.

So if we have a bank with £40bn of mortgages needing to generate net interest income (the difference between income received on assets (loans) and paid on liabilities (deposits)  of £250mn, what  is the required spread (the difference between loan rates and deposit rates)?  The answer is a very low 0.625%.  The net interest margin for the UK banking as a whole for retail customers is currently 2.35%. Let’s say that Northern rock should aim for a spread of 0.80% (generating a surplus £70mn a year).   

So a mutualised Northern Rock could either charge 1.55% less on mortgages than other banks, offer 1.55% more savings or some combination of the two.

I’d be inclined initially to focus on offering more on savings to raise deposits.

A net interest margin 1.55% below the UK average, on a £40bn loan book, would benefit Northern Rock customers to the tune of £620mn annually either through lower repayments or higher savings income.  

 Selling Northern Rock could raise £11bn. If that was used to reduce the public debt it would reduce the annual interest bill by only £396mn (Government debt yielding 3.6%).

Remutualising represents an annual saving of £224mn for the UK economy.

 

Osborne: What he’s missing on bonuses

I’ve now had a chance to read George Osborne’s speech from yesterday.

It’s a curious beast, the opening full of strange contradictions of previous Tory lines. Osborne mentions: 

the radical monetary action taken by the independent Bank of England, which we were urging and welcomed

And there was me thinking that Cameron thought that ‘printing money’ led to inflation and had to be stopped.

He moves on to note:

According to the independent Institute for Fiscal Studies, a study of last week’s public finance figures shows that the Government are currently on course to spend £10 billion less on public services than they claimed in the Budget – offsetting half of the £20 billion discretionary stimulus. 

But I thought Brown was vastly, and recklessly, over spending?

Of course the meat of the speech was the section on bonuses. And here we got lots of soundbites and real sense of confusion. For example:

I am today calling on the Treasury and the FSA to combine forces and stop retail banks – in other words the banks that lend directly to businesses and families – paying out profits in significant cash bonuses. Full stop.

That includes their investment banking arms.

RBS is a large retail bank with an investment banking arm but Barclays is a large investment bank with a retail arm, how will Mr Osborne classify it?

He goes on to note:

So where banks do want to pay bonuses this year to those senior staff who have earned them, those bonuses should take the form of new equity capital – shares in the business.

This equity capital will strengthen the balance sheet and support new lending. (My emphasis)

Now this bit confused me.

Banks currently have very high ‘leverage ratios’ (broadly put the ratio of assets to equity). This is a problem because it makes banks vulnerable. For example imagine a bank with a leverage ratio of 20x, it has assets of £1,000mn but equity of only £50mn. If 5% of its assets turn bad then it’s equity is wiped out and the bank is insolvent.

Banks are currently (sensibly) trying to reduce these ratios. There are two ways to do that, the first is to reduce assets. This generally means shrinking the amount of loans that they issue and isn’t helpful to the wider economy.

The second way is to increase equity.

So, going back to our fictional bank with assets of £1,000mn and equity of £50mn – if it wants to reduce its equity ratio to 10x it could either cut its assets to £500mn or raise its equity to £100mn. Or some combination of the two (cut assets to £750mn and raise equity to £75mn, for example).

Osborne is arguing that if banks pay their bonuses in shares then not only will this encourage a longer term approach but it will also help reduce leverage ratios 9’strengthen balance sheets’) and mean that assets (loans) don’t have to be reduced so much and so support the economy .

The Tories claim this could free-up up to £20bn which could then be lent to businesses and consumers.

The Tories seem to be implying that their plan cunning reduces leverage whilst alternatives don’t.  Very neat.

Sadly though it’s not quite that straight forward.

Banks can’t just make equity out of thin air. There is a cost. If they could then there would be no banking crisis – the banks could simply issue to their staff (or anyone else for that matter) in return for nothing and claim they were well capitalised (i.e. had a low leverage ratio). New equity (if it’s not retained profits) needs to be paid for. New shares require new money.

Let’s go back to our imaginary bank with assets of £1,000mn and equity of £50mn.  Say that this year it makes  profit of £10mn before bonuses (but after other costs). If it chooses in the extreme to pay all of this out as bonuses (option i) , then the £10mn profit vanishes from the balance sheet (into bank accounts) and the bank still has a leverage  ratio of 20x.  If on the other hand it pays no bonuses (option ii) , than that £10mn profit flows into equity (as retained profits). So equity increases to £60mn and the leverage ratio falls from 20x to 16.7x.

If £10mn was paid entirely as shares (option iii) then the  bank issues £10mn worth of new shares and buys them for its staff. So equity rises to £60mn (thorugh new equity rather than retained profits).

Notice that options (ii) and (iii) have the same effect on leverage ratios.

But that’s not the whole story. Option (iii) involves the issuance of new shares and so we need to consider the concept of dilution.

Let’s make our fictional bank more realistic. Let’s say that it needed bailing out in 2008 and is now 50% owned by the government. Now let’s look at out three options again.

Option (i)

Bank pays out all the £10mn in cash bonuses. Leverage ratio stays at 20x. Government still owns 50%.).

Option (ii)

Bank pays no bonuses at all. Leverage ratio falls to 16.7x. Government still owns 50% of what is now a safer bank -as no new shares are issued and ‘retained profits’ is attributed to the current owners. (Equity increases from £50mn to £60mn, the Government’s share from £25mn to £30mn).

Option (iii)

Banks pays out £10mn to staff as new shares (by issuing new shares, buying them itself and giving them to staff). Leverage ratio falls to 16.7x. The Government, which previously owned £25mn of the £50mn equity, now owns £25mn of £60mn (41.6%) equity in a safer bank.

And this is the real difference between options (ii) and (iii). They both reduce leverage but one rewards staff whilst punishing existing owners (the Government in the case of Lloyds and RBS) whilst other reduces leverage whilst safeguarding owners’ (Government) money.

I lean towards option (ii). Banks need to reduce leverage and i don’t think the Government needs to be diluted to do that. And I’m not alone. Two the financial sectors most successful figures agree with me.

Warren Buffet:

I get paid enormously, and it’s no great credit to me, I was just lucky at birth. It’s nice to give me a fair amount of the benefits from that but I shouldn’t delude myself into thinking that I’m some superior individual because of that.

George Soros:

“Those earnings are not the achievement of risk-takers. These are gifts, hidden gifts, from the government, so I don’t think that those monies should be used to pay bonuses,” the paper quoted him as saying in its Saturday edition. “There’s a resentment which I think is justified.”

The U.S. government committed hundreds of billions of dollars to bailing out financial firms, some of which have since reported surging profits.

Soros said there was a need to regulate payments to employees, even if that meant banks found it difficult to retain talented risk-takers.

“That would push the risk-takers who are good at taking risks out of Goldman Sachs into hedge funds, where they actually belong, because hedge funds take risks with their own capital, not with deposits and not with government guarantees.”

Financial sector professionals are very well paid before we even consider bonuses. Why do we think they need even more? Why should existing owners bear the costs of deleveraging?

US loan defaults worse than Depression (plus gloating)

Lots of developments to cover over the weekend, and I hope to do a response to Osborne’s speech tomorrow.

But, very quickly, I found this most interesting.

…the pace of charge-offs (write-offs on bad debt) for rated US banks now exceeds the early years of the Great Depression. (Chart via the link).

This is clearly deeply worrying news.

Although, on a personal level, I now feel entirely justified in gloating that when I had this debate with Tim Congdon, back in May,  ‘I was right and he was wrong’. (Gloating finished).

GDP

I’m in Brussels today, so no time for a proper update but…

This clearly isn’t good news.

Oct. 23 (Bloomberg) — U.K. gross domestic product unexpectedly dropped in the third quarter as enduring slumps in services, manufacturing and construction kept the economy mired in its longest recession on record. The pound tumbled.

Gross domestic product dropped 0.4 percent from the previous three months, the Office for National Statistics said today in London. Economists predicted a 0.2 percent increase, according to the median of 33 forecasts in a Bloomberg News survey. None forecast a contraction. The economy has now shrunk over six quarters, the most since records began in 1955.

I only question the word ‘unexpected’. If anything the numbers are in line with the Treasury forecasts from thr Budget of growth ‘returning at the end of the year’.

Surely, in light of the above, now is not the time to be discussing cutting back on support for the economy?

Debt & the CPS: Misleading and Wrong

The Centre for policy studies published a pamphlet by Tory MP Brooks Newmark last Friday. It states the public sector debt is far higher than commonly believed (hattop to Commentator Dannyboy for bring this to my attention). (thanks to commentator Dannyboy for mentioning it). It really has rather annoyed me. The results are summarised below:

 

 

 These figures are at best incorrect and at worst seriously misleading. Whilst the ‘official net debt’ figures appear to be correct, every over category is open to question.

Public Pensions

Pensions represent a future, uncertain liability not a current ‘debt’. As Mr Newmark writes:

Estimating public sector pension liabilities is notoriously difficult. Calculations are affected by assumptions on individuals’ pension tenure, their final salaries, the method of indexing pension benefits and the longevity of public sector workers.

 However, the precise size of the liability is, to some extent, theoretical, even nebulous, not least because of the dramatic impact of interest rate changes on the figures.

 Despite this he feels confident to state the rather precise figure of £1,104bn.

Mr Newmark also neglects to mention that there is little agreement in the accounting profession as to how to accurately account for pensions, a problem that affects both the public and private sectors. As PWC have noted:

There are some problems in accounting that refuse to go away. Deferred tax, goodwill and the impact of changing prices have been debated for decades, and accounting for pensions is another subject ripe for debate. The IASB issued a discussion paper in March representing new proposals for significant change in this area.

 PFI

Mr Newmark provides some detail on how the £139bn figure was derived:

According to HM Treasury, the capital value of PFI projects is now £64 billion, with an additional £181 billion of unitary charge payments due until 2047. If the total of £245 billion is discounted to present value (using a 2% growth rate), this is equivalent to £139 billion worth of liabilities that are not included on the balance sheet.

However he makes no mention of why a discount rate of 2% was chosen. Using a rate of 4% radically changes the present value of the liability. Using a 2% discount rate is particularly strange given that the Tories, according to David Cameron, believe that ‘printing money leads to inflation’.  I don’t what the right rate to use, neither, I suspect, does Mr Newmark.

Network Rail

This is simply misleading. Net Work rail is listed as liability worth £22bn. But look at the balance sheet. It has liabilities of £32.9bn (it has other liabilities as well as the debt) but assets worth £40.1bn. It’s net book value is £7.2bn. Last year it made a profit of £0.6bn. This shows the folly of simply looking at one side of the balance sheet.

Bank Bailout

Here Mr Newmark seems quite confused. £130bn is certainly plausible but it’s a guess. (Our stakes in Lloyds and RBS are currently worth £29.9bn). Scanning the report I’m not at all sure of the methodology used to reach that figure, they seem to conflate several issues – looking at the banks’ debt but not assets, guessing what future write downs will be, etc. I think this one remains very difficult to judge.

As Newmark says:

The eventual cost of Government support for the UK economy and banking sector remains uncertain.

The £130bn figure comes from this IMF report.  A report written on March 6^th this year. It notes: 

The medium-term net budgetary cost of financial support operations will depend on the extent to which the assets acquired by government or the central bank will hold their value and can be disinvested without losses, and the potential loss from guarantees.

Since then the markets are up by approximately 50%.  Which should bring down that £130bn figure quite a lot!

If Mr Newmark is so keen on the IMF report, I wonder why he neglects the following table:

A Couple of Things…

Just two quick links today, I’m afraid.

I like the look of this:

Borrowers face a mortgage affordability test from lenders amid plans by the Financial Services Authority (FSA) to step up the regulation of home loans.

Self-certification mortgages will be banned under the proposals with lenders required to verify borrowers’ incomes.

FSA chief executive Hector Sants said that some people who were able to get home loans in the boom would no longer be able to under the proposed rules.

The industry will have until 30 January 2010 to comment on the plans.

The FSA, in its mortgage market review, has outlined a series of proposals for increasing regulation in the mortgage market.

 And I’m amazed that banks have to be told to do it.

Second, a question of ethics. I was reading the Sunday Times Money Section over a pub lunch yesterday and came across this long article on how to ‘beat the 50% rate’. This raises two questions, first how many Sunday Times readers actually earn £150,00 a year? More importantly why do we, as a society, consider it acceptable to publish this sort of advice? How would people react if a tabloid started publishing ‘ maximise your benefits’?

Governments Vs Capital

When lefties talk about a conflict between governments and capital, many people roll their eyes and assume that the speaker is at best doctrinaire and at worst a little crazy…

So I find it interesting when the FT runs an article from a well respected investment strategist (and author of a superb history of Wall Street) on this very topic:

 One consequence of the financial crisis is that fund managers are increasingly going to come into conflict with governments. Actions taken in the best interest of fund managers’ clients are likely to be considered against the national interest. Preserving clients’ capital in the “great recession” is a big enough challenge. But this ignores the much more important structural change that has just occurred.

…

This differs from the environment of the past few decades when investors were happy to save in their own currencies, buy government debt and participate in credit-fuelled domestic asset booms. Will fund manager fiduciaries now be prepared to finance record fiscal deficits? Will they buy domestic assets in an era of sub-par credit growth? And will they buy shares in banks stuffed with government credit and loans aimed at securing employment rather than sound returns?

…

Until 2008, capital colluded in maintaining the myth of prosperity, by providing the credit for excessive consumption. Capital supported the illusion of savings by pumping up equity valuations to ridiculous levels; and it supported the need to speculate, most notably in the housing market, by manufacturing savings that could not be earned. This support ended with a bang, and governments stepped in to prevent the deflation that would have brought poverty all too quickly.

…

Capital controls seem impossible to many, but when a choice has to be made between economic principle and government bankruptcy, they are a likely political response. In 1931, JM Keynes, acting as director of the Independent Investment Trust, refused to sanction a new financing arrangement that effectively involved shorting sterling. According to his biographer Robert Skidelsky, this reluctance was due to public interest considerations rather than the shareholders’ interests. Within the month sterling had left the gold standard and the Trust had missed out on a profit of £2 million (in today’s money). A hedge fund manager with such priorities today would risk major fund outflows and perhaps a civil action. In the West’s long boom, capital and the public interest were largely aligned. That alignment ended in 2008; now, conflict between government and capital is the future of investment. (My emphasis).

A Strange World

We live in strange economic times. Yesterday I wrote a post in which I essentially advocated the Central Bank printing money and giving it to a National Investment Corporation which would then use that money to support investment and economic rebalancing. If I’d advocated that just a year ago people would probably assume I was crazy.

But we live in a world where the Government runs a 12% of GDP deficit, where major banks have been de facto nationalised, where just one year ago the major banks came within hours of failure, where central banks print money, where interest rates have been slashed to zero across the globe. We came so incredibly close to depression – and a depression caused by a breakdown of the financial system, that what once seemed crazy is now accepted.

We live in a world where Samuel Brittan can write articles like this one in the FT: 

Recovery depends on a rediscovery of investment opportunities – “animal spirits” if you really must – reduced attempted savings or injection of demand by governments or central banks. China is not going to save less because of western lectures, which would be better directed to the political tyranny in that country. Until western consumers have reduced their indebtedness to reasonable proportions, demand must be supported by the monetary injections and budget deficits now in place, and possibly more of them. Thus the IMF is right to warn against premature withdrawal of these stimuli. British Tory Bourbons who want a draconian belt-tightening policy either have not read these warnings or think they know better.

Please note that I have got so far without once mentioning banks other than central banks. Commercial banks certainly worsened the recession by greedily seeking higher returns than those provided by market interest rates; and they can put grit in the recovery by refusing to lend. I can only suggest making Paul Krugman, the radical Keynesian economist, Comptroller of the US Currency with over-reaching powers to take over old banks and initiate new ones, with similar appointments in other countries.

The world we live in is one familiar to Keynes. The sensible commentators recognise this.